Thursday, June 30, 2011

Learning to Live with Volatile Oil Prices

Robert McNally and Michael Levi discuss oil supply and demand and the resultant price issues in an article in Foreign Affairs: A Crude Predicament: The Era of Volatile Oil Prices. They discuss these issues both from a historical context and in light of the current situation. As their title suggests they predict that oil price volatility is here to stay, and we will have to learn how to live with it.

While demand can change relatively quickly due to changing economics, warfare, and/or natural disasters, supply can only change on a much larger timescale. The way in which major price swings have been avoided in the past is by having spare production capacity available. The authors contend that excess capacity of at least 5% of total capacity is required to be effective at damping out short-term variations in either supply or demand. In recent years the Saudis have played the role of moderator by maintaining the ability to provide extra production as needed.

This chart from The Economist provides a history of this excess capacity.

The recent data appears consistent with the authors’ target of 5%. However, to say less than 5% excess capacity puts one in an unstable situation, is not the same as saying the lack of excess capacity caused the extreme price rise seen 2008. At that time there was considerable talk of the role that speculators played in the price increase. The authors are dubious about that claim:

“....careful studies by the U.S. Energy Information Administration and the U.S. Commodity Futures Trading Commission have found that medium-term and long-term price shifts are primarily a function of changes in global supply and demand.”

Toni Johnson of The Council on Foreign Relations discusses Oil Market Volatility and at least leaves the question open for further evaluation.

“A growing number of analysts say oil-price trends can no longer be explained simply through supply and demand. While energy analysts still see those factors as the foundation of the oil market, they also view oil investor behavior as a factor in recent prices. Increasingly speculative behavior by a more diverse set of investors outside the oil industry--including hedge funds, pension funds, and investment banks--has made oil-market trends harder to predict, say analysts. Many believe speculative investments from financial firms contributed to record-high global oil prices seen in early 2008, and that a selloff by firms contributed to the subsequent massive price decline later in the year. As major political events rock the Middle East, analysts also worry about market speculation in 2011, which has already experienced the largest increase in oil's history.”

“However, evidence suggests the price increases of 2008 did not reflect major changes in market fundamentals or political instability. Saudi officials noted that in the year between 2007 and 2008, when oil prices more than doubled, increases in oil supplies outstripped the rise in oil demand, according to a January 2010 report prepared for the International Energy Forum.”

“An August 2009 report from the James Baker III Institute for Public Policy found that noncommercial players now constitute about 50 percent of the U.S. oil futures market, compared to an average of about 20 percent before 2002. "The speculative fervor is so remarkable that the big trading firms now have nearly twice as many long contracts open as they did in 2008, when oil spiked to $147 in the summer....”

To be fair, Johnson’s article quoted a number of experts who would agree with the authors of the Foreign Affairs article. However, there seems to be sufficient smoke out there to keep stoked our suspicions of another conflagration.

The authors go on to detail why this 5% target is not likely to be met in the future. One major reason is the lack of will and, to a certain extent, the lack of capability of the Saudis to maintain the same level of excess capacity they provided in the past. There does not seem to be any other player or players capable, or willing, to step into this role. The result is that we should expect significant fluctuations in price in the future as the inevitable perturbations in supply and demand occur.

The authors suggest some steps that can be taken to protect ourselves from these price excursions. The first involves encouraging all participants to provide current and accurate supply and demand data. Apparently the US and Japan are the only countries who currently provide such data in a timely manner. Clearly, uncertainty in these numbers can only add to volatility.

Interestingly, they also encourage greater participation by financial players. The goal is to help protect industries that are vulnerable to price swings, like automobiles and airlines, by making sure they can hedge against these price swings. This hedging allows them to insure a relatively stable effective price by providing someone who is willing to bet against them on a price move. The airline, for example, can lose if the price of oil goes up, but can balance that loss with winnings from a bet that the price would go up. They need to be able to find people willing to take that bet. The authors believe that planned changes in regulations could improve this type of market if done properly, or make it worse if not done properly.

Other suggestions focus on limiting demand. A number of countries subsidize gasoline for their populations. This is certainly popular, but not likely to help contain gasoline consumption. They encourage the US to try to convince these countries to eliminate this practice.

As for steps the US should take at home, there are no surprises. They recommend increasing domestic production, increasing R&D on alternate technologies that would limit oil consumption, and placing a higher tax on gasoline and diesel fuels.

Given recent history and the current situation, we are clearly at risk for price rises capable of limiting economic growth. The only certain way to protect ourselves is by limiting our demand for oil by a mechanism other than a major recession. Hopefully steps will be taken. And hopefully, someone will keep an eye on those speculators.

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