These ____ Blessed Oil Prices

Unpredictable Oil Prices are Hurting Everyone

This post examines the recent swings in the spot price for crude oil —
especially in light of the currently rapid rising spot prices. Noting
that the current run up of prices looks a lot like period leading up
to the sudden price spike that occurred in the summer of 2008. It goes
on to argues that the global economy needs a better market regulating
mechanism that can help manage these swings and reduce their amplitude
so they become less damaging to the world's economies. The energy
business — whether it is alternative energy or oil, gas or coal
exploration and development — has huge up front capital needs. This
needed capital is much harder to raise in a climate of such extreme
near term price uncertainty.

In the summer of 2008 the benchmark ICE Brent crude oil closing price
peaked well above $130 per barrel only to collapse within a few short
months all the way down to slightly above $40 per barrel – a price of
just one third the price it was trading at a few short months before.
This wild price swing did immense harm to the global economy and made
it very hard for anyone making long term capital allocation decisions
to confidently predict what the future cost for a barrel of oil would
be in just a few years let alone the ten or more years that these
planners need to be able to predict on.

This massive price swing, which in part helped trigger the worst
financial crisis and economic recession the world has experienced
since the Great Depression is not a onetime event. In fact once again
the benchmark ICE Brent crude oil price has crossed the $100 per
barrel threshold – trading at $102.19 on 2/18/11. Other oil indices,
such as the OPEC Reference Basket or the West Texas Intermediate (WTI)
index also reflect this currently rising unit price. The current run
up of prices also looks a lot like period leading up to the sudden
price spike that occurred in the summer of 2008; are we soon going to
live through another wild spike followed by a price crash as the
global economy is tipped into steep recession and economic activity

ICE brent crude oil closing price Unpredictable Oil Prices are Hurting Everyone

This graph, from, tracks the Brent index from 1988 to the
present. The very large price spike of 2008 and subsequent equally
phenomenal price collapse can be clearly seen. The recent rapidly
rising prices is also clearly seen. Notice how in recent years the
market has seen much more rapid price volatility than has historically
been the case.

What is driving these recurring price swings? Clearly there is massive
speculation going on in the oil futures market and in both the up and
down directions. Once again the speculative fever seems to be rising
in temperature as the psychologically important $100 per barrel price
is crossed. Speculation seems to be exacerbating the amplitude of the
swings, but the crude oil energy market is far too large to be driven
purely by groups of speculators no matter how many billions they have
behind them. Something else is also going on to trigger these swings.
The World has Reached the Peak Plateau of Global Oil Production

A clear hint at the underlying reason has recently become a part of
the public domain; although some oil insiders have known this for some
time now. Leaked cables (WikiLeaks) from the U.S. embassy in Saudi
capital Riyadh reviewed by the Guardian, describe a warning from a
senior Saudi oil executive, who said the country's crude oil reserves
have been overstated by nearly 40 percent, some 300 billion barrels.
In the leaked cable Sadad al-Husseini, the former head of exploration
at the Saudi oil monopoly Aramco, told the U.S. consul general in
Riyadh that the Saudi oil company could not keep up with the 12.5
million barrels a day needed to keep prices low. Peak oil, he said,
could be reached as early as 2012. The importance of this – to anyone
who is listening – cannot be overstated; this is major news that is
going to impact everyone in a very major way.

The driving force for the price swings is that the world's swing
producer is losing its historic ability to drive prices down when it
chooses by flooding the world's market with surplus oil. Saudi Arabia
can no longer produce a whole lot more oil to quell the speculative
fever that is unleashed as the global surplus in supply is mopped up
by economic recovery. In fact as the world's economies recover from
depression or the dip in the growth rate for countries like China,
demand for oil is rising. The world's suppliers cannot physically meet
that demand and so the price is going to sky rocket once again.

global oil production Unpredictable Oil Prices are Hurting Everyone

The graph above shows the world oil production over the last seven
years. Notice how even when prices spiked above $130 per barrel in
July of 2008 oil output did not increase by very much — even at this
historically very high price. This is powerful evidence that any
alleged Saudi spare capacity, being held in reserve does not in fact,
actually exist.
Why is the World on this Terrible Rollercoaster?

Why… because oil is a particularly inelastic kind of commodity. Oil is
not like doughnuts or most other things that are quite easily
substituted or done without if prices rise too much. People NEED oil
and it is very hard to do without or to substitute with something else
— you cannot put coal into your tank.

And so… the price skyrockets… until finally the marginal consumers are
finally forced out of the market. What then happens is that as
billions of people in the world pay out a much larger share of their
previously disposable income just to meet their critical energy
consumption needs the global pool of disposable income, quite suddenly
dries up and all manner of discretionary spending collapses. People no
longer buy things or go out or travel. Inevitably this leads to a
collapse in factory orders and pushes the world's economies into

As recession sweeps the world the demand for oil DOES finally collapse
to some degree and as it does – once again – surplus oil appears on
the market and the price begins a violent swing in the other
direction. This process is exacerbated by speculators on the way down
just as it had been previously driven by speculators on the way up.
This is precisely what happened during the violent price swing of
2008, from the historic summer price peak to the four year low set
just a few months later.

The spot market price regime that we are beginning to see develop as –
what I feel – will be a recurring pattern of wild price swings between
peaks and subsequent price troughs is being driven by the lack of
reserve production capacity. The world has effectively reached the
global peak in oil production. Saudi Arabia can no longer turn up the
spigot. It can no longer control the market as it once could.

In the coming decades I fully expect wild successive price swings in
the spot price for oil as the world bumps along the plateau of maximum
global oil production. Because oil is such an inelastic product price
will tend to swing over a wide band. As global economic recovery
pushes on the demand side available "extra" supply will quickly be
soaked up and speculation will drive the spot price to stratospheric
levels. This will collapse economic recovery as energy costs soak up
more and more of the discretionary income. As the global economy again
slides into recession and economic contraction, demand for oil will
fall and each new historical peak price will collapse as speculation
now drives it in the opposite direction.

Rinse and repeat.

This regime of swinging oil prices, oscillating between successive
price highs and troughs, will mask a longer term moving average of
increasing energy costs and it will harm everyone except perhaps the
few speculators who are able to cash out fortunes on the swings (in
both directions I might add). A regime of wildly swinging prices will
prevent much needed long term capital investment in the energy sector
by making it harder to forecast future price levels needed in order to
justify the capital expenditures. It will wound economies across the
globe in a damaging price cycle that will force successive
contractions on the global economy each time it begins to recover from
the preceding contraction.

We Need a Better Global Oil Price Stabilization Mechanism- Continues

by Chris de Morsella, writer for the Energy Collective

Scott's Contracting


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