Over the two previous days oil fell $10.50 a barrel. By definition this is driven by news about supply and demand but has so much news come out so quickly?
Here are two ways to think about the mechanisms at work. First, some producers could supply more but they figure that China will be buying more tomorrow so maybe it is better to wait. If they see a signal that future global demand will be lower, they are less likely to let oil sit in the ground. In other words the market develops the expectation — true or not — that oil supply will rise more rapidly than had been thought (or "decline less rapidly" may in some cases be a more accurate phrase but the net direction of the effect is the same). Lower expected demand is thus paired with greater expected supply and that tends to make price volatile. Higher expected demand is paired with lower expected supply in similar fashion. noting in either case that you can make lots of different assumptions about the relative timing of the expected changes.
Second, any new information leads to more trading and to more trading at different ranges of price and quantity. This trading reveals more information about the elasticities of market supply and demand curves and that information in turn feeds back into the market price. In a nutshell, some initial price and quantity movements lead to further price and quantity movements.
Neither of these phenomenon are correctly called "bubbles" but neither do they fit the story where the price of oil is determined by fundamentals alone. "Expectations" is a central word here, noting that only time will tell whether or not the expectations are rooted in reality or not.
china, india, the middle east are the real culprits. How they keep quiet and suck up oil is suspect.
I’m seeing some news coming out of the US in the past few days as the culprit. First, gasoline consumption has actually dropped in response to prices. Second, gas guzzling vehicles are selling very poorly, and GM and Ford are flailing as a result. Third, the US economy is taking a very big hit, which should mean less frivolous spending, which should mean even lower fuel consumption. That’s, respectively, short, long and medium term drops in fuel consumption right there.
There are two other whimsical reasons for the price drop. One, Batman came out. Two, the price of oil could be moving away from the dollar to another, more stable, currency. (That’s right, I said it, the dollar is unstable.)
In response to tony (with the first comment,): do you know how incredibly condescending that sounds to people from China, India and the Middle East? Together they account for half the people in the world, yet they probably equal the oil consumption of the US which has only 300m people. Who is sucking up oil then?
The situation is unstable. There isn’t a lot of excess capacity. Consumption can be expected to keep going up — china and india are poised to increase consumption as well as increase industrial production etc, and they will need more oil. Problems in the USA might dampen their economies, but in the medium run why should they let the US economy determine theirs? Iraqi oil production could plummet any time if the other shoe drops and violence goes up. Iranian oil production could plummet quickly if the USA or israel attacks them. The US dollar is unstable, nobody knows how fast it will depreciate. Six months from now will we be starting a partial pullout from iraq or will we be digging in for at least a 4-year stay?
Given all this, what market-maker could be expected to stabilise oil prices? The idea that prices will be stable unless new information causes them to move is backward. In a free market prices are inherently unstable unless a market-maker works competently at damping fluctuations.
There are two other whimsical reasons for the price drop. One, Batman came out. Two, the price of oil could be moving away from the dollar to another, more stable, currency. (That’s right, I said it, the dollar is unstable.)
The Fed’s broad index of the dollar’s value was 95.97 on February 28 and 95.97 on July 8. The broad index of the dollar reached its low in March of this year. It is currently around what it was in December of 2007. The fall in the dollar is something that happened throughout last year, for the most part. It has not been happening this year since March (and was only a very small decline from December to March, almost all of which has been recovered), despite oil prices going up.
Another possible reason, I suppose– President Bush did lift the executive branch restriction on offshore drilling this week. Of course, that has no immediate effect, especially since the restriction on drilling has a legislative restriction as well that much be repealed. However, he did also call on Congress to do that same; it’s possible that oil traders, mistakenly or not, were responding to that possibility.
@John Thacker:
The legislative restriction on drilling does not have to be repealed. It sunsets on September 30. If Congress does not pass another one, offshore drilling will be open for business on October 1. In the current political environment, the chances of passage of a new restriction are considerably less than one, and I think that is part of what the market is reacting to.
Why would today’s oil prices react strongly to something that might marginally increase oil supply 10 years from now?
Far more likely that they’re reacting to the news that Bush is making a last-ditch attempt at diplomacy with iran before the attack, and the attempt might “succeed” and we won’t after all have a war.
