One can be forgiven for not understanding the state of our world today in terms of oil and its availability. A new article in Forbes assures us that peak oil is off, that the world is awash in oil. Meanwhile, an article from the current issue of The Economist claims the opposite: that oil supply is insufficient to keep up with demand. Looking in a third direction, the president is blaming high prices on those nasty speculators. So which of these competing claims is a person to believe?
For the uninitiated, peak oil is the point in time when maximum extraction of the world’s oil endowment is reached. Since oil is a finite resource, we can exploit it in increasing amounts until we can’t any longer, and flows begin to decline.
First, let’s dissect Forbes‘ claims that peak oil is no longer a concern. Author Matthew Hulbert commits one of the most common errors when discussing peak oil: he conflates the size of oil reserves with flow rates. Large reserves do not equal rapid flow rates, and large reserves are worthless without the ability to get the oil to market. Think of it like a bank account: even if your balance is millions of dollars, you may still be limited by your ATM’s daily withdrawal limit. Since we need the oil now, not at some unspecified point in the future, this is a problem. Another factor here is that these large reserves are often located in inconvenient and expensive areas to develop, such as deepwater plays or shale oil formations. These expensive, technically challenging and environmentally risky resources require higher prices at the pump to justify their exploitation.
Hulbert continues making common errors when he equates shale oil and liquid natural gas(LNG) with oil. My car doesn’t run on shale oil or LNG, does yours? And now you see the problem with that claim. Although both can be processed into reasonable substiutes for many of crude oil’s uses, they are not crude oil. This processing adds time and expense to the production flow, and therefore impacts both flow rates and the prices for end-use.
Hulbert also offers clues as to why oil is so expensive these days: China and India and bidding heavily for access to oil reserves in Africa, as are European countries and oil majors. All this bidding drives the price up– simple economics that you’d think a Forbes contributor would be well-acquainted with. Hulbert goes on to explain how strife and conflict in the African continent has taken hundreds of thousands of barrels of oil offline. Again, simple supply and demand dictates that decreased supply = increased price. At the risk of repeating myself, this price behavior is independent from the size of the oil reserves in question. Flow rates are what matter, and the flow is constrained by a number of factors.
Which is where the Economist article picks up, neatly explaining that rising prices are based on supply/demand factors:
One leading asset manager talked recently of the world being “awash with energy” because of the exploitation of American shale gas. Nevertheless, oil is still the main fuel for cars and trucks. And crude output (as opposed to alternatives such as biofuels and liquids made from gas) has been flat since 2005.
A number of countries (including Britain, Egypt and Indonesia) have turned from net oil exporters into importers in recent years. And although rich countries have curbed their energy-guzzling a little, demand continues to surge in emerging markets.
This has left the oil market very vulnerable to temporary supply disruptions, such as the war in Libya.
Output flat (having plateaued in 2005), demand increasing– that sounds like a recipe for increased prices.
So, what’s up with the oil speculators? Believe me, I have no sympathy for big Wall Street traders, and if they can find a way to make an illegitimate buck, I firmly believe that they’d take it. But this is not one of those cases. We’ve established that the fundamentals of oil are acting to raise prices, and higher prices down the road are always attractive to speculators, so of course we would expect to see these oil futures contracts traded heavily.
But perhaps we can look at a similar market for an understanding. Natural gas is traded on futures markets, just as crude oil is. Yet natural gas prices are trading at record lows, due to a huge oversupply in the market. We don’t blame the natural gas speculators for driving down prices, they are responding to the fundamentals of the resource. Oil markets work in the same way: tens of thousands of contracts are traded every day, but the fundamentals determine the direction of prices. Look at how rising inventories are leading to lower prices.
James Hamilton explains at Econbrowser.com:
Let’s take a look, for example, at NYMEX trading in the May crude oil futures contract. A single contract, if held to maturity, would require the seller to deliver 1,000 barrels of oil in Cushing, OK some time in the month of May. Last Friday, 227,000 contracts were traded corresponding to 227 million barrels of oil, which is indeed a large multiple of daily production. But it is worth noting that at the end of Friday, total open interest– the number of contracts people actually held as of the end of the day– was only 128,000 contracts, much smaller than the total number of trades during the day, and not much changed from the total open interest as of the end of Thursday. Many of the traders who bought a contract on Friday turned around and sold that same contract later in the day. If the purchase in the morning is argued to have driven the price up, one would think that the sale in the afternoon would bring the price back down.
So speculators buy and sell, which one is responsible for driving the prices up? Research done by the St. Louis Fed confirms that the fundamentals of the oil market are driving prices, rather than idle speculation, which they assign no more than 15% of the blame for rising prices. Other researchers with the University of Michigan and the Oxford Institute for Energy Studies concur (PDF). But high gas prices are devastating to an incumbent president in an election year with an already-struggling economy, so don’t expect politics to match up with reality any time soon.