I am currently seeking feedback on the following argument (meaning that it seems intuitively valid to me, but I am not convinced of its completeness or actual correctness—I’m looking for loopholes and problems. I would love to hear if you disagree with me and why):
It is commonly reported that a large portion of the price of a barrel of oil—especially a large portion of the recent run up in oil prices—is actually a speculative premium driven by fears of geo-political events. While possible future events such as war with Iran, major terrorist attack on oil infrastructure in Saudi Arabia, or escalation of violence in Nigeria could create a very real supply disruption that would justify such a premium, there is a limitation on how far and how long such speculative premium can elevate prices above the equilibrium point of current supply and demand. Oil is not subject to the same kind of wildly speculative forces that can drive, say, a bubble in technology stocks because, at the end of the day, an actual and fixed commodity is subject to delivery. While economics is not especially well adapted to mathematical proofs, what follows is an attempt at an “economic proof” that the risk-premium is in fact a negligible component of current oil prices:
- Oil producers are currently pumping oil out of the ground at the maximum possible rate—there is, for the sake of this proof, NO economically meaningful spare capacity for light, sweet crude oil
- When oil is pumped out of the ground, a producer has two economically viable choices: deliver the oil for sale to a consumer or store it to deliver for sale to a consumer at a later date. Regardless of who actually stores the oil (producer, middle man, storage of refined products, etc.), oil (and its derivative products) must be either consumed or stored.
- There is a limited global storage capacity for oil (and its derivatives), and storage costs are themselves a commodity with the price for storage increasing with demand over the short-term.
- The spot price of oil cannot incorporate any risk premium IF it there is no alternative option available to store that oil or to store any of the refined products of that oil. In a world without storage capacity—where oil must be consumed at the rate at which it is produced—concern about the availability of future supply cannot factor in to the price equilibrium between current supply and current demand.
- In a world WITH the ability to store oil (and associated refined products), the price of that storage (the equilibrium of demand for storage and supply of storage capacity) correlates directly with the price-premium in the market due to fear that future supply will decrease. Put otherwise, if fears of a geo-political supply disruption increase, then the incentive to store oil today to take advantage of the future higher price of oil also increases, creating increased demand for oil storage facilities, which is reflected in higher oil storage rates.
- Crude oil tanker fleets are a capital asset that are most efficiently utilized when they are in continuous operation at maximum capacity—meaning that if oil is to be stored, it makes the most economic sense to store it at the consuming nation, keeping your tanker fleet in optimal utilization.
- National, strategic crude oil storage facilities (Such as the Strategic Petroleum Reserve or the rumored Saudi “tank farms”) are designed to address strategic concerns and are not responsive to market influences. Therefore, they do not themselves significantly influence the market dynamic of risk-premium and price of oil storage.
- There is very high elasticity of supply of oil storage facilities over the medium term (the term required to build an oil storage tank). If people are willing to pay a lot for storage of oil at existing facilities because there is a shortage, it is relatively easy to build more storage tanks. This high elasticity of supply means that, over time, a significant terror premium will not increase the price of oil storage, but will rather increase the demand equilibrium point—it will lead to the construction of more oil storage facilities, the supply and demand for oil storage will return to an equilibrium price roughly equal to what it was before the demand for oil storage jumped, and there will be more oil in storage.
- In other words, a risk-premium will drive increasing oil inventories. It doesn’t matter how tight supply is, if it is more profitable to sell oil for delivery at a future date than it is to sell it for present consumption (NOT merely sell it now), then oil inventories will increase as oil is stored for future delivery. It is actually this oil that is unavailable for current consumption because it is more profitable to store it that decreases de-facto supply and creates a higher price equilibrium—what is commonly called the “risk-premium” or “terror-premium.”
- An increasing risk premium will, then, lead to an increase in the amount of oil stored at ever-expanding storage facilities in consuming nations such as the
- This is not happening—in fact, inventories have remained relatively steady (perhaps declining slightly, and with seasonal variations) in the
Who cares if there is or is not a “risk-premium”?? The risk-premium concept is, in my opinion, the convenient smoke-screen used to prevent discussion of the real issue: this is a supply and demand driven problem, and we are rapidly approaching or passing peak oil. Sure, geo-political events may make traders jumpy as they unfold, but it is my opinion that any price increase “on nerves” is quickly checked by the fundamental supply/demand picture. In this way, geo-political events act like a lubricant, but are not a prime mover themselves: they provide random inputs (and, psychologically, easily justifiable inputs in the minds of traders) to the markets, but a geo-political spike (or dip) will quickly bounce back to prior supply/demand equilibrium if it was not supported by some behind-the-scenes, supply/demand pressure in the corresponding direction.