Can the oil stabiliser work?

So, last night oil got thumped, down 2%. Given the fall, and the prospect for further weakness, I thought it might be useful to ask, where oil might head to and what the implications are for this price trajectory.

The stakes could not be higher. There’s an opinion at large that the current slowdown in the US and, increasingly, global growth can be turned around if the globe’s automatic stabiliser, the oil price, eases. Gavyn Davies of the FT recently hung his hat squarely on this peg:

In summary, then, the decline in business surveys has been greater than occurred in the spring of last year, when the world economic recovery hit a temporary pot-hole. This is especially true in the manufacturing sector, which has continued to nosedive in the month of May, while the services sector seems to have stabilised. The good news is that, although the survey results have fallen sharply from the extremely healthy readings which were recorded in February, they have not yet fallen to anywhere near the levels which would trigger serious concerns about a double dip recession.

Clearly, markets are going to be extremely sensitive to what happens next. If manufacturing surveys start to advance as the Japan impact begins to reverse, then worries about a double dip will start to fade. If the downward momentum continues in manufacturing, and starts to undermine the strength of services, concerns about the recovery will mount rapidly.

Another excellent macro mind has recently emphasised the role of oil prices. Tim Duy reckons:

Temporary weather and tsnumai induced disruptions for one, but we should be trying to look through such short term events.  The crisis in Europe, although to be honest I don’t think this is having much of an impact on the decision making of the average US citizen or firm.  I tend to think the rise in commodity prices, particularly oil, was the primary culprit, as consumer spending faltered and businesses struggle to pass increasing costs onto consumers. 

In his recent speech too, Ben Bernanke dedicated a lot of space to the oil price, suggesting that with substantial falls, the way could be cleared for further simulus:

…gasoline prices are exceptionally important for both family finances and the broader economy; but the fact that gasoline price increases alone account for so much of the overall increase in inflation suggests that developments in the global market for crude oil and related products, as well as in other commodities markets, are the principal factors behind the recent movements in inflation, rather than factors specific to the U.S. economy. An important implication is that if the prices of energy and other commodities stabilize in ranges near current levels, as futures markets and many forecasters predict, the upward impetus to overall price inflation will wane and the recent increase in inflation will prove transitory. Indeed, the declines in many commodity prices seen over the past few weeks may be an indication that such moderation is occurring.

So, let’s take a look at the oil price:


The above chart marks the key moments in the MENA (Middle East and North African) crisis. As you can see, each key event was accompanied by varying degrees of increased risk premium in the oil price. If we take a starting point of $88 in mid December when Tunisia sparked the revolution and a finishing point in early April, when the Libyan war was in its early stages and supply anxiety reached a peak at a price of $113, we get some notion of the risk premium currently built into the price: $25.

Of course, this is guesswork to the extent that the MENA crisis cannot be isolated from other factors acting upon the price. But it does give us at least a guide to how significant the risk premium is, if we accept that expected global growth rates were roughly consistent through the period.

It is also important to note that the recent 15% or so retracement in the oil price cannot be put down to any easing in the MENA crisis. Given a similar selloff occurred across the commodites complex, it looks rather more like a downgrading of global growth expectations that has driven the correction.

Further evidence that security of supply that is governing the current oil price can be found in the International Energy Agency’s monthly statistics. In early April, I wrote a post called Boom and Bust is back:

Like housing supply in Australia, commodity supply is inelastic. That is, it cannot respond quickly to a sudden surge in demand. The chart offered below (and mentioned above) shows the effects on any given market if supply cannot respond quickly. Don’t be scared of it, it is easier than it looks:

Q0 and P0 represent the initial equilibrium situation in any market. Initial demand is provided by D0, whereas supply is shown as either SR (restricted) or SU (unrestricted).

Following an increase in demand, such as a surge of emerging markets looking to engineer an historically swift catch-up in living standards through mass urbanisation, the demand curve shifts outwards from D0 to D1. When commodity supply is restricted, prices rise sharply from P0 to PR. By contrast, when supply is unrestricted, prices rise more gradually from P0 to PU.

The situation works the same way in reverse. For example, if there was a sharp fall in demand following a contraction like that of the GFC or an inflationary bust causing commodity demand to fall from D1 to D0, then prices fall much further when commodity supply is constrained.

The graph illustrates that demand shocks combined with inelastic supply do not result in a one way bet of upwards price movements. Rather, such economic settings produce volatility, with steeper price rises and spectacular collapses.

