Left Flank

The Oil Drum's Jerome a Paris argues both why speculation affects the price of oil and why demand for oil consumption must be destroyed.

Many don't agree with my assertion that speculation has little or nothing to do with the run-up in oil prices, and consider that the brutal price increases, followed by just as brutal price decreases, cannot be explained by fairly small changes in supply or demand figures.

Let me try to explain again why, in today's conditions, small variations have precisely such consequences.

In a market where supply is plentiful, balancing the market will be done by supply adjusting, i.e., the price will be such that just the required volume of oil is extracted to fulfill demand, and no more. In that case, competition between suppliers plays in full, and the price will the be the marginal cost of supply, is the cost of the most expensive barrel needed to fulfill exactly demand. All cheaper producers will get that same price (and will make a nice profit the cheaper their costs are), and those that are more expensive won't produce. In such circumstances, variations in demand (or new supply coming online) can only cause price to move slowly along the production cost curve, and bigger price movements usually come from «above ground» factors, ie geopolitical crises that include a risk of major disruption of supply.

But if you move to a market where supply is fully used to satisfy demand, you enter a whole new world. In that case, if potential demand still increases, there is no supply in the short term to fulfill such demand, and the absolute requirement for physical balance of the market translates (beyond using stocks, which can only be temporary) into a need to destroy demand, i.e., for some potential users to forgo using oil. As we all know, oil is really convenient, and we are all unwilling (and, in many cases, unable) to stop using it. And yet the demand destruction needs to happen. In the short term, that requires prices to go high enough to convince someone to stop using the stuff, either because s/he can't afford it, or because s/he chooses an alternative which is less convenient but cheaper and, at such level of saving, worth the hassle. In such circumstances, short term price movements can and will be quite violent. In fact, any event that disturbs supply, any news that shows that demand was higher than expected, or supply less than hoped, or that suggest that demand will be higher than thought, or supply lower than expected, will push prices up immediately (and the opposite news, down, of course), because thee news translate into a unbalance between supply and demand and a bigger need for demand destruction (conversely, a lower need for such).

* So, a pipeline blows up in Nigeria - bam, 200,000b/d of (high quality) oil off the market, demand destruction is needed!

* Ben Bernanke suggests that a recession is unavoidable - psssh, prices go down as a slower economy will translate into less demand for oil, and thus less demand destruction will be required;
* Oil storage goes up - aha, demand was lower than we thought (or supply higher) in the last month, and there will be less need for demand destruction in the next one!
* Bush agrees to direct talks with Iran - bam, the war premium goes down, as the probability of an oil-supply-endangering conflict (which would cause a massive and brutal need for demand destruction, unless strategic storage is tapped) goes down.

In fact, in the past month, these was a succession of news that all went in the same direction. In the same week, Bernanke was extremely bearish on the economy, oil stocks were higher than expected, and talks with Iran happened. Each of these took about 3-4% each from the price of oil, bring the price down by more than $15 in 3 days.

And any time this happens, speculators are wrong footed and they need to close out their positions, which usually reinforces temporarily the underlying movement (haha! so there are speculators! And they push prices around! Well, yes, there are speculators - but, for the most part, they follow the market rather than driving it. Any price overshoot is usually temporary. And they do provide valuable services, by bringing in liquidity to prices - and by providing willing counterparties to those that want to buy hedges - you know, like airlines that buy futures or options for their supply over the next few months or quarters at prices to protect themselves - and their fares - from yet higher prices).

One point that needs to be made again is that demand destruction in the US (or even in Europe, where it is happening too) is not enough on its own to bring prices down, because it needs to be larger than the supply growth in the rest of the world to limit the requirement for further demand destruction and price rises, given that production is still largely stagnant. And the problem is that demand is not growing just in China and India, thanks to rapid growth, it is also growing massively in oil producing countries themselves (Saudi Arabia, Iran, Russia, Venezuela), which often subsidize gas and which can afford it given that they have a natural hedge against (the subsidy gets bigger when oil prices are higher, i.e., when their own income is bigger, and the income growth is larger than the subsidy growth for those that export any volumes). In fact, most of the demand destruction happens in price sensitive places, like the poorest oil-importing countries (but they weren't burning much of it anyway), and the rich world (which can still afford oil, but consumes lots of it). But we can't be sure it happens fast enough to actually cause prices to go down because of what's going on in the rest of the world.

And, that means daily news, like the Georgian-Russian war in South Ossetia, or the pipeline fire in Ceylan, Turkey, will send the prices at the pump reeling with annoying precision.