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The Age of Aquarius

Aquarius_hair When the moon is in the Seventh House
And Jupiter aligns with Mars
Then peace will guide the planets
And love will steer the stars
This is the dawning of the age of Aquarius

      —from the musical Hair (1968)

I wonder if much of the debate about the run-up of oil prices could be resolved simply by looking at this graph.

   

                               World Oil Supply & Demand (all liquids) from 2003-2007
                                            Source: EIA supply and demand data

As you can see, world oil demand surpassed the available supply in 2007. Demand rose 7.51% during period shown while supply only rose 6.26%, with all of that increase occurring in 2003-2004. The EIA demand numbers measure the quantity of oil demanded. When the quantity demanded exceeds supply, the extra consumption must be met by draws on inventories.

                                 Source: Economagic Data Series up to last week

The oil price rose precipitously throughout 2007 (graph above). In September 2007, the average monthly price ($79.93/barrel) finally surpassed the previous record ($74.41/barrel) set in July, 2006. The price has climbed pretty steadily ever since, with only two months, December, 2007 and January, 2008, not showing a net oil price increase (defined therein, ASPO-USA, April 9, 2008).

Maybe it's just a coincidence that the price started its steep rise during the same year that available supply fell below demand. Why does the crude oil price keep rising? Econ 101 helps us out here.

  1. There has been no downward shift in the global demand curve accompanying the price rises over the last 8½ months. On the contrary, the demand curve seems to be moving up and to the right (graph below). Subsidized oil demand in China, the OPEC countries and other developing economies shields consumers from price increases. Consumption in the OECD countries (including the U.S.) is largely inelastic (i.e. insensitive to price increases) in the short to medium term.
  2. High prices since 2003 have not stimulated a supply-side response that allows the oil markets come into balance at a new equilibrium price. The world's oil supply has been almost perfectly inelastic since 2004 (first graph above).

This one-two punch forms the meat & potatoes of the oil price hikes — everything else is gravy. The Nymex WTI price and the price on other exchanges all over the world has shattered the inflation-adjusted highs of 1980, so we no longer have to deal with the obligatory references to the previous record anymore. Thank God for small favors.

It's Not An Oil Price Bubble

Some economists like lots of gravy with their meat & potatoes, never passing up a chance to transform the essentially simple into the marvelously complex. Without the benefit of a longer term perspective on the fundamentals, it is always possible to analyze shorter term price movements to death, although Paul Krugman eschewed such confusion in The Oil Nonbubble, New York Times, May 12, 2008.

Wsj_fundamentals_of_inflation The Wall Street Journal's Bubble Isn't [a] Big Factor in Inflation surveyed 53 economists to see what their gustatory preferences were. The gravy-lovers, 20% of those surveyed, thought speculation or central bank policy was responsible for the recent oil price hikes (graph left). The rest were meat & potatoes people, and eight of them actually said that "supply constraints" were the most important factor driving energy inflation. Bravo!

A CNBC analyst noted that demand had not increased by 43% , so why has the price moved up by that much in 2008? (Actually, 35.5% over the January average price.) Shouldn't something else be driving the price?

First, the relationship between price and demand needn't be one-to-one and linear, meaning that an X% price increase does not necessarily require an X% increase in demand (3rd graph above, I suppose this is why he's on CNBC and I'm not.) Most of price rise since the beginning of the year is still driven by the fundamentals. Nonetheless, some reputable economists (e.g. James Hamilton's Commodities and the Fed: Answering the Skeptics) believe that a growing supply & demand imbalance is insufficient to explain the steepness of the price rise during 2008. Be this as it may, there is always some slop in the oil price taking the form of premiums on the "base" price resulting from different factors.

My best guess is that the base (floor) price is now somewhere around $110/barrel and the current premium, which is ≅ $15/barrel, results from investors (a.k.a. speculators) riding the oil (commodities) price wave as a hedge against uncertainty in the financial markets the shaky dollar, and the economic slowdown in the United States. They're surfing! These commodity transactions are encouraged by the low interest rates and low upfront costs on buy orders. But remember, there have also been some significant supply disruptions in Nigeria lately, where production fell 250,000 barrels per day from March to April of this year.

