The price of oil

here is plenty of noise out there that since oil prices have gone down, the threat of peak oil has went the way of Y2K, Planet X, Sinbad, and all other threats to society as we know it. Of course, there is a fundamental misunderstanding about what peak oil is, and what it has to do with price.

I will admit that up until recently, I thought that there was really no where for oil to go but up. Sure there would be price volatility, but I had read plenty of peak oil proponents talk about how the price would fluctuate within a range and with a general upward trend – notably Matt Simmons said that oil would see higher highs and higher lows. That was until it didn’t. Oil at around $40/barrel does not fit in any particular up trend I can fathom. So clearly, this was one point that the peak oil community got wrong, or did not explain clearly enough. We were so obsessed with chattering up the price that we didn’t stop to think about a few issues, and we still are not, largely because its drop has been so stunning. I decided that now is as good a time as any to take a look at several different ideas I have read about before and after the price spike.

Awareness and the “peak oil premium”

Earlier in the year, it was fairly common to find mention of a peak oil premium being priced into the oil price. That is, journalists and pundits began to seize on the idea that peak oil was a real concern and that a portion of the oil price could be explained because of it. I credit this much to websites like Energy Bulletin and The Oil Drum for providing a strong technical background for more mainstream journalists to go to when formulating stories about the rise in oil price. These sites and many others also acted as an echo chamber for any peak oil news of note. In fact, recognition of peak oil by the mainstream media was something that was regularly celebrated on peak oil oriented websites.

But the peak oil crowd missed something, and so did I. No matter how strongly I believe peak oil to be either taking place or on the verge of taking place, I do not trade oil. Even some players in the oil game that believe peak oil is a reality are not listened to by the rest of the market. In other words, oil is priced by a huge number of traders and very few of them believe peak oil is a reality now. They also don’t think that the idea of peak oil is one which they should take into consideration regarding the oil price. Without traders believing peak oil is an important issue and factoring it into their bids, there will not be a “peak oil premium” priced into the market. I also have my doubts about whether traders have the long term vision to think beyond factors they are trained to consider when bidding oil prices up and down.

So, 2008 was the year that awareness of the notion of peak oil increased, it was not the year that the awareness translated into a premium in the oil price.

Dollar fluctuation

The value of the dollar has changed dramatically in the past few months, along with the price of oil. Here is a graph of the exchange rate between the Canadian Dollar and the US Dollar, June 25th to present:

graph copied from xrates.com

You can see that as recently as September 24th, the exchange rate was about one to one (CAD to USD). On September 24th, the price of oil was $105.73 (found here) and the price on 12/12 $42.07 which is a change of $63.66 or about 60%. There has been an increase of about 25% in the value of the US dollar in this same time span. So, a part of the change in the oil price has been the rally in the dollar – it can also be said that a big part of the high oil price earlier in the year was the result of a weaker dollar. If we were to value oil in Canadian Dollars instead of US dollars, the price on 12/12 would have about $52.50 which would be a change of 53.23 or about 50% from September 24th.

So, even though the changing value of the dollar can provide some explanation, it does not adequately explain the huge fluctuation.

Oil, the equity markets and other commodities

Whether it should be treated this way or not, oil futures contracts are treated as an investment by some large investors. Given that the whole financial system took a hit in 2008, oil’s price drop does make some sense in connection to the broader market. But in looking at the changes in the short run (as seen below) it does not show a clear indication of movement along with the stock market.

I am not the best at making sexy graphs but here are few of oil’s price decline in relation to the S&P and other commodities (I awe at the skill of CR and several contributors at TOD).

Here is the S&P 500 closing price (the red line) and NYMEX oil price (the blue shaded area) from Sept 24th to December 19th.

S&P 500 and Oil price graphs, Sept 24 to December 19

You can see that both have experienced a devaluation, and there is far more noise in the S&P graph than the oil price graph. In this span, the S&P lost about 25% of its value while oil lost 59%. Sorry I couldn’t make the difference more pronounced, I mainly wanted to show that movement was generally similar, but not directly related.

To give broader perspective of the two, here is the S&P 500 closing price (the red line) and NYMEX oil price (the green line) from 1982 to present.

You can clearly see the two bubbles in the S&P 500. You can also see that early on that the two prices have historically responded independently of one another, but they have shared upward and downward trends in the past. That is, different inputs go into the pricing of equities in the S&P 500 than do in oil.

So again, the overall deflation of the economy should be a component, but it isn’t a full explanation.

Demand Destruction

The idea of demand destruction is one which is regularly talked about in peak oil circles. The idea is basically that once oil reaches a certain price – assuming that the free market is allowed to function – marginal consumption will become too expensive and some demand will be curtailed. Unfortunately, finding numbers for consumption of oil is not easy to do. Instead, I will use this graph from Rembrandt at theoildrum.com for production.

Keeping in mind that production does not take oil stocks (oil already purchased and in storage awaiting resale or refinement) which are high right now. Even with that in mind, you can see a drop in production starting just around July or August 2008. Although this could be a demonstration of a lack of supply, it is more likely showing the reaction of producers to lower demand forecasts. For the record, I do not think this is demand destruction as outlined above. What we are seeing instead is external realities in the greater economy driving down demand through lower economic activity. Although oil was outrageous over the summer, I don’t think it was high enough to effectively destroy any significant portion of existing demand. I do believe that it did play some role in curtailing future demand as both individuals and organizations had to start thinking differently about their petroleum consumption at higher prices. Again, this is another unfortunate side effect of the price crash in the second half of 2008. The economic incentive to consume less oil has been removed for the vast majority of the world.

Conclusion

Taking all of the information into account shows that thereare a number of different inputs that impact the trading price for oil contracts. In looking at everything, there is not one clear explanation to explain it all away.

As oil price was on its way up, traditional indicators (stocks, forecast production, forecast demand and “above ground issues) all pushed the price higher. The spike in price over the summer at least partially had to do (given what we know now) with people looking at the economic trends and taking investment positions in the market based on their assumptions about future economic activity.

I think the most interesting thing about all of it is that it unraveled so quickly and so dramatically. Given the present circumstances, I am sure that I will no longer look to oil price for an indication of the status of peak oil. I also think that it is unfortunate, given that I believe in the immediacy of peak oil, that the people involved in the market are still using yesterday’s analysis methods to determine the fair market price.

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