This post examines the recent swings in the spot price for crude oil — especially in light of the currently rapid rising spot prices. Noting that the current run up of prices looks a lot like period leading up to the sudden price spike that occurred in the summer of 2008. It goes on to argues that the global economy needs a better market regulating mechanism that can help manage these swings and reduce their amplitude so they become less damaging to the world’s economies. The energy business — whether it is alternative energy or oil, gas or coal exploration and development — has huge up front capital needs. This needed capital is much harder to raise in a climate of such extreme near term price uncertainty.
In the summer of 2008 the benchmark ICE Brent crude oil closing price peaked well above $130 per barrel only to collapse within a few short months all the way down to slightly above $40 per barrel – a price of just one third the price it was trading at a few short months before. This wild price swing did immense harm to the global economy and made it very hard for anyone making long term capital allocation decisions to confidently predict what the future cost for a barrel of oil would be in just a few years let alone the ten or more years that these planners need to be able to predict on.
This massive price swing, which in part helped trigger the worst financial crisis and economic recession the world has experienced since the Great Depression is not a onetime event. In fact once again the benchmark ICE Brent crude oil price has crossed the $100 per barrel threshold – trading at $102.19 on 2/18/11. Other oil indices, such as the OPEC Reference Basket or the West Texas Intermediate (WTI) index also reflect this currently rising unit price. The current run up of prices also looks a lot like period leading up to the sudden price spike that occurred in the summer of 2008; are we soon going to live through another wild spike followed by a price crash as the global economy is tipped into steep recession and economic activity retracts.
This graph, from oilnergy.com, tracks the Brent index from 1988 to the present. The very large price spike of 2008 and subsequent equally phenomenal price collapse can be clearly seen. The recent rapidly rising prices is also clearly seen. Notice how in recent years the market has seen much more rapid price volatility than has historically been the case.
What is driving these recurring price swings? Clearly there is massive speculation going on in the oil futures market and in both the up and down directions. Once again the speculative fever seems to be rising in temperature as the psychologically important $100 per barrel price is crossed. Speculation seems to be exacerbating the amplitude of the swings, but the crude oil energy market is far too large to be driven purely by groups of speculators no matter how many billions they have behind them. Something else is also going on to trigger these swings.
The World has Reached the Peak Plateau of Global Oil Production
A clear hint at the underlying reason has recently become a part of the public domain; although some oil insiders have known this for some time now. Leaked cables (WikiLeaks) from the U.S. embassy in Saudi capital Riyadh reviewed by the Guardian, describe a warning from a senior Saudi oil executive, who said the country’s crude oil reserves have been overstated by nearly 40 percent, some 300 billion barrels. In the leaked cable Sadad al-Husseini, the former head of exploration at the Saudi oil monopoly Aramco, told the U.S. consul general in Riyadh that the Saudi oil company could not keep up with the 12.5 million barrels a day needed to keep prices low. Peak oil, he said, could be reached as early as 2012. The importance of this – to anyone who is listening – cannot be overstated; this is major news that is going to impact everyone in a very major way.
The driving force for the price swings is that the world’s swing producer is losing its historic ability to drive prices down when it chooses by flooding the world’s market with surplus oil. Saudi Arabia can no longer produce a whole lot more oil to quell the speculative fever that is unleashed as the global surplus in supply is mopped up by economic recovery. In fact as the world’s economies recover from depression or the dip in the growth rate for countries like China, demand for oil is rising. The world’s suppliers cannot physically meet that demand and so the price is going to sky rocket once again.
The graph above shows the world oil production over the last seven years. Notice how even when prices spiked above $130 per barrel in July of 2008 oil output did not increase by very much — even at this historically very high price. This is powerful evidence that any alleged Saudi spare capacity, being held in reserve does not in fact, actually exist.
Why is the World on this Terrible Rollercoaster?
Why… because oil is a particularly inelastic kind of commodity. Oil is not like doughnuts or most other things that are quite easily substituted or done without if prices rise too much. People NEED oil and it is very hard to do without or to substitute with something else — you cannot put coal into your tank.
And so… the price skyrockets… until finally the marginal consumers are finally forced out of the market. What then happens is that as billions of people in the world pay out a much larger share of their previously disposable income just to meet their critical energy consumption needs the global pool of disposable income, quite suddenly dries up and all manner of discretionary spending collapses. People no longer buy things or go out or travel. Inevitably this leads to a collapse in factory orders and pushes the world’s economies into recession.
As recession sweeps the world the demand for oil DOES finally collapse to some degree and as it does – once again – surplus oil appears on the market and the price begins a violent swing in the other direction. This process is exacerbated by speculators on the way down just as it had been previously driven by speculators on the way up. This is precisely what happened during the violent price swing of 2008, from the historic summer price peak to the four year low set just a few months later.
The spot market price regime that we are beginning to see develop as – what I feel – will be a recurring pattern of wild price swings between peaks and subsequent price troughs is being driven by the lack of reserve production capacity. The world has effectively reached the global peak in oil production. Saudi Arabia can no longer turn up the spigot. It can no longer control the market as it once could.
