Tuesday, May 10, 2011

The Price of Oil Drops

Between Wednesday and Thursday of last week, the price of oil dropped precipitously. WTI spot prices dropped below $100 a barrel from a high of close to $115, though it's now again above $100. This is a pretty darned huge drop. It came pretty close on the heels of Osama bin Laden's death, too.

To me this suggests that the price rises in oil over the past couple of months have been largely speculation driven, though not necessarily for the reasons you may think. It's certainly not demand or supply driven. Supplies in Libya may have contracted, but they provided maybe 2% of world supply. It's pretty much certain that the price elasticity of supply for crude isn't that extreme. Though Libya does provide a significantly larger amount of the world's remaining light sweet crude (i.e., the good stuff), on a macro scale enough refineries are configured to run heavy sour crude nowadays that it shouldn't have affected supply overmuch anywhere except Italy, where the hapless refineries are configured to accept high-quality deliveries from Ras Lanuf. It also wasn't demand. While China has continued growing at a blazing rate, it is difficult to believe that global demand grew enough to increase prices 15% over the course of 2 months. That's a pretty derpy suggestion, in fact; spikes like that are only seen during some pretty extreme cases, like wartime.

So what we have is, I think, pretty clearly a short-term, speculative increase in the price of oil. It's pretty obvious that there were distinct triggering and ending events - rebellion in Libya and assassination of bin Laden, respectively. That doesn't necessarily mean that each phase was sustained by the triggers, however. I think there were other structural factors keeping the speculative capital in the market.

Econbrowser had some interesting analysis on the subject (http://www.econbrowser.com/archives/2011/05/lower_oil_price.html). Broadly, I'd agree with the conclusion that the precipitous price drop is also a function of the fact that after almost stagnating production for the past couple of years, supply is starting to exceed demand, albeit just a little bit. This is starting to impact inventories, driving the price down.

Obviously I don't have enough experience to know what the phase lag in between sustainably higher oil prices and supply increases ought to be, but a gap between world supply and world demand has been ridiculously high from 2001-2008. It follows from my perspective, at least, that supply is only now responding to higher price signals and driving the prices down because of one of two reasons. The first might be the lack of skilled drillers and drilling equipment, or other exogenous supply bottleneck. The second is that it's just getting harder to find enough oil to sustain production. I think both apply. It's important to note that the first bit is a problem that's been around for a while, but that it's gotten more severe as larger oil finds have been rarer and rarer.

As an aside, I went ahead and checked on something else. Unsurprisingly for me, it seems that the Brent-WTI price differential hasn't changed. The structural factors that are keeping buyers at Brent trading at higher prices than in Cushing haven't changed, and aren't likely to. Oh, the joys of a landlocked oil port with too much supply coming from Canada.

I was also thinking of talking about other oil supply trends here, but that might have to wait because I'm going to work on my thesis now.

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