Tuesday, November 06, 2007

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.

16 comments:

Anonymous said...

LOLOLOL! Definitely in the Kunstler vein today. But at least you're spot on!

Tom Konrad said...

Don't forget about the stupid supply inelasticity.

I was just reading an article by Geffrey Colvin in the most recent Fortune, which attributes the high oil price solely to robust demand... and predicts a fall from the "current" high 80s per barrel (he was talking to an analyst from CERA- duh) The thing the CREA analyst missed was supply inelasticity... blithly assuming that high oil prices will provide an incentive for new supply. Economics may say that will happen, but the laws of Economics must bend to the laws of geology.

Jeff Vail said...

Good point on supply inelasticity. I'm of the view that prices will be high enough to make supply purely a geologically constrained figure. Very soon, every bit of oil (and most other energies) that can be reached for a positive EROEI will, due to skyrocketing prices, also be reachable at a profit, and therefore will reach the market. For liquids, I think we will see overall decline in the very, very near term as the rate of decline in crude, NGL, and lease condensate totals overtake the much more modest increases in biofuels.

Big Gav said...

I think everyone sounds like Kunstler today - I couldn't find a single piece of good news for my post last night, and I was looking for it.

I'm not so sure about demand inelasticity though.

IIRC, Australian oil demand dropped 5% last year due to high prices (even with the economy expanding fairly rapidly).

Surely there are some ways people can reduce demand, even in a suburbia dominated landscape - renters can move closer to work, home owners can sell and buy somewhere closer to work, businesses can relocate closer to public transport hubs (in cities where they exist), people can buy more fuel efficient cars etc

I think the US may be an anomaly thus far simply because your fuel prices are so much lower than elsewhere - they have to rise a lot before people feel any noticeable pain.

Tom Konrad said...

Gav- the thing about demand elesticity is that it's not one number... demand tends to be elastic in the long term (as people replace cars and switch transport modes) but very inelastic in the short term, since it is very hard to change habits and vehicles are around for a long time. It takes a while to get a good carpool going... it's not something that you do by just calling up a coworker at 6pm one evening.

casey said...

you're analogy of market prices is perfect.
price is not a "value' it is merely the equilibrium point represeting the maximum a buyer will pay and the minimum a seller will accept. until there is offer and acceptance there is no "price"
anyway keep up the good work

kwark said...

When OPEC closed their valves during the 70's there were places (where I lived for instance) where the pumps simply ran dry - for a day or two at a time. I recall hearing the attendant saying "well, we're SUPPOSED to get another load tomorrow." Supply uncertainty of that sort didn't last long enough to generate a black market but if one had existed I'm sure some folks would've paid $5/gallon back then! Seems like we face the potential for a similar situation, if geologically-induced this time rather than political. I wonder if supply uncertainty will bring about a change of behavior as much as the absolute price.

dearieme said...

Buy a bike. Buy a spare bike. Buy a house on a bus route. Then pray.

Anonymous said...

One of your best posts! I still think that gasoline is underpriced relative to the level of productivity it gives us, therefore consumers will continue to complain about the high prices and then proceed to fill up the car and drive to work.

C @ UF

Sal said...

Looking at the price of gold and the dollar to euro exchange rate, this last run up in oil from the $70's price range appears to be entirely the result of a plunging dollar. Europe is still paying $70 a barrel as far as they are concerned. This would indicate that there was no shift in oil supply/demand so much as the was in the supply/demand of the dollar.

Jeff Vail said...

The degree of ignorance being voiced on this topic by some people is astounding:

http://gristmill.grist.org/story/2007/11/14/19748/699/

Joel said...

Jeff--Great blog.

Regarding demand elasticity, I believe the price of gasoline would have to go *much* higher before people will conserve.

I drive a 12-year-old Audi with 200,000 miles. It only gets about 17-18 MPG and I would like buy something more fuel-efficient...my next car will definitely get at least twice the mileage. However, the Audi is paid-for, registration fees are cheap, and I only carry liability insurance.

At 15,000 miles per year, I figure gas would have to go to about $8 before the fuel savings and reduced maintenance/repairs of a new vehicle would cover my car payment, as well as increased insurance and registration expense.

I rationalize that keeping my current car saves the resources required to build and deliver a new one (and dispose of the one I already have). I would like to do the right thing but am currently unwilling to incur a greater expense while my neighbors continue buying gas-hogs subsidized by low fuel costs.

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mememonkey said...

Your analysis is all fine and good, but I'm still reeling from the revelation that the virgin Mary on my toast is merely happenstance. Now my well laid plans for a mueseum/shrine are toast.

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