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Oil prices below 40 dollars per barrel

by Luis de Sousa Mon Dec 15th, 2008 at 04:22:14 AM EST

Oil prices under fourty dollars per barrel? It can't be true.

Yes it is true, oil prices are back to where they were more than four years ago. Time for a few thoughts on these past years and what led to apparently dissonant energy prices.

promoted by afew


Updated in 14-12-2008 to put a loose paragraph back in its place. Thanks to Migeru for cleaning the formating mess.

Back in July no one that I am aware of was forecasting a 100$ drop in oil prices during the following six months. Even Daniel Yergin, the Nemesis of modern day Peak Oil study, was at the time predicting higher prices. Back then a friend told me to go short on oil, because all price forecasts by CERA are wrong. Were I a trader I would have probably followed that advice, but could never imagine what was to come.

One of my first dives into the Peak Oil world was with Kenneth Deffeyes' book Beyond Oil. In it the Princeton Professor explains how resources' prices go through chaotic periods in face of scarce supply. Without knowing it, he derived an expression to explain movements like spot Natural Gas prices in the US after 2002, that was equivalent to the Queueing Theory. This made immediate sense to me, after studying this theory in my formative years at the University.

Let me try to explain in brief words what this theory is. Imagine a supermarket with a certain number of points-of-sale (POS), to which a certain number of costumers arrives per hour. The Queueing Theory allows one to derive information like the average queue length at each POS and the average waiting time each costumer spends in the queue. This information is not only useful for supermarket managers but also in other fields like transport and tele-communications.

The Queueing Theory shows also another important thing: if the load on the system goes above a certain threshold it becomes impossible to predict queue lengths or waiting times, the system goes into chaos. Going back to the supermarket, imagine that for some reason the flow of costumers increases severalfold over its normal rhythm (e.g. Black Friday in the US). At first, lengthy queues form at each POS, waiting periods then go beyond costumers' patience and they simply start quitting the queue and leaving the supermarket without shopping. The dissatisfaction is such that costumers quit entering the supermarket altogether and the manager is eventually forced to close down some POS. But this is Black Friday, the avalanche of costumers eventually returns and it starts all over again. During this chaotic period a random sample of queue length at any given POS can result in any possible number and becomes effectively impossible to predict.

Substituting costumers by oil importers, POS by oil exporters and queue length by oil prices we have the international oil market.

This chaotic outcome to commodities prices in face of scarce supply was studied by Ugo Bardi, who found interesting examples of it in the past. I first got to know his work soon after I read Kenneth Deffeyes' book and was especially impressed with the pattern Ugo identified in whale oil prices after the peak in sperm whale catches in 1850. The Whaling Industry was possibly the largest of its time, at a global scale that in many ways can be compared with the modern day Oil Industry. To me a most fascinating aspect about Peak Whale Oil is that in the book Moby Dick, published right about that time, Herman Melville lays down quite clearly the reasons for a coming decline of the Industry: in his view Easy Sperm Whale was over.

With all this information I became convinced an increased volatility in oil prices would unfold, eventually leading to a series of "boom and bust" cycles, just like whale oil prices in the XIX century. Predictions of oil prices would become impossible, and I never attempted to do so.

Another important aspect to my understanding of this issue was presented by Carlos Cramez and Jean Laherrère in 2006 at the seminar that kicked off ASPO-Portugal. They showed a chart with oil prices as the number of working hours in the US and France and concluded that to return to 1980's levels, the last oil crisis, prices would have to reach something like 125$ per barrel (in 2006 dollars). This number stuck to my mind, and I assumed this would be about the level at which the "boom" would turn around into "bust".

Oil prices as a function of working hours by the French minimum wage. For 2008 the oil price is taken as the July peak.

Jean updated this graph recently and was kind enough to mail it to me, showing that by July these hurt levels were again very close. As oil prices fell after that, they did so in dollar terms, but not so much against the euro, thus the 2008 barrel price in working hours will be below the 1979 - 1985 period but will likely surpass the 1974 - 1978 period.

My mental model of oil prices evolving with scarce supply and expanding monetary mass.

Finally there was another piece to add to this puzzle: paper currency supply has been growing at two digits percentage-wise every year. So these fluctuations would possibly occur within a band of ever higher numbers but without never surpassing the 1980s record oil price in ters of working hours. Following is a graphic rendition of this mental model for the long term evolution of oil prices.