Or it could be anything. Without a market-maker adequate to stabilise prices, whyever would we expect prices to be stable? We should expect prices to fluctuate wildly in a free market in the absence of an actor whose job is to stabilise them.
You can see on Intrade’s site that there’s been a lot more movement in the “US to lift offshore drilling ban” contract (which is moderately high, around 40%) than in the “US or Israel to overtly strike Iran” contract (which remains low, around 8%).
If you want to give Bush credit, the announcement that the US is sort of opening relations with Iran probably has a much bigger impact on oil market than the lifting of restrictions on off-shore drilling.
John Thacker, your first hypothesis above is that the markets are rationally handling expectations about oil supplies 10 years down the road.
This does not fit my experience, observation, or reading. We have no market mechanism to achieve the right amount of oil production 10 years from now. For most of the time of oil production we had no efficient guess how much oil there would be — a series of unexpectedly large oil strikes revised the estimated reserves at random intervals. When each strike was announced did oil prices immediately fall a lot to reflect the increased supply in coming years? It’s been awhile since we had large unexpected bonanzas, and total reserves are more predictable than they used to be though improvements in recovery, oil shale, etc might still have hard-to-predict effects on supply in coming years. I don’t think anybody is making workable predictions 10 years out. Among other things we can’t predict the stability of middle-east governments, or the venezuelan government.
We *should* conserve more now, but how does that translate to our actually doing it? All the oil that gets pumped will be consumed, except the little bit of it we pump back into the ground for our strategic reserves. Every barrel of pumped oil the USA fails to consume will be consumed by somebody else. It’s the market at work, man.
The odds of an attack on Iran, even just an airstrike by Israel and nothing by the US, have always been pretty small. (Including as judged by betters at Intrade.)
And how can you prepare for it? It’s like planning for a Richter 10 earthquake, you do better to just shrug your shoulders and hope it doesn’t happen. You can’t bet oil futures on the possibility even if you think it’s likely — when you win the markets are likely to shut down and your oil gets confiscated by worried governments etc.
So the markets can factor in a small or moderate disruption in trade in a fizzle of a war, which isn’t all that likely, and a change in the likelihood won’t affect oil prices that much.
Is there another explanation? How about this?
http://afp.google.com/article/ALeqM5hkLCJIKdipOHqJ8bwdjN1JUZSFtA
——
Oil surges to new heights after Israeli warning on Iran
Jun 6, 2008
NEW YORK (AFP) — Crude oil prices went on a record-setting surge Friday as fears of a new Middle East conflict were fanned by comments from a top Israeli official about Iran.
New York’s main oil futures contract, light sweet crude for July delivery, leapt 10.75 dollars a barrel — its biggest one-day jump ever — to close at a record 138.54 dollars.
——
Last month we had the biggest one-day rise in oil prices ever, which some people attributed to the israel/iran thing. Now we get the biggest-one-day drop in many years, smaller than that rise, which pretty much cancels out that increase. Over 5 weeks the price of oil hardly rose at all!
If last month’s war scare was the reason for that one-day rise, maybe people have gotten used to the idea now and have started to discount it.
But my own favorite theory is the null hypothesis. There’s nothing special going on except the market is increasingly volatile. We can expect bigger highs and lows because nobody is putting many resources into moderating those fluctuations.
The short-run elasticity of oil is extremely low — the supply is fixed, and consumers give it high priority in their budgeting. Large price swings are therefore required to balance even small changes in quantity.
Of course it’s expectations! Expectations of fundamentals. This is how all markets work.
Don’t we make every decision in our lives based on what we expect the outcome of that decision to be? And don’t we change our minds when new information makes us rethink the expected outcome.
Why would oil markets be different. When traders talk about “fundamentals”, they’re always talking about expectations of the change in fundamentals. It’s still about fundamentals. I thought everybody understood that.
I’m waiting for congress to explain to me how the oil price dropped so much what with all those rascally speculators still about and uncontrolled by the saintly Friends of Anegelo Mozilo [sarcasm].
Bill, that’s an excellent post. Just to add….
