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The Truth About Oil Pricing? Let's Discuss This

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Below is the Oilprice.com interview of Professor James Hamilton. James is a professor in the Economics Department at the University of California, San Diego. He has been a visiting scholar at the Federal Reserve Board in Washington, DC as well as many of the Federal Reserve Banks; and has also been a consultant for the National Academy of Sciences, Commodity Futures Trading Commission and the European Central Bank and has testified before the United States Congress. You can find more of his work on his website Econbrowser. This discussion is continued on BoomBustBlog in the Financialization of Physical Energy: Does Paper Oil Distort Physical Pricing post.

Topics include:
•    Why we shouldn’t get too excited with the shale revolution
•    The “Real” cause of high oil prices
•    The incredible opportunity presented by natural gas
•    Why long term oil prices will creep upwards
•    The geopolitical hotspots that could cause an oil price spike
•    Why sanctions could cause Iran to lash out
•    Why speculators and oil companies are not to blame for high oil prices.
•    Changes we can expect to see under a Romney Administration
•    Why Short term oil price forecasts are worthless
•    Peak oil & Daniel Yergin

Direct link can be found here.

James Stafford: Oil prices have shot up in the last month. What range do you see oil prices trading in over the next 12 months?

James Hamilton: Oil prices have always been very volatile.  If you look at 12-month logarithmic changes in WTI going back to 1947, you come up with a standard deviation of 0.27.  In other words, 25% moves up or down within a year are fairly common, and 50% moves or greater have also been seen on a number of occasions.

If you look at options prices at the moment, they imply the same level of uncertainty looking forward.  For example, somebody today is willing to pay $2.90/barrel for a NYMEX option to buy oil in September 2013 at $120/barrel, consistent with a standard deviation of annual log changes of 0.26.  The market is saying that prices that high or higher are not that remote a possibility.

And if you look at current fundamentals, it’s not hard to imagine big moves in either direction coming fairly quickly.  The price of oil would surely collapse if we saw a significant economic downturn in China (something nobody can rule out) or if Iraq succeeds in producing even half of its ambitious production targets (though I personally consider the latter unlikely). On the other hand, a military confrontation with Iran could produce a pretty spectacular price spike.  If the Strait of Hormuz were to close, for example, it would represent a shock to world production that in percentage terms would be 3 times as big as the 1973-74 OPEC embargo.

Because the demand for oil is so insensitive to the price over the short run, and because there is little excess capacity in the world at the moment, even small disruptions or additions could produce big price changes.  For this reason, I do not have a lot of confidence in anybody’s near-term oil-price forecasts.

On the other hand, I think we understand pretty clearly the main factors behind the overall increase in oil prices since 2005.  Demand for oil, particularly from the emerging economies, has grown significantly, and we have had a hard time increasing global production.  The single most likely outcome is that both conditions will continue to be with us.  The most likely scenario is that the next decade will look something like the last, with oil prices volatile but exhibiting an upward trend.  
 
James Stafford: For the past century or so, economies have generally been built upon energy. The economies with access to plentiful, cheap energy have developed the most. With the stagnation of oil production growth, how do you suggest economies could continue to grow from here? Should we stop expecting to see constant economic growth as the norm?

James Hamilton: I think this has put a significant burden on the oil-consuming countries.  These economic problems have been compounded by the fact that some of the key manufacturing that once came out of countries like the United States and Japan has now been taken over by the emerging Asian economies.

But there is still a strategy for trying to take advantage of the resources we do have.  The United States has had astonishing success in producing natural gas.  This could be the basis for a renewed manufacturing advantage, a new source of U.S. exports, or an alternative transportation fuel.  We should be looking for regulatory reform and infrastructure investment to encourage consumers and entrepreneurs to adopt alternatives to conventional gasoline-powered vehicles.

James Stafford: Apart from the Iran and Syria situations – are there any other geopolitical risks that could lead to increased volatility in the energy markets?