Why you might ask? It’s pretty simple. This is a mathematical representation of human panic. When a market is perceived to be unable to increase supply easily then speculators move in. In strategic markets like oil, governments begin to fret about security of supply. They stockpile. More speculators enter the market. So on, and so forth.

So long as the perception that supply is constrained remains, the frenzy continues until it exhausts itself in a new crash.

For the global economy, this dynamic is now apparent across a spectrum of commodities. None, however, is more important to the prospects and pattern of global growth than oil.

As I wrote recently, for much of the last decade, oil has been priced on the assumption that supply is in jeopardy of being unable to respond to burgeoning demand. The situation first arose in 2003 when, ironically, the US invaded Iraq:

As the graph shows, that invasion marked two vital turning points in the oil market. The first was that OPEC’s spare capacity became severely constrained on geo-political concerns and, second, it was the last time that the world saw oil priced in the $20 range, in my view, for good. From 2003 to mid 2006, OPEC’s spare capacity oscillated in a band between one and three million barrels per day and the oil price more than doubled from $30 to $80. For the following year, spare capcaity rose to four million barrels and the oil price corrected to $60. Then, as the last growth cycle wound itself toward its blowoff hase, and spare capacity dropped toward 2 million barrels again, the price skyrocketed.

In the IEA’s last report in May, OPEC’s spare capacity would have risen above 6 million barrels per day, however, it instead fell to 4.88 million barrels because Libyan spare capacity was removed from the equation.  

So, if we’ve still got $20+ risk premium in the oil price, without it we’d already be returning to the sub $80 range that would enable further monetary easing in the US.

This suggests several speculative conclusions. First, unless global growth weakens significantly again, the downside limit for oil looks around $90. Second, the automatic stabiliser role of oil of removing comsumption power from deficit economies as growth rises and returning it as growth falls is going to operate in a wider band of volatility. Three, the current soft patch in US growth will need to get worse before we’ll see QE3.

Comments

  1. I think there’s a pretty solid floor under the oil price these days because almost no-one in the market believes we don’t have supply constraints, even the big oil majors.

    We’re all Malthusians now.

    I note that Grantham has gone all Peak Oil recently, well, more so than usual.

    I get what he’s saying here, but would someone please explain to me the table labelled “The Mother of All Paradigm Shifts” with Iron Ore topping the “z-score”. Is this the same iron ore, one of the most abundant minerals in the Earth’s crust? The same iron ore with new capacity coming online everywhere?

    What were GMO’s boffins smoking?

    I think even Grantham noted in one of his newsletter that this was a nutty number.

    • ‘Is this the same iron ore, one of the most abundant minerals in the Earth’s crust?’

      Yes. But there are limited amounts of high quality iron ore deposits, and the largest and easiest to find and extract are generally used up first.

      So the economically recoverable iron ore is considerably less than the iron in the crust.

      Without knowing anything about global iron ore reserves or current extraction rates, it is still possible to reach peak extraction rates while still having stupendous amounts of iron left in the crust (similar to oil). It isn’t a question of whether or not its there, but whether or not it is worthwhile/economic to extract.

      • Are you seriously suggesting the long term supply constraints in the iron ore market are anything like as tight as oil?

        Seriously?

      • So why on Earth would GMO conclude there was a near zero chance that iron ore is in a bubble, and a much larger chance that oil is in a bubble.

        Makes no sense.

      • Simple:

        Iron ore is traded by contract between producer and consumer and therefore reflects supply/demand dynamics at contract time.

        Oil is traded on markets in which anyone can take a position and do.

      • Iron ore contracts pretty much follow the spot market and reflect the demand-supply situation. The contracts really just smooth out the spikes and troughs. If either party doesn’t like it they can renege on the deal and buy and sell on the spot market … and that’s precisely what they did during recent spikes and troughs.

      • Spot prices at contract negotiation time can be in a bubble, so contract prices will reflect that.

        I don’t think you can argue iron ore can’t be in a bubble because its mainly traded on contract. Perhaps less of a bubble that the spot market, but a bubble nonetheless.

      • You need to explain how prices could ever be in a bubble in a market in which only producers and consumers participate.

        There is a clearing price at which consumers get the iron ore they need. period. no bubbles.

        And for clarity I use the term “contract” in the generic legal sense. When you buy on the spot market it is a contract.

      • So the Saudis will pump 10mbpd. So what?

