In August 2007 I explained in the Energy Bulletin that financial markets were not reflecting peak oil in crude oil forward prices, even if many economists were already convinced by the concept (see On sale: 2015 Crude Oil below $45!).
The issue changed dramatically in the past week. This article is a follow-up to my 2007 article.
Crude oil future prices in nominal and deflated dollars
Forward curves represent the consensus between buyers and sellers on the price of the oil on a future date, such as December 2016 (currently the last maturity traded on Futures markets). It is not the result of a mathematical calculation. There are two forward curves for two qualities and delivering locations: one for the West Texas Intermediate (WTI) and one for the Brent. They differ by a small amount, typically less than 2 dollars a barrel. On Thursday 15th May 2008 the closing forward curves were (Graph #1):
These two curves may look different at this scale, but they are not. In the scale of oil prices moves in the coming 8 years, they were flat. Prices were not materially climbing, not even at the projected inflation rate. This shape has prevailed since the spring 2007 (and motivated my August 2007 posting).
In less than a week both curves have changed a lot: far maturities have moved up by 20 dollars, i.e. much faster than the spot maturity. As of Wednesday 21st May 2008 the same curves are as shown in Graph #2 below:
This magnitude of change in a week cannot reflect a random walk: it is a dramatic shift.
Can we now say that the market now believes in peak oil? Well, more so than last week, but let’s look at the question more closely.
Nominal vs. inflation-adjusted dollars
The curves displayed above do not take inflation into account. If we calculate the forward prices in 2008 dollars (with a 4% inflation rate) we get the following pictures.
- A week ago (graph #3):
The flat curve on the top is expressed in nominal dollars like in the preceding forward curve graph (# 1 and 2), while the downward curve is expressed in today’s dollars.
- Same view with yesterday’s closing prices (graph #4):
The upward curve on the top is expressed in nominal dollars like in the graphs #1 and 2, while the downward curve is expressed in today’s dollars. The result is: in 2008 dollars crude oil prices are still moving down!
This last graph tends to mitigate the degree of acceptance of peak oil by financial markets. Indeed the forward curve is not (yet) steep enough.
Implicit inflation rate
We can go one step further by reverting the calculation: from a curve of forward prices we can deduce the inflation rate assumed by the market (the calculation is a bit tedious because it is not a simple slope regression). Here is this implicit inflation rate over the past year:
This rate is a way to quantify peak oil acceptance by market players: any rate higher than the current inflation rate (4% in the US) means that the market anticipates a tight supply.
With this measure, it is clear that something is happening now, but half the way remains to be covered.