James Hamilton: The list of oil-producing countries is almost a Who’s Who of world trouble spots.  There is ongoing unrest in Sudan and Nigeria, and it wouldn’t take much to see a major turn of events in Venezuela and Kazakhstan.  Iraq, a key hope for future increases in production, has been a place of conflict for most of the last three decades.  The same forces that disrupted production in Egypt and Libya last year could easily return.  And the key worry about Syria and Iran is the possibility that instability there could spill over into other nations of the region.   
 
James Stafford: Even though many Asian nations have found a way to continue trading with Iran, its economy is still suffering from high inflation and high unemployment. Do you believe that the US Sanctions are having enough of an impact on the Gulf state’s economy to force them into a deal over their nuclear program?

James Hamilton: I was surprised that the sanctions were as effective as they were in preventing Iran from selling all the oil it wanted.  But the other key element of that diplomatic strategy is the assumption that Iran will respond to economic pressure by acceding to U.S. demands.  The other possibility is that, if significantly wounded, the regime would lash out more desperately.  This looks to me like a scary situation.
 
James Stafford: Whenever oil prices spike politicians are quick to blame speculators and oil companies for manipulating the markets. Are you in agreement with this – are speculators and oil companies to blame? Or are there other factors that are overlooked deliberately or otherwise by the mainstream media?

James Hamilton: The story is pretty simple, and even though politicians may try to distort it, you’d hope that the media would do a better job of reporting the truth than they have.  World oil production was basically stagnant between 2005 and 2008, even though world GDP was up 17%.  With economic growth like that you’d normally expect increased demand, particularly from the rapidly growing emerging economies, and in fact China did increase its consumption by a million barrels a day over these 3 years.  But with no more oil being produced, that meant that the rest of us-- the U.S., Europe, Japan-- had to reduce our consumption.  It took a pretty big price run-up before that happened.  To those claiming the price is too high, I would ask, how high do you think the price had to go to persuade Americans to reduce oil consumption by a million barrels a day?
 
James Stafford: Could you let us know your thoughts on the shale revolution. How do you see it playing out and do you think we have been oversold on shale’s potential?

James Hamilton: This is a real success story, and a primary reason that U.S. production is now rising rather than falling.  But there are several key points to keep in mind.  First, it is not cheap to produce oil with these methods-- tight oil is never going to be the reason we get back to $50/barrel.  Second, we’re likely to face much steeper production decline rates from individual wells than was the case for conventional oil production.  The same also applies to deepwater production.  So those who think these new technologies will put us back in the world we once knew are in my opinion missing the big picture.
 
James Stafford: Drilling technology advances, new oil finds and now all the hoopla over shale oil – one would assume we are swimming in the black stuff, yet we have seen no material increase in global annual crude oil production for six straight years. Have we reached a period of peak oil? Or is Daniel Yergin correct in saying that we have decades of further growth in production before flattening out into a plateau?

James Hamilton: I do not think the expression “peak oil” is the most helpful way to frame the question.  Too many people have a knee-jerk reaction as soon as they hear the phrase.  I can’t tell you how many times I’ve seen people assume that it means that we’re “running out of oil”, which straw man they then try to debunk.  I would instead call attention to the basic fact that the annual production flow from any given field shows an initial period of increase followed by subsequent decline.  Anyone who tries to deny that has a serious lack of grip on reality.  Production from the original Oil Creek District in Pennsylvania peaked in 1873, and from the state of Pennsylvania as a whole in 1891.  There’s a long, long list of areas that have exhibited declining production rates for a long, long time.   Global production nonetheless continued to increase for a century and a half, not so much because we got more out of the old fields, old states, old countries, but because we turned to new ones.  But that game is obviously not one we can continue to play forever.

Yes, Yergin today is optimistic about the future.  But I remember that Yergin was also very optimistic in 2005, and the last 7 years have not looked at all like he was predicting they would.  We’ve increased production only a little bit since 2005, despite tremendous incentives to do more.  I think many people are making a mistake if they assume that world oil production is always going to increase, year after year.
 