Oil inventory figures, released Wednesday morning, showed an increase of 3 million barrels when a small draw was expected. Draws are typical in summer months when most people travel. This is a relatively big increase in inventories and has obviously negative implications for changes in demand.
Here is another way to look at the price formation of commodities and why prices are very volatile in the short term. Expectations are fed into the spot price through the expansion and contraction of inventories from the futures pricing mechanism. The spot price itself is based on current supply and demand balances.
The spot market price represents the market’s view of current supply and demand balance. The current supply will either go to current consumption or inventory. New supply will be brought on based on exploration and whether future prices are greater than costs and is a longer term process. The current supply and demand curves are very steep so small deviations in demand result in big price changes but not necessarily big inventory changes.
Speculators and hedgers buy and sell risk (or information). For instance, if a speculator believes that total demand will rise, they may buy a future with the expectation that when the information becomes well known, the price will rise above the price bought. This is an expectation. The hedger may sell or buy to ensure a specific price, this is an expectation.
The carrying cost of oil at this moment is an expectation. The difference between the future and the spot is the market price to carry oil. After buying the future, an upward pressure is placed on the price. The total market price for carrying will increase. Those that have lower carrying costs would buy the spot, carry and deliver (link to physical market) as well as sell the future. The spot price rises as a result.
The rise of the spot price affects long term contract pricing with indexing methods (physical link).
The current price of oil is set by current consumption requirements competing with future consumption expectations (throught the inventory process) to set the current price given the current supply. The spot price is set with an immediate supply/demand balance with some supply going to current consumption and some supply going to future consumption in inventory.
As a result, expectations regarding conflict, supply shortages, demand increases or visa versa are incorporated into futures prices that feedback to spot prices (as well as long term contracts through indexing methods) that are set by immediate supply and demand for consumption or inventory. Future supply may also be affected by expectations that would slow down or accelerate development projects. The steepness of the supply and demand curves results in large changes in prices for small changes in future expectations.
A big factor is the speculators are starting to get nervous as people are realising they can affect the price of oil:
http://peakoildebunked.blogspot.com/2008/07/366-futures-prices-determine-physical.html
In fact the price of oil is set on the futures market not the other way around, so speculators are in charge of the price of oil. So it is likely a bubble that will be shorted down in price to make money by the same speculators.
I thought this was particularly interesting:
http://www.simmonsco-intl.com/files/012798.pdf
The average total open interest in NYMEX crude is about 400,000 contracts. Each contract represents approximately 1,000 barrels of West Texas Intermediate crude oil. Thus, with $17 per barrel as a representative price, the NYMEX market represents $6.8 billion nominal value of crude oil.
However, since commodity contracts are purchased by putting up only $2,025 per contract as margin equity, the $6.8 billion of crude oil is controlled by a total cash investment of only $1.6 billion — $800 million invested long and an offsetting $800 million in short positions.
The “non-commercial† contract holders, which are refered to in this piece as “funds†, rarely make up more than 10% of the total open interest in crude contracts. In fact, while the total open interest in crude averaged slightly more than 400,000 contracts for 1997, the funds averaged a net position of around 4,000 contracts (27,000 short and 23,000 long).
However, the funds’ total short position on January 2, 1998 was 76,887 contracts, the highest short or long crude position ever held by non-commercial holders.
The record short position (shown in the table above) represented a total investment of only $156 million, a pittance for most financial institutions in today’s highly liquid markets. Amazingly, this net short position is held by only 47 owners. On average, each has a total investment of a mere $3.3 million. While obvious to state, this is not a lot of money to end up pricing the world’s most powerful commodity.
The Fed’s broad index of the dollar’s value was 95.97 on February 28 and 95.97 on July 8. The broad index of the dollar reached its low in March of this year. It is currently around what it was in December of 2007. The fall in the dollar is something that happened throughout last year, for the most part.
This is a broad index in terms of other floating currencies. An index of floating currencies is made up of unstable currencies, currencies that themselves on average undergo quite significant inflation. Neither individual floating currencies nor indices of them are stable standards of value.
As I wrote here:
An overview of the monetary explanation of commodity prices can be found here.
Bill, that’s an excellent post. Just to add….
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