In the coming decades I fully expect wild successive price swings in the spot price for oil as the world bumps along the plateau of maximum global oil production. Because oil is such an inelastic product price will tend to swing over a wide band. As global economic recovery pushes on the demand side available “extra” supply will quickly be soaked up and speculation will drive the spot price to stratospheric levels. This will collapse economic recovery as energy costs soak up more and more of the discretionary income. As the global economy again slides into recession and economic contraction, demand for oil will fall and each new historical peak price will collapse as speculation now drives it in the opposite direction.
Rinse and repeat.
This regime of swinging oil prices, oscillating between successive price highs and troughs, will mask a longer term moving average of increasing energy costs and it will harm everyone except perhaps the few speculators who are able to cash out fortunes on the swings (in both directions I might add). A regime of wildly swinging prices will prevent much needed long term capital investment in the energy sector by making it harder to forecast future price levels needed in order to justify the capital expenditures. It will wound economies across the globe in a damaging price cycle that will force successive contractions on the global economy each time it begins to recover from the preceding contraction.
We Need a Better Global Oil Price Stabilization Mechanism
The world’s economic system would really benefit from a spot price stabilization fund/reserve or some other pricing mechanism to smooth out these swings and prevent speculation (in both directions) from exacerbating the amplitude of the swing.
It would be far better for everyone, for energy producers and consumers, if the market for energy was not buffeted by these price swings (at least to the degree that the market is swinging under the current speculative driven system) and instead was faced with the steadily rising long term moving average cost for petroleum that is a reflection of the physical limits of petroleum. If capital allocation planners in all kinds of markets including in the oil market itself could reliably predict a future of steadily rising prices they would be able to make much more informed decisions and better capital allocations.
At least then energy planners could make long range plans. Product developers could predict what energy costs would be in say two or three years and so forth. As it now stands one year prices will reach stratospheric levels and the next they will with equal speed collapse. This makes it much harder to make long term capital investment decisions and will hurt every alternative energy sector from wind to solar to biofuel as well as making it harder to raise capital for long term capital intensive hard to recover petroleum development (increasingly the only kind of new fields left on the planet as all the easier oil has already been burned).
The wild swing in price hurt every single energy sector and not just the renewable energy sectors. The very same price uncertainty that can make it impossible to raise the capital needed for a new wind farm, solar array, geothermal heat pump, or biofuel startup will also make it hard to raise capital for building an exploratory drilling platform or for drilling for natural gas.
What would a Stabilization Mechanism Look Like?
This is a problem that is bigger than any single nation state or integrated economic market including the US, EU, China or OPEC can handle by itself. I believe that this is one of those truly global problems that demand a global response. It is of such massive scale that no single economic power no matter how big have the resources (alone) to be able to effectively tamper down the wild price swings. For this reason I think that the mechanism/organization needs to be an international organization that combines the world’s biggest oil consumers with the world’s biggest suppliers – linked by a shared common interest and need for long term price stability.
Naturally by price stability I intend predictable and relatively smoothly rising prices. Trying to keep the price of oil artificially low is bound to fail. But the energy capital allocation planners can deal with a future of rising energy costs; just as long as there is good long term predictability for the future value. It is the wild swings that are literally killing everyone – from the drillers, to alternative energy developers, to energy efficiency, recovery project planners, to smart grid and smart appliance makers… and the list goes on and on. In fact every single sector of the world’s economy that needs to make any kind of long range plans and to any significant degree depends on oil will be severely affected and not in a good way by a future characterized by successive wild price swings, with each succeeding price peak triggering significant economic downturns and each subsequent price collapse killing off promising projects.
This is a big problem and it needs an equally big organization to front it.
The US strategic petroleum reserve could be linked up with other big strategic reserves and more of a reserve could be created and built out – every time the price collapses below some long term moving price average and released when prices shoot above that moving average. Perhaps something could also be done at the market level to cool the speculative fevers. For example if oil commodity speculators were required to cover their bets to a higher degree than is currently required. The world’s big producers and consumers could collectively fund and own this reserve – and it would need to be a massive fund with hundreds of billions of dollars that would buy on the lows and sell on the highs.
Predictable Future Prices Are In Everyone’s Interest
Pricing predictability is in everyone’s interest. It benefits the big energy consumers like the US, China, the EU and Japan and it benefits the big suppliers. It benefits the oil majors and it benefits the alternative energy suppliers. It benefits the global economies that can make better long range plans and it benefits you and me.
Sure the politics are formidable and a new cooperative approach between the big consumers and producers would be a requirement for this to work, but the payoff in terms of avoided economic disruption and financial pain and bad capital allocation are of such a huge magnitude that I believe this is something that is worth trying.
A future of steadily rising prices – tracking some moving average – is better than the unpredictable and wildly swinging pricing regime that we are guaranteed to have to live under if the world does nothing instead and just allows speculative market forces to drive the spot price.