Monday, May 26, 2008

Oil Price "Head Fake"?

Late post today as I've just returned from vacation--I try to get new posts out early Monday mornings, but at least it's still Monday...

Oil prices have certainly been in the news lately, and I've written here and elsewhere that the concept of Peak Oil has "tipped" in the mainstream media and in the markets. Many people still think that oil prices are just a bubble. Others think that the recent run-up in oil prices are just due to the declining dollar (apparently they haven't viewed a chart of oil price superimposed over the Dollar:Euro price chart lately, as that clearly can't explain the last few weeks' dramatic run-up). Others think it's all evil speculators--I won't repeat what I've said before about why that opinion does little but demonstrate a fundamental misunderstanding of the oil markets. But increasingly people are waking up to the reality that this is simply an issue of geologically and geopolitically constrained supply and rising demand. Over the long-run, we'll either develop a new substitute for oil and/or we'll reduce our demand for oil. Unless some new miracle technology (or miracle cohesive political will) moves us consciously away from oil, or unless the global economy collapses for reasons other than energy, then over the long-run these substitutes or this demand reduction will be a result of prices rising to significantly higher than they are now. The questions, to me, is whether this price rise will be relatively smooth or whether it will come in waves with serious retracements.

In other words, will oil prices make a "head fake," and decline significantly for a few years as current high prices cause a global recession, only to prevent us from mitigating the near-term onset of production declines causing truly dramatic price increases 5-10 years down the road? Charles Hugh Smith seems to think so.

Here's Smith's graphic depicting a potential "head fake" in oil prices.

Let's consider the potential for such a "head fake" more closely:

Taken in isolation, I don't see how increased oil prices cause destruction in demand sufficient to cause prices to decline, but rather only enough to prevent or slow additional price increases. The exception to this is the time-delay inherent in demand destruction. If oil prices now make everyone choose a more fuel-efficient car when they buy their next car, then current prices will cause a reduction in demand that continues over several years as we roll-over our auto fleet. Similarly, it may take oil prices staying at current levels before people are adequately convinced that they'll remain high, and therefore incorporate these prices into their decision making. That's a reasonable enough argument, but absent this time delay, I don't see how oil prices alone can cause a massive collapse in demand that isn't already present at current price levels. I do see how we could reach a wall where it would be difficult for prices to rise further because any increase is met immediately with a demand response, but that doesn't seem like a possible cause for a significant price decline--a "head fake." Why would $5 gas suddenly cause people to radically cut consumption any more than $4 gas did? I think there's a generalized perception that at some point there will be a demand response to high prices, but I think the common fallacy is assuming that this response will be digital, that at some magic number everyone will sit up and take action. Rather, demand response to high prices is extremely graduated, with a little bit happening at every rise in demand. Sure, some psychological barriers (e.g. $5 gas) may have a bit of an extra kick, but in general price increases won't cause a decrease in demand sufficient to significantly lower price. It just isn't logical--why would $4 gas cause prices to drop to $3, when people were apparently willing to consume enough gas at $3.50/gallon to sustain that price level? It's difficult to account for the time-lag issue, but I don't think that there's such a large time-lag waiting to unfold to actually decrease prices significantly.

The "head fake" scenario proposed by Smith IS, however, possible if increased oil prices merely act as a catalyst to set off a larger economic chain reaction that, in turn, destroys far more demand than the catalyst alone can account for. This is similar to what happened with the recent credit crunch--mispricing of risk in one area cause an entire risk-pricing industry to suddenly clam up, over-correct, and over-price risk for a brief period. This same thing could happen if gas prices caused a general recession that led to people postponing capital investments and other economic activity until the recession had ended--a sort of chicken and egg problem. While I do think that gas prices alone can cause economic hardship, any recession caused by high gasoline prices seems to be only a problem of the global economy evolving to a new reality, not to an inability to maintain current levels of economic growth. If $500 Billion a year is going to the Middle East, and they are in turn spending it on luxury products, then the global economy must re-tool and re-orient to produce luxury goods for Middle Eastern sheiks rather than Fords for Ohio factory workers. That might be a painful transition, but it doesn't necessarily reflect either a decrease in economic activity OR a decrease in energy consumption, just a shift in where and how it takes place. It is important to differentiate a recession caused by the market's inability to quickly re-tool for a new economic environment due to high oil prices and the very different even of a recession due to an actual decrease in economic production due to a decline in oil production (and, possibly, also total energy available to the economy). This latter event--something that I think is still a few years away--could cause a very serious recession. The former--just high prices due to tight supply/demand issues--should only cause a re-focusing, which might be painful for some, and painful in general in the short-run, but may actually be beneficial in the long-run because it could allocate energy to higher value-added tasks than in the present. I'm not sure that the more minor recession caused by mere high oil prices would be enough to cause a "head fake" in prices, but I think it is a distinct possibility due to issues of market psychology.

