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What goes Up …sometimes takes a different path coming Down

November 14, 2008

Jon, regarding the question you posed in your post “What Goes UP…”

In order to understand where oil (gasoline) prices are going, one needs to take into consideration why/how oil prices ramped up in the first place.

A simple regression analysis by
showed an 87% correlation between the M3 money supply and the price of crude, and yes that doesn’t mean there’s an underlying causal link, but….

Add to this, another report by the Washington Post (A few speculators dominate vast market for oil trading) that indicated, “reports that financial firms speculating for their clients or for themselves account for about 81 percent of the oil contracts on NYMEX,” effectively crowding out the user market. That finding was shared by Roger Lowenstein writing for the NYTimes ( What’s really wrong with the price of oil) .

These two factors seem to indicate that (past) pricing was impacted not only by consumption requirements – but by an influx of money seeking to earn a return on their investment. The problem isn’t the investment per se – but where it is being invested. If for example the investors/speculators traded in the stocks of the oil companies like PetroCan or Exxon the resulting stock price gyrations would have negligible impact on the price of crude – which is established in a different market…

However when participants in the crude market speculate on a relatively constrained supply commodity that has inelastic (short/medium term) demand – it simply ratchets up the cost of the crude for all users ultimately trickling down across all sectors of the economy throughout the world. And since we don’t have reasonable energy alternatives, everyone is forced to pay the new-found intermediaries….who by insinuation became a defacto financial OPEC.

It seems the tipping point was reached when US retail gasoline prices hit $4/gallon in June 2008. Consumers finally pushed back, businesses cocked their eyebrows, politicians proclaimed from the stump – all of which set into motion new impetuses for alternative energy initiatives.

Today, in our post financial-bubble world speculators are no longer flush with cash and global economies are tanking – including China and India that were pointed to as a contributing ’causes’ for the ramp up in demand. And so the rubber band has snapped and powerful forces are now constraining demand for the black gold in addition to a reinstatement of normal pricing mechanisms.

So to offer an answer to your question, in the short term – I suspect we will tend to see the current prevailing prices until such time that:

1.the balance between the reduced demand and reduced supply that OPEC (and others) are able to achieve via production cut-backs

2. oil stockpile inventories dry up, and

3.that we don’t have distribution choke points develop somewhere or some significant political instability.

It will be interesting to follow whether the government enacts a floor price tax to encourage the innovation and infrastructure push for the establishment of a new energy matrix, and whether oil companies elect to push forward their invests in the development of new energy reserves or whether they distribute more of their windfall profits to shareholders etc…

Where should the price of oil/gasoline be?

This chart plots weekly retail gasoline prices in Toronto (cents/litre) versus the spot price of a barrel of West Texas Intermediate crude (US$/barrel) from 1987 through to May 2009. We see that at any given price of crude (horizontal axis) there is quite a large range of retail prices. For example at $60/barrel – retail prices over the years have ranged from $0.80/l and $1.02/l


Some may think with crude topping $61/brl today (March 20,2009) and Toronto retail at $0.97/l – that in the midst of the weakest economy since the Depression,  retail prices that push the top boundary seem excessive.

Or maybe ask these folks:
(sources courtesy of Econbrowser : How big a contribution could oil speculation be making?)

Akira Yanagisawa, Senior Economist at Japan’s Energy Data and Modeling Center: “In the most recent terms (the third and fourth quarter in 2007), the fundamental prices [of oil] are estimated around 50 to 60 dollars. On the other hand, it is estimated the premium has risen up to around 40 dollars at maximum.” [Institute of Energy Economics, 3/08, p. 13]

Larry Chorn, Chief Economist of Platts: “says the actual costs incurred in producing the most expensive oil is only around $70 or $80 a barrel, meaning that about $50 of the current price represents ‘the market’s risk premium plus speculation.'” [ BusinessWeek, 5/13/08]

J. Stephen Simon, Executive Vice President, Exxon-Mobil: “the price of oil should be $50 to $55 per barrel based on supply and demand fundamentals.” [House Testimony, 4/1/08]

John Hofmeister, President, Shell Oil Co: The proper range of crude oil is “somewhere between $35 and $65 a barrel.” [Financial Post, 5/22/08]

At least we have all learned some valuable albeit expensive and painful lessons that will guide our energy policies going forward. The US-led public shift in recognizing the strategic security issues surrounding the massive transfer of economic wealth from oil consuming to oil producing countries, the long-term economic importance of an expanded menu of energy alternatives, global warming, rising and more aggressive mandated fuel efficiency standards and changed consumption habits have created a dramatic new landscape that is just beginning to unfold – witness the changes in the auto sector.

It doesn’t take a rocket scientist to see that demand has and will be changing …..permanently.

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5 Comments leave one →
  1. April 30, 2009 1:45 pm

    The tipping point was before $4 gasoline.

    Vehicle Miles Traveled plateaued around the beginning of 2005 or end of 2004. It peaked about between August and October 2007.

    Diesel fuel consumption peaked the same time. Gasoline consumption peaked about the time, though the curve (12 month smoothing for seasonality) is pretty flat until May 2008 when things really fall.

    You also might enjoy this reading from Paul Krugman in 2001.

    “The basic idea was that oil differs from ordinary commodities not in the existence of a cartel, but in three other facts: it is an exhaustible resource, production is controlled by national governments, and for the major oil exporters oil is the overwhelmingly dominant source of national income.

    The fact that oil is an exhaustible resource means that not extracting it is a form of investment. And it is an investment that might look attractive to a national government when oil prices are high. If a country does not want to spend all of the massive flow of cash generated by a sudden price increase on consumption, it must do one of three things: engage in real investment at home, which is subject to diminishing returns; invest abroad; or “invest” by cutting oil extraction, and hence reducing supply.”

    I wonder how much “investment abroad” was actually buying debt and debt backed securities that were financing our consumption.

  2. April 30, 2009 2:22 pm

    Thxs Aaron
    can you share your source regarding the vehicle miles traveled data?

    re your point about petro debt
    one can get a sense of this by looking at how Kuwait was buying up assets around the world in advance of the day their wells run dry – and how Russia emerged from being a financial basket case to having a bursting treasury, but I believe China is the primary holder of US debt at the moment. Does anybody want to take a bet as to how long it will be before we get a blended global currency basket to replace the US dollar?

    thxs for the comment

  3. April 30, 2009 4:27 pm

    The data I’ve looked at is from the energy information administration and the FHWA

    I’m on my mobile phone right now, I can provide you links and email an excel sheet w/ graphs later.

    Product supplied, finished motor gasoline is the EIA gasoline consumption data. Product supplied, distilate fuel oil is diesel consumption. They can be found in weekly and monthy formats.

    The VMT data is monthly, historical though 2007 (I believe), after that they have monthly reports the other numbers can be found in.

    I have images of some graphs in recent blog posts.

  4. April 30, 2009 6:33 pm
    Column 19, MGFUPUS1, is all Gasoline Supplied (diesel is not considered gasoline).

    Column 25, MDIUPUS1, is Distilate fuel oil, which includes what is considered diesel.

    Caveats: Not all gasoline is used for on-road driving [don’t for get planes, boats, lawn maintenance, etc.). Even less distilate fuel oil is used for on-road transportation (much is used for power generation; industry, such as construction, mining, etc.; overseas shipping; etc.)].
    Vehicle Miles Traveled data.
    Gasoline Price Data (inflation adjusted).

    BTS can provide estimates of passenger miles traveled, energy used per passenger mile by certain modes, etc. But they’re estimates and not released frequently.

  5. April 30, 2009 6:35 pm

    Another big diesel user is locomotives.

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