Back in July with prices nighing on 150$ I was getting concerned that either my mental model was rubbish or that the fist turn was now overdue. I had the opportunity to write at that time that oil prices had become unbearable to many people in developed countries, protesters were dying in picket lines and less scrupulous people started stealing diesel from their neighbours. Something had to break and something broke.

But I would expect something more in the line with the price turn that took place in the second half of 2006 and could never imagine so much in such a short time: more than 100$ in six months.

As anyone know, oil prices are in fact being pulled down by the Credit Freeze. It is perhaps worth to take a look back to the events that lead here, in which Oil played an important role:

  • 1999: Glass-Steagall Act is fully repealed;

  • 2001: September the 11th, NATO goes to war;

  • 2002: Interest rates are now at historic lows, monetary mass starts expanding fast to finance the war (eventually reaching as low as 1% in the US);

  • 2003: Half of NATO invades Iraq;

  • 2004: OPEC's spare capacity dries up;

  • 2005: Oil prices go above 60$, interest rates are inverted towards ascent;

  • 2006: US interest rates reach 5.25%; households are confronted with increasing daily prices and increasing mortgages simultaneously;

  • 2007: The US housing market bubble pops;

  • 2008: Bear Stearns and the Lehman Brothers collapse, panic leads to a halt of the fractional reserve system, Central Banks are effectively unable to put their monetary policy at work;

Interest rates set by the European Central Bank, the US Federal Reserve and the Bank of England.

The most important thing to take home here is that the Fed started the rate hike in 2004/2005 because it misunderstood the oil price rise as a consequence of its ill monetary policy. But instead crude oil production had reach a plateau that remained up to the second half of 2008. In fact the underlying physical economy stopped growing soon after the invasion of Iraq.

With this interest rate hike, millions of American families slowly became unable to honour their debt compromises, squeezed between mortgages and consumer prices, both rising. This lead to a sharp decline in home prices (demand collapsed, supply sky-rocketed) that were the physical collateral for much of the paper currency created during the low interest rates years. Losing this collateral Banks had to devalue or even write off asset after asset in their balance sheets. These problems started to affect an increasing number of banks and financial institutions to the point of breaking trust among them. The rest is history.

In Europe events unfolded in similar ways, although the interest rate swings were of smaller magnitude. Here the rate set by the ECB never dipped below 2% and never went above 4.25%. The problem was that many European banks had acquired financial instruments backed by assets in the US housing market; within days of the spectacular collapse of Lehman Brothers several institutions here started showing serious difficulties. In spite of the reversal in monetary policy by the ECB the inter-banking lending rate, Euribor, was perilously going up, menacing to squeeze households.

Governments are scrambling to invert the Credit Freeze and get their economies back on track. Luckily the ease seems to be coming first to Europe: the action by the ECB rapidly reducing interest rates and by state governments in providing credit and guarantees to ailing banks (or in some cases simply nationalizing them) has apparently restored confidence, as the collapsing Euribor rates show. Households in Europe are now facing declining consumer prices, with the fall in commodities' prices, and declining mortgages. This will bring some ease to European families and eventually pave the way for a turn around in Demand and avoid a serious expansion of unemployment. A major difficulty remaining is that an economic turn in Europe also depends on a turn in aggregate Demand of its main trading partners - especially the US.

In the US things are not as simple, not only the interest rates swings were much wider, but more important, the crisis is coinciding with the incipient period of transition between two governments (from two different parties). Interest rates have been brought down to the floor again and consumer prices are falling (also a consequence of a turn of the dollar exchange rates with other major paper currencies) but it came too late to avoid unemployment expanding. Restoring the confidence in the banking market seems a harder task, and like in Europe, easing households from their obligations doesn't guarantee an immediate pick up in aggregate Demand.

All these actions by Governments and Central Banks, that translate into a rapid expansion of money supply, don't go without consequences. But that will be an issue for another time.

__________________

The Credit Freeze impacted the oil market in two different ways:

a) It decreased Demand, by crippling industrial activity - this is especially the case in the US where unemployment is already reaching significant numbers; in Europe several states entered Recession in the third quarter. At this moment there isn't enough data yet to evaluate how much Demand retracted; only in following months, as institutions like the IEA or the EIA produce their regular reports, it will be known.

b) Companies hedging their business in the futures market were forced to liquidate their positions in order to meet near term obligations, leading to a collapse of the number of transactions in the market.