James Stafford: What are your thoughts on the Keystone XL Pipeline – is it something that needs to be pushed through after the presidential elections? Or something the country can live without?

James Hamilton: It is ridiculous to see oil selling in Cushing at a $20 discount to the world price and oil in North Dakota selling at a $20 discount to WTI.  Since the 1860s we understood that pipelines were the logical way to transport oil.  Somehow the Keystone pipeline became a symbol of some bigger controversies that in my opinion should be completely separate from the question of the most economically efficient (and for that matter, the most environmentally friendly) way to transport oil.

There are several work-arounds in progress, such as reversal of the Seaway Pipeline and plans to build just the Gulf Coast portion of Keystone.  But I think that given the magnitude of the drop in U.S. demand and success of North American production, we’ll need additional measures.
 
James Stafford: How would you see energy production changing in the U.S. under a Romney Administration?

James Hamilton: Romney wants to be more aggressive in approving oil exploration and development, and that should make a difference.  But it’s easy for the politicians to overstate how much they can change.  The U.S. is moving ahead with tight oil production, and is going to do so no matter who is the president, because the economic incentives are just too powerful for anybody to stop it.  On the other hand, it’s a big world out there, and anyone who thinks that U.S. production alone is going to make up for declines from mature fields and burgeoning consumption of emerging economies is in my opinion way too optimistic.  The world faces a huge challenge, and I think we need to take that challenge very seriously.

James Stafford: James, thank you for taking the time to speak with us. For those of you who haven’t seen Professor Hamilton's site please take a moment to visit Econbrowser

Related BoomBustBlog research: 

Frontline investment highlights - Pro Page 1Frontline investment highlights - Pro Page 1

Frontline investment highlights - Pro Page 2Frontline investment highlights - Pro Page 2

Frontline investment highlights - Pro Page 3Frontline investment highlights - Pro Page 3

This discussion is continued on BoomBustBlog in the Financialization of Physical Energy: Does Paper Oil Distort Physical Pricing post.
 


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Thu, 09/06/2012 - 12:53 | Link to Comment yt75
yt75's picture

In the US context, what should be "pounded" is most probably :
- The US passed its oil production peak in 1971
- The label "Arab oil embargo" attached to the first oil shock (together with an "OPEC agressive move") is nothing but public opinion (US in particular) management, the fundamental reason for the first oil shock --is-- the 1971 US PRODUCTION PEAK, and US diplomacy and the majors PUSHED FOR the price rise and OPEC quotas, necessary in particular to start Alaska, GOM, North Sea

Note : of course in parallel (or a bit before) there was the "rebalance" of oil production benefits between the majors and production countries, but one could understand that this had to happened anyway, and doesn't change the fact that the price rise (and OPEC quotas) especially post US peak, was a win win situation between the majors and OPEC or let's say common strategy interests.

Note : great documentary about above "la face cachée du pétrole" with James Akins interviews in particular (James Akins was the guy named by Nixon for auditing US production capacity further to 1971 peak, and was then US Ambassador to Saudi Arabia)

Thu, 09/06/2012 - 11:56 | Link to Comment Stuck on Zero
Stuck on Zero's picture

The phrase "peak oil" should be replaced with "peak cheap oil."

 

Thu, 09/06/2012 - 12:50 | Link to Comment yt75
yt75's picture

No, why ?

Peak oil is an utterly simple concept and his the contraction of "oil production peak"

That is, peak oil is defined as the point in time where the maximum flow of extracted barrels (per day month year depending on time unit chosen) is reached over oil usage history : FULL STOP.

That point exists for the very basic reason that any positive function which integral is finite (here the function is the production rate, number of barrels per day, its integral the number of barrels extracted up to date T), goes through a maximum and tends to zero at infinity, that is all.

 

In the case of oil extraction we know the intgral is finite (as is the earth), so the extraction flow will go (or has already been) through a maximum.

 

Then the date is determined by utterly complicated interactions between what is in the ground, technology used, economic environment and investment, wars, etc , doesn't change the basic fact.