One think does seem certain--if we accept the assumption that oil prices will rise over the long-term, then a steady rate of increase with minimal volatility will best facilitate adaptation to a lower-energy, costlier-energy world. The "head fake" that Smith writes about is potentially very dangerous because it could cast new doubts over the very notion of Peak Oil at exactly the time when the world must address the problem with great urgency. A "head fake" would breathe new life into the abiotic oil crowd, the "markets will always provide" crowd, the Super-Hummer crowd, etc. Because I think that there is a significant possibility of a "head fake" due to market psychology (or, possibly, due to a short-term increase in supplies if the megaproject and geopolitics stars all align over the next 24 months or so), I think that our outlook and investing in the energy sector needs to incorporate a fairly long-term time horizon. I don't think that $200 oil is a sure thing this year or next (though I think it's a strong possibility). But oil under $200/barrel in 2016 seems highly, highly unlikely absent a general economic collapse (and, in that even, we have equally big problems to deal with).

Hat tip to FutureJacked.


Anonymous said...

People who used to buy gasoline at $3.50 and who pull back at $4.50 may just have run out of fuel in their money tank. People tend to run their economic lives straight off the edge of a cliff. Out of work people in bankruptcy can make remarkable cutbacks in their energy use. When you're broke $3.50 is just as unreachable as $4.50.

Much ASCII has been promulgated about the US now being a service economy and, as such, less susceptible to major job losses during a recession. We shall see about that. I suspect that employers will be slower to fire and also slower to rehire than Ford and GM during the halcyon days of Detroit. This recession shall be more like trench warfare - slow, ugly and gruelling.

I'm betting on oil dropping to about a hundred bucks in the near future. Refinery crack spreads are very low and that has to mean that the end users of gas and diesel are cutting back. The refineries continue to buy and process product but can't raise prices enough to make a decent profit. That, to me, is a giveaway that prices have gotten ahead of themselves. Once prices start declining the speculators who have bid up the far forward contracts out of backwardation into contango will dump their positions and force the forward spot prices back down. This could easily cause an exit of the hot money with an ensuing drop of twenty or more dollars a barrel.

If the hot money leaves it will be very interesting to see if the normal hedge buyers of future contracts will step in to hold the prices up. Or will they bide their time in hopes of getting an even better deal in a month or two?

Currently the forward prices are higher than spot. The airlines claim that today's price makes them unprofitable. It's hard to believe they will snap up futures until they drop enough to fit their economic model.

In an inelastic market a speculator can bid up a price without causing any significant increase in storage. If I bid up the price of something you absolutely have to have and that you can't store on your property - gasoline - then you'll pull out your wallet and pay me the ransom. That's the deceptive truth of inelasticity. You need the gasoline to get to work and back. So you buy it even though it's twice as expensive as last year.

It's hard to believe the Saudis aren't smiling all the way to the bank.

And, of course, the fact is that a barrel of oil is only eighty Euros. High but still only two Euros a gallon (to mix metaphors). When we talk about Europeans paying eight dollars a gallon it's important to realize they aren't paying that at all. They are paying in Euros and they are earning their money in Euros. That makes fuel a lot cheaper for them than it seems when we translate the Euro price into dollars. It's still higher than we pay but not as much as it seems.

Antoinetta III said...

"If I bid up the price of something you absolutely have to have and that you can't store on your property - gasoline - then you'll pull out your wallet and pay me the ransom." Posted by Anonymous

Not if your wallet doesn't have enough money in it to pay the price of the ransom.


I also notice that the Head Fake graph in the article indicates that they feel that the exporters will increase their production to try to maintain cash inflow. I don't think this will happen; if the price looks like it is going to stay below $100 per barrel for more than a month or so, Saudi Arabia and the others will decide to save a few more barrels for future generations, and cut production to keep prices at what they consider a satisfactory level. I mean, if you were King Abdullah, would you rather export 8 million barrels a day at $50 per barrel, or 4 million at $100 barrel. Same cash flow but you are depleting your finite resource at only half the rate.

