On Odalisques and Obelisks (e.g. Bartiromo & Yergin)

Alternate Title: It’s the Demand Inelasticity, Stupid.

Oil prices again. Tapis (Malaysian Crude) just broke $100 a barrel and West Texas Intermediate breached $98 briefly in after hours trading. I can already hear tomorrow’s cries from the pundits and purveyors of financial “news” that the fundamentals don’t support these prices.

Huh?

Let me back up and explain what’s happening here. We have a generation of financiers who were trained in a very specific methodology to analyze stocks. They are now applying that reality tunnel of how stocks behave to deliverable commodities, and in the process are making a huge error. This error culminates in their thinking that speculators and geopolitical threats are artificially inflating the price of oil beyond what the “fundamentals” support as if that’s possible. Here’s the problem: oil futures are deliverable. Every owner of a future contract on the NYMEX can hold that contract to expiration and actually take delivery of 1000 barrels of oil at Cushing, Oklahoma. Admittedly, most contracts will be settled for cash and won’t result in actual delivery, but their value can’t depart from the actual value of delivered crude because, if it did, one party would simply take delivery and collect the difference. So there you have it: the price of oil, as a deliverable commodity, isn’t subject to a speculative bubble like stocks are. The price of oil will always equal that which the end consumers of oil will pay for oil-derived products. If speculators bid the price of a futures contract to $100 when end consumers are only willing to pay, on average, $50 equivalent per barrel for oil-derived consumables, one of two things happens: consumption declines (this is called demand destruction); or someone is taking a bath to the tune of hundreds of billions of dollars settling his expiring contracts because no one is willing to pay $100 at delivery. Neither is happening. Why? Because we are willing to pay $3.00 a gallon for gasoline without reducing our consumption.

It’s like the house near me that has a big “For Sale” sign with a banner saying “Priced Below Market!” No, actually the definition of price is the value at which a buyer and seller come together to affect a transaction—that’s the “market” price. Similarly, the fundamentals support $100 oil because society is happily filling their gas tanks at that price. The issue isn’t geopolitics or speculation, it’s pure inelasticity of demand. Speculator’s can’t drive prices up on a deliverable commodity without highly inelastic demand. Geopolitics can’t create a “threat premium” without highly inelastic demand (setting aside for the moment the issue that we wouldn’t be trying to get oil from Iraq or Nigeria at all if there was plenty of geologically “easy” oil to find elsewhere—e.g. we’re at Peak Oil). So the pertinent question isn’t “what price do the fundamentals support?” because the answer to that is the easy: the market price. The pertinent question IS this: what does the demand inelasticity curve look like going forward? Will we cut back on our consumption at $4 gasoline? $5? They’re already paying close to $10 in parts of Europe. How high will oil have to get before you sell your suburban home to move to a location closer to jobs? Oh, right, you can’t sell your home right now—at least not for as much as your interest only mortgage pay off. How high will oil have to get before you *gasp* car pool? That’s downright un-American, so I’m told. Personally, all things accounted for, gasoline would have to cost $20 a gallon before it would be a financial break-even to use the light rail station (right by my house) to get to work (at the cost of an extra half-hour each way, assuming that I can bill 50% of my time on light rail and 0% of my time driving) than to drive. That doesn’t bode well for demand destruction. We, as a nation, have calcified our demand for oil through our massive, and largely not unloadable (due to refinanced mortgages at or above the actual present values of our homes) commitment to suburbia. We won’t significantly curtail our driving until it is so costly to continue driving that it is worth losing our perceived life “savings” and either sell our house at a fire sale or declare bankruptcy to get out from under our mortgage obligations (assuming this remains possible for much longer). Christ, I’m sounding like James Howard Kunstler today. Then again, doom and gloom is only a bad thing when it’s wrong.