Now that oil Demand has retracted, bringing prices down with it, an opposite phenomenon occurs: Supply destruction. Current prices are too short for the development of many reserves, especially those in the fringe of technology. The perfect example is the sub-salt layer reservoirs identified in the Santos Basin off Brasil. A recent study by Deloitte pointed 90 $/barrel as the break even for production from these fields. An optimistic figure possibly, given that as indicated by Brazilian scientists last year, the technology for doing is so is yet to be developed.

With time new projects needed to offset ageing fields won't be there, either by lack of exploratory activity or lack of financing. Even healthy fields can become unprofitable and be mothballed or abandoned. Supply will go down to the point it can't fulfil Demand any more at low prices, the cycle is closed and a new "boom" phase unfolds.

It would be interesting to know when this new cycle will start. That's all but easy, made even more difficult by eventual monetary policy shifts. Looking at the present futures market, presenting a heavy contango pattern, it doesn't seem a oil price rise is imminent. Likely, only when the futures market moves towards backwardation will the environment be propitious for a new price rally.

This impossibility in predicting long/mid term oil prices is a serious problem for governments and business planing ahead. But this is all part of the game: the destructive process of dependence on scarce resources. If a steady increase in prices was the outcome (as some believed) business would be able to plan ahead, for instance hedging on the futures market. Contrarily, these unpredictable price swings are heavily disruptive. Taking the example of an airline company, if it plans for a high oil price and prices go down it will likely loose competitiveness, on the other hand if it plans for a low price and it happens to go higher the company will lose profits and eventually go into financial difficulties. If the Queueing Theory applies fully to the oil market, prices are effectively impossible to predict in the long term guaranteeing losses to all airline companies.

Probably these "boom-and-bust" cycles will henceforth perpetuate until at least one of two things happens:

a) A "bust" phase permanently erases an important part of Demand;

b) A "boom" phase eventually takes place supported mainly by alternative energies;

I'm hoping for b).

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This is an important diary, and this is the money quote which I think you should find a way to sneak above the fold: paragraph 5 is not good enough.
The Queueing Theory shows also another important thing: if the load on the system goes above a certain threshold it becomes impossible to predict queue lengths or waiting times, the system goes into chaos.
This is obvious with hindsight, but if you hadn't pointed it out I wouldn't have realised...

For laymen, in the following chart derived from the logistic map, you can see the analogue of "load" on the horizontal axis (increasing to the right) and the analogue of "equilibrium" queue sizes on the vertical axis.

Click on the image for a fuller explanation.

Now I must go and reflect deeply on what Luis is writing here...

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith

by Migeru (migeru at eurotrib dot com) on Sat Dec 13th, 2008 at 02:32:40 PM EST
Important, and very thought provoking.

I can swear there ain't no heaven but I pray there ain't no hell. _ Blood Sweat & Tears
by Gringo (stargazing camel at aoldotcom) on Sat Dec 13th, 2008 at 09:28:18 PM EST
[ Parent ]
This impossibility in predicting long/mid term oil prices is a serious problem for governments and business planing ahead. But this is all part of the game: the destructive process of dependence on scarce resources. If a steady increase in prices was the outcome (as some believed) business would be able to plan ahead, for instance hedging on the futures market. Contrarily, these unpredictable price swings are heavily disruptive.

Maybe it's time to read J K Galbraith again, who argued that the industrial economy is incompatible with free market prices and more or less openly advocated price controls.

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith

by Migeru (migeru at eurotrib dot com) on Sat Dec 13th, 2008 at 04:00:44 PM EST
gas taxes are about controlling prices, by at least setting a floor for them.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Sun Dec 14th, 2008 at 05:48:51 AM EST
[ Parent ]
First of all thanks for your comments and formatting, as usual I was in hurry to finish it and didn't try it with lower resolution.

I'm all in favour of free markets, they are the best way we have to take full advantage of the emergent behaviour bound in human societies. They answer the classic question: "Who decides how much bread is needed to supply a certain city every day?"

Engels and Marx understood that the free market running by default ends up generating social inequity, another consequence of emergent behaviour. They found a different economic boom-and-bust cycle created by the collapse of demand when social inequity reached unbearable levels. To some extent we learnt how to deal with this problem.