Prices may fall later this year, but will not likely dip below the $110/barrel floor price. It is actually more likely that the price will continue to rise this year, as Goldman Sachs believes, because 1) stuff happens, e.g. deepwater project delays, project cost inflation, blown-up pipelines, and 2) we are now living in Flatland.

Living in Flatland

I put together a non-OPEC forecast for 2008/2009 a few months ago and I'm already prepared to revise it downward. (ASPO-USA, February 20, 2008—I was critiquing the EIA's much more optimistic estimates.)

Non_opec_flatland Flatland (graph left) does not include OPEC natural gas liquids, which is the normal accounting method. The source is the current EIA all liquids data from the beginning of 2007 through April of 2008. The scale intentionally de-emphasizes insignificant monthly differences, which are the only kind of differences there are in the last 16 months for the countries shown and non-OPEC liquids as a whole.

Russia was chosen because their production has been the primary driver of non-OPEC liquids growth in the 21st century. Russian production is flat.

China was chosen because anything they can not produce themselves puts additional pressure on the world oil markets. Chinese production is flat.

Brazil1 was chosen because this deepwater superstar is supposed to be the main driver of non-OPEC growth in 2008 and 2009. Brazilian production is flat.

We can not depend on OPEC, so we can expect only modest rises in the oil supply in 2008. Things don't look promising so far, do they?  (Read Sleepwalking Toward the Oil Precipice, ASPO-USA, April 30, 2008.) Flatland forms the important part of the Big Picture outside of OPEC, which I no longer expect to change much. Brazil will likely compensate for any Russian declines and add a bit more heavy oil, China can not get out of their production plateau, etc.

An End to Confusion? — The Age of Aquarius

I remember when "refinery bottlenecks" were thought to be a key factor driving the oil price rise. We don't hear that one anymore. The narrative is always shifting but has remained consistent in one important respect: the media has grasped at any straw they can find to deny the ongoing shift in market fundamentals that has been underway since 2004. This pattern is starting to change, as we see in Amid High Oil Prices, Danger Signs in Production (New York Times, April 18, 2008). The heretofore not-very-savvy Jad Mouawad, in keeping with his mission to never mislead us, now reports some three years after the fact that there are some warning signs that world oil production is faltering. I never thought I'd live to see the day.

Maybe I'll stop using the phrase "peak oil." This common term was used in Why $120 oil is good (CNN Money, May 8, 2008)—

"The market is starting to send a signal: You got to get your alternative in line," said Robert Kaufmann, director of Boston University's Center for Energy and Environmental Studies. "Societies that ignore this kind of signal do so at their own peril."

Kaufmann isn't promoting the so-called "peak oil" theory - he doesn't think the world is quickly running out of oil.

[Note — Kaufmann spoke at ASPO-USA's 2006 Boston Conference]

My brief correspondence with CNN Money reporter Steve Hargreaves about his incorrect inference—"peak oil" does not mean the world is quickly running out of oil— has convinced me that the phrase "peak oil" is now sufficiently debased so as to be all but useless in persuasive writing. I generally know who to thank for Hargreaves' casual doom-ridden understanding of this phrase, which reflects a now common misconception among the media and the public, but I won't play the blame game, and I can't change Human Nature.

Every petroleum engineer, everybody in the oil business, knows what it means to say that an oil field, or a country, or the whole world, has "peaked." But it's hard enough to persuade others of the dangers of "peak oil" without having to fight through a boatload of confusion about what "peak oil" means. Maybe I'll say "global maximum volumetric flow rates" or something like that. Distorted semantics is not a battle I want to fight, and did not choose to fight. Life's too short, and this is the Age of Aquarius, is it not?

Harmony and understanding
Sympathy and trust abounding
No more falsehoods or derisions
Golden living dreams of visions
Mystic crystal revelation
And the mind's true liberation
Aquarius!
Aquarius!

Contact the author at [the original article]

Notes

1. A fuller treatment of Brazil is coming soon. That article will discuss what we can expect from the Tupi and Carioca fields in the next decade. The latest update for Brazil shows that Petrobras' oil (including gas liquids) output is flat at about 1.8 million barrels per day (b/d). Petrobras produces almost all of Brazil's oil.The EIA's April number for Brazil (2.26 million b/d) also includes sugar cane ethanol.

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