Saudi Arabia may no longer be a "swing producer" in the sense that they can flood the market with crude and bring the price down, but they can still "swing" the other way, reducing production to maintain price.

Antoinetta III

Rice Farmer said...

Certainly a temporary price drop is possible, I think. But it's hard to choose between scenarios on how prices would go and how oil producers would react. As usual, we have lots of variables to deal with.

Let's say there's a severe global recession (Second Great Depression?), which is certainly very possible. Demand plummets, and so does crude price. If I were an oil producer, I would try to choose a price level that cash-strapped economies can still afford, but which also gives me the maximum possible revenues. If the world economy comes to a complete standstill, I have no revenue. Bad scene. So I have an interest in lowering my price enough to keep the world economy at least limping along.

But other problems creep in. For example, costs of production are getting steadily higher. What if my "reasonable" price level doesn't allow me to reinvest enough in oil field development?

Etc. So I see no elegant way out of this, unless it's alien technology or something like that.

Jennie said...

This is my first time to your blog, I got here from Aaron Newton's "Powering Down" blog.
I have a small question, why only the one "head fake"? I mean, I understand only the first price dip would coincide with the head of production, but wouldn't there be other price ripples? What's to stop the price from roller coasting up and down after the head fake?
Economics are not my strong suit, so if this is a silly question, I apologize. :-D
Very interesting writing, I'll be back next week to read the next installment.

Anonymous said...

I've been following energy for many years. I read this figure, that figure and a whole lot of opinions. This I know. Last couple of weeks, I've spent some time on the local interstate running my motorcycle at 60. I catch no one. However, I am passed by lots and, in spite of all the whining, semi's pass me at a good clip. So I tend to trust what I see rather than what I read, particularly, if it's from the government or any other organization with an agenda. I'm taking a long road trip in a couple of weeks. That will tell me a lot.

Jeff Vail said...


I don't think there need be only one "head fake," or "retracement" to use the more accepted lingo. I think, actually, that you're exactly right--there will be many moves up and down of varying sizes, each corresponding with different developments in supply/demand, market psychology, etc. I do think that the oil markets will continue to exhibit fractal price movement, as most markets do--that is, self-similarity across scale, so you'll see many of the same looking features over a day, a month, several years (but, if you put much stake in Benoit Mandelbrot's work on finance as I do, then these aren't "intelligent" like some Fibonacci-series theory, but rather deceptively un-intelligent movement). What I do think is likely is that, on a large scale, there could be a significant retracement that can, after-the-fact, be attributed to a "head fake" notion as Smith suggests. It's always easy to explain a price movement after the fact, but we tend to confuse correlation and causation when we describe the past. I don't think that we really "know" why prices moved in the past, and I certainly don't think we "know" why they'll move in the future, but it's never dull trying to figure it out!

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Anonymous said...

"Unless some new miracle technology (or miracle cohesive political will) moves us consciously away from oil..."

In fact we have a lot of miracles in our sleeves. The problem is ROI.
For example, new cold climate heat pumps with seasonal COP of 3.0 (means it's in average produces 3 BTU of heat for each BTU of electricity) burns electricity at approximately $2/gallon equivalent. But with 10-15k installation price tag it would take forever to cover the cost (unless oil stays at above 140, of course).
The same story holds massive sales introductions of hybrid cars. And the same consideration may harm sales of future serial hybrids and PHEVs.
But we obviously have tricks that limit possible top oil price.
Say, if diesel hits around $5.5/G it will be cheaper just to burn electricity for residential heat and modern heat pump pays itself in 4 years. Extra 5k for hybrid suddenly pays out in 2-3 years and for many people it may be cheaper to dump their old gas guzzler right now...
So where is that critical ceiling? My guess would be not higher than $5/G for gasoline or somewhere around $160-180/bbl

Anonymous said...

Hi Jeff,

I think the current dip in oil price is more to due the expectation of oil use reduction, rather than actual reduction.
I think that with these price drops in the futures markets, oil use may not drop as much as the traders expect.

Ian from the UK, where gas is $8 a gallon and I ride a bike!

Anonymous said...

"... pay a random"

Responded with:

"Not if your wallet doesn't have enough money in it to pay the price of the ransom."

And I would respond, you wont pay a random, you will pay zero - you wont use it. Which is fitting because it isn't even available for you to use anyways.

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