But there are other things the free market can't do for you, especially: it can't transform a scarce resource into a plentiful resource. So this is a different problem, it is the managing of the commons. If we need to use a common resource that is vital to our lives, but that is in scarce supply, the free market is not exactly the best option. You could argue that the free market could work in ways to scramble alternative resources, but as I showed before, in the case of energy this is not that simple.

In the end, if we manage the situation to release ourselves from scarce commons, then there should be no obstacle for free markets to work in our favour, provided we don't disregard the findings of the scientific socialists in the XIX century.

Vencit omnia veritas.

by Luis de Sousa (luis[dot]a[dot]de[dot]sousa[at]gmail[dot]com) on Sun Dec 14th, 2008 at 12:08:11 PM EST
[ Parent ]
[ET Moderation Technology™]

Some of the images are a bit too wide to be set as 'floating' and text doesn't flow appropriately around them. I'm replacing 'inline' images with 'displayed' ones as appropriate.

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith

by Migeru (migeru at eurotrib dot com) on Sun Dec 14th, 2008 at 07:05:39 AM EST
I've seen yet, thank you. I can see I should have studied economics. Well, it's not too late.

One point resonates with me, the psychological tipping point when the shopper leaves the queue is an aspect that can be affected to a certain extent. (Store management could hand out candy to waiting shoppers, that's exactly what we do and yes, it works.) I have already noted that the fall in oil prices has taken place largely after the notion that the situation in Iraq has settled down somewhat. Into this chaotic mix, lets toss in Obama's election, and the possibility of, if not a new direction, then perhaps a shifting emphasis in US policies, both foreign and domestic.

I withdrew all my money from the equity markets years ago, thinking that the market was in bubble-mode when the Dow Industrials hit 10,000, I hadn't been watching the financial news, but, of course, lately I've tuned into CNBC, where Mark Haines regularly dismisses the news, good or bad, as having any effect on the market.

Of course, handing out candy only goes so far, and the messages coming out of the US establishment from the White House on down have been pretty much just that for the last 7 years.

Right now on CNBC, there's some guy named Harrison who's telling us that retail numbers are going to be "disastrous" this year (his word), and that the consumer is scared. Likely this is an overstatement, and what we see here (with a characteristic overreaction in the markets) is a long-overdue tightening of belts in an overheated economy fueled by cheap money, unrealistic expectations, and too much free-market ideology being bandied about.

But like I say, I'm not an economist.

Very good diary, Rec'd and hotlisted. Thanks again.

"It Can't Be Just About Us"
--Frank Schnittger, ETian Extraordinaire

by papicek (papi_cek_at_hotmail_dot_com) on Mon Dec 15th, 2008 at 07:07:19 AM EST
I can see I should have studied economics.

No, you shouldn't. This stuff is dynamical systems theory. You should have studied physics or control engineering :-)

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith

by Migeru (migeru at eurotrib dot com) on Mon Dec 15th, 2008 at 07:18:32 AM EST
[ Parent ]
that is what economics actually is?

"It Can't Be Just About Us"
--Frank Schnittger, ETian Extraordinaire
by papicek (papi_cek_at_hotmail_dot_com) on Mon Dec 15th, 2008 at 07:47:04 AM EST
[ Parent ]
Maybe that's what it should be...

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Mon Dec 15th, 2008 at 07:52:39 AM EST
[ Parent ]
maybe even most of it, is equilibrium relationships.  Dynamics doesn't enter in much.
by tjbuff (timhess@adelphia.net) on Tue Dec 16th, 2008 at 09:14:10 AM EST
[ Parent ]
Isn't that just what economists would like it to be about?
by Colman (colman at eurotrib.com) on Tue Dec 16th, 2008 at 09:21:38 AM EST
[ Parent ]
Sure makes the math easier.
by tjbuff (timhess@adelphia.net) on Tue Dec 16th, 2008 at 09:27:09 AM EST
[ Parent ]
I just did a book search for "Dynamic systems." I don't want to tell you what titles the miserable text search returned, manga, new age self improvement, "how to fly a kite", etc....

There's one System dynamics title. Hmmm. Looks like I'll have to learn MATLAB as well.

"It Can't Be Just About Us"
--Frank Schnittger, ETian Extraordinaire

by papicek (papi_cek_at_hotmail_dot_com) on Mon Dec 15th, 2008 at 07:55:26 AM EST
[ Parent ]
Dynamical systems?

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Mon Dec 15th, 2008 at 08:04:34 AM EST
[ Parent ]
This is a little book I like.