        Your article must only be referering to conventional crude (as total ‘oil’ liquids are already at 10mbpd including NGL’s)
        The Saudis are currently producing about 8.5mbpd conventional crude only. So increasing to 10mpbd would just compensate for lost Libyan production of around 1.3mbpd.

        The Saudis are keeping us on the plateau.

        The only way to maintain the plateau is through more natural gas liquids, tar sands, and smaller oil fields. Thanks to their lower energy returned on energy invested, they require $75/barrel to cover costs.

        And this is what is supposed to replace the 70% of current production represented by aging conventional oil fields that have entered the declining production stage (from the IEA in 2011)

      • Whether they’re short of oil is up for debate (its not exactly gushing out Ghawar these days) but why would you burn something at home, that’s incredibly profitable to export, that’s pretty much the world’s only transportation fuel, when you have millions of square kilometres of baking hot desert to put solar?

        Of course you could say the same about Australia and coal, but unlike Australia pretty much all the major population centres in SA are in the desert, baking in the sun … and I’m pretty sure SA has more free cash sloshing around for investment in renewables than we do.

    • Except that the only current solar power technology that has the chance of supplying economic baseload power is solar thermal, and (most) solar thermal needs water.

      Not that it can’t be done in Saudi Arabia, however the country is already severely water constrained. Maybe if Environmission succeed in building their 1km (!!) high solar thermal tower in Arizona, the Saudis should have a look, as this does not require water to work.

      • Well, the Saudis don’t seem to have have a problem building huge pipelines into the desert to pump seawater into oil wells, and besides the newer solar thermal designs use air-cooling to convert the steam back into water.

  2. In his recent speech too, Ben Bernanke dedicated a lot of space to the oil price, suggesting that with substantial falls, the way could be cleared for further simulus:

    He was actually talking about levelling of oil prices, rather than a substantial fall, and in effect was just making a statement of basic maths. Bernanke was just recognizing that oil prices don’t need to fall to reduce inflation – by definition if they level off the energy contribution will be washed out of the inflation rate. Given an expectation that oil prices can’t rise forever Bernanke has been fairly constant in his prediction that the small energy driven rise in inflation is transitory.

  3. The ‘correlation’ between USD and oil price has long been a subject of debate and whilst not absolute, has been observed pretty consistently over recent years (a relationship somewhat different to that of say the 90s).

    Basically USD up – Oil down : USD down oil up

    From 2008, but still generally applicable, one of my favorite ex-bloggers, Brad Setser – discussing the above:

    Podcast:
    http://www.cfr.org/international-finance/understanding-correlation-between-oil-prices-falling-dollar/p16569

    Texts (with links to Martin Wolf and Goldmans on same):
    http://blogs.cfr.org/setser/2008/06/18/why-has-the-dollar-tended-to-go-down-as-oil-goes-up/

    Current Economics:
    http://www.currenteconomics.net/Economic_Research/Dollar_Oil_Puzzle_106.htm

    It’s interesting to read Bernanke’s statement again in light of the USD/Oil correlation and see they are at odds with each other. Curiously when I first read Bernanke’s statement (via MB) I was going to comment on the perceived USD/Oil effect, as I’d read Setser ages ago.

  4. Just doesn’t seem right to me that there seems to be so much “only us the oil price…” sentiment around, that we all, collectively, seem to be missing the point that the system itself is sick, to the Point of death, such that if if the the itme of interest was not oil, it would just be something else.

    Not a criticism of MB bloggers and commenters, no; just more philosophical observation…

    “the problem” is hot oil, per se, as if something micro could fix the real, fundamental problems; the issues are far more basic, and lie back in time.

    My 2c

  5. “It is also important to note that the recent 15% or so retracement in the oil price cannot be put down to any easing in the MENA crisis. ”

    I disagree with this. Egypt is calming down. Libya is nearly over – Germany just recognized the rebels as the legitimate government.

    We could see much, much lower oil prices in the next few months.

  6. It might be more instructive to look at gasoline/diesel prices for the time period in terms of “seeing” the shock, which has next to nothing to do with OPEC surplus capacity.

    If you look at gasoline prices, for example, you see that they reached the higher levels of 2008 in April/May. Cracks remain very strong with futures indicating gasoline prices of above $3.50/g this Summer, down, but still above the pain threshold.

    The pretty exorbitant cracks could possibly lift the price of crude even without additional demand–yesterday front month RBOB traded at a $28.57/b premium to WTI; HO traded at a $33.14/b premium.