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Mon Dec 15th, 2008 at 08:05:52 AM EST
[ Parent ]
Thanks for the link to the book, too bad Amazon is down for me right now, but I will check it later.

Wikipedia has a nice little entry on Systems Dynamics.

When I'm done with my Phd (which has still a few years to go) my long term goal is to do research on Systems Architecture, especially trying to build Languages to support it.


Vencit omnia veritas.

by Luis de Sousa (luis[dot]a[dot]de[dot]sousa[at]gmail[dot]com) on Mon Dec 15th, 2008 at 09:18:34 AM EST
[ Parent ]
It's called Response and Stability: An Introduction to the Physical Theory by A. B. Pippard. It seems to be out of stock or out of print: all the copies on sale are used...

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Mon Dec 15th, 2008 at 12:45:56 PM EST
[ Parent ]
most of the foreign policy titles I read are out of print, so I buy used copies all the time. No problem there. Response and Stability has been added to my Barnes and Noble wish list. Probably delve into it later this winter.

Thanks all :)

"It Can't Be Just About Us"
--Frank Schnittger, ETian Extraordinaire

by papicek (papi_cek_at_hotmail_dot_com) on Mon Dec 15th, 2008 at 10:29:13 PM EST
[ Parent ]
I like Strogatz Nonlinear Dynamics and Chaos.

It won't drag you though all kinds of mathematical PNing, but it does have sufficient structure and rigour that it's possible to do a self-study from it.

- Jake

Austerity can only be implemented in the shadow of a concentration camp.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Dec 15th, 2008 at 01:30:08 PM EST
[ Parent ]
A $265 book. I should buy two :)

"It Can't Be Just About Us"
--Frank Schnittger, ETian Extraordinaire
by papicek (papi_cek_at_hotmail_dot_com) on Mon Dec 15th, 2008 at 10:52:39 PM EST
[ Parent ]
250 US$? You're being ripped off. I didn't pay more than 70 US$ (although that was back when the US$ was half again as expensive as it is now...). Call it a round hundred in today's exchange rates.

- Jake

Austerity can only be implemented in the shadow of a concentration camp.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Dec 16th, 2008 at 05:11:21 AM EST
[ Parent ]
Eh? This one? £30 from Amazon.co.uk?
by Colman (colman at eurotrib.com) on Tue Dec 16th, 2008 at 05:18:23 AM EST
[ Parent ]
You know, we should just spare people the expense and write a bunch of diaries...

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Tue Dec 16th, 2008 at 05:29:19 AM EST
[ Parent ]
... except I paid Danish VAT on it too...

Y'know, I support this whole "paying taxes" thing, but sometimes I wish the ways around paying taxes were a little less obvious and/or a little less legal - I can't quite tell whether it's ethical to pay a tax you can easily and legally get around, or just plain stupid...

But hey, it's worth what I paid for it, so why am I complaining?

- Jake

Austerity can only be implemented in the shadow of a concentration camp.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Dec 16th, 2008 at 07:04:53 AM EST
[ Parent ]
That appears to be the original edition, and there's a 2nd edition out, and yes the hardcover is indeed $265. On further investigation, I find the paperback's also available though, at $95.

Hmmm, no used editions. It'll have to wait then. I have lots of other reading lined up.

"It Can't Be Just About Us"
--Frank Schnittger, ETian Extraordinaire

by papicek (papi_cek_at_hotmail_dot_com) on Wed Dec 17th, 2008 at 01:30:24 AM EST
[ Parent ]
Any control engineer would find what's happening to oil prices very familiar.
by tjbuff (timhess@adelphia.net) on Tue Dec 16th, 2008 at 09:11:54 AM EST
[ Parent ]
The best part is that by May, oil will be at $0! Simple linear extrapolation of the past five months proves this beyond question.
by asdf on Mon Dec 15th, 2008 at 07:48:20 PM EST
I mean it's a wonderful analysis of a multitude of factors and all that but consider the place that I currently come from in my following statements.

Zero scamming scam artists went to jail for artificially profiting from the previous oil scare and that just ain't right.

Or could it be that nobody is working(outside of China) so we don't need to burn the oil anymore.

As usual it is perfectly timed to prevent any ramp up in the US of alternative energy sources due to the terminally short term outlook held by American business models.

by Lasthorseman on Mon Dec 15th, 2008 at 10:57:22 PM EST


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