 

We obviously are around it right now, and when the down slope truly sets in (around minus 4% a year or something), going to hurt for sure (already the case today)

 

(to be more precise in a math sense and avoid "pathologic functions", one should say the average over any non finite interval gors through a maximum and tends to zero towards infinity)

 

Thu, 09/06/2012 - 11:53 | Link to Comment Eally Ucked
Eally Ucked's picture

1 barrel of oil 100$ is not renewable commodity, produced mostly outside of USA

1 barrel of cocacola 120$ or more, product of USA 

1 barrel of shitty toast bread 150$ or more depends how you pack it. Product of USA

Oil is cheap.

Thu, 09/06/2012 - 11:28 | Link to Comment williambanzai7
Thu, 09/06/2012 - 11:43 | Link to Comment DaveyJones
DaveyJones's picture

Our own has been freaking out on the issue for some time.

Thu, 09/06/2012 - 12:45 | Link to Comment YHC-FTSE
YHC-FTSE's picture

+1 I remember reading about the US SPR and the vulnerabilities in the theatre of war dated around the time of the Vietnam war. As for the Germans, they've been freaking out since before the Battle of the Bulge, no? Makes me kind of glad that oil is a fungible commodity, else who knows how many more wars there could have been? 

As much as I loathe the neocon megalomaniacs who came up with PNAC, my guess is that their current plans are what is preventing price discovery in OPEC, an organization defined for their cartel activities in any management case study. As such we will continue to see downward pressures on the price of oil, until the bullshit becomes too apparent to hide (Are we there yet? I don't know). Just as we see the treasurers of sovereign countries announce the selling of gold every now and then to drive down the price of gold (Then not selling a fucking thing), we will no doubt hear about miracle new discoveries of oil every now and then to drive the price down, especially during the elections. Or the miraculous stepping up of crude production in some hell-hole guarded by Blackwater goons. It works the other way too of course, if you want to get rid of the puppet in government and replace it with another, all one has to do is create instability where the crude is produced.

I blame Plato - for defining a man as a political animal. In the end, everything seems to be related to the whims of those in power.

Thu, 09/06/2012 - 13:33 | Link to Comment DaveyJones
DaveyJones's picture

nice post and you're right, this is part plato's fault and part playdough's

Thu, 09/06/2012 - 11:27 | Link to Comment CrashisOptimistic
CrashisOptimistic's picture

A conversation about a geological process conducted by economists with no geology training.

What sense does this make?

To understand oil, start at one point.  Learn about the rate of decline in output of an oil well that has been extracting oil a few years.  Just start there.  Learn how the rate of output begins to decline.  Then extrapolate that to multiple wells in a given oil field.

Once you understand decline rates, you understand walking up a downward moving escalator.  Then running (by drilling more wells).  Then sprinting by drilling more wells frantically.  

Just remember, each well you drill will, in just a few years, add to the declines you are trying to overcome with more drilling, because they will start to decline.  The declines are additive, just like new discoveries.  They just have a negative sign in front of them. 

This worked decades ago because the sheer number of declining wells was fewer.  New discoveries could overwhelm that.  But the well count of declining wells has become huge, and it grows every day.  It has people drilling down 20 miles in oceans.  It used to be you just drilled a hole in Oklahoma.  Now you have to have enormous ocean rigs.

And every single day, another well drilled 5 years ago starts to die, and raises the discovery requirement.

Understand the geology.  Then you understand oil.

Thu, 09/06/2012 - 11:37 | Link to Comment hannah
hannah's picture

oil pricing is set by 'economist' not 'geologist'....the price of oil is controlled by wallsteet and doesnt have anything to do with supply and demand right now. after the markets collapse, then oil will be priced by demand.

 

perfect example is the rig count is down and the price of nat gas is still down.....

Thu, 09/06/2012 - 12:37 | Link to Comment boiltherich
boiltherich's picture

It is not so much that it is not controlled by supply and demand, though you are not exactly wrong, but both supply and demand have been manipulated since whales were our main source of oil. And both supply and demand beg the question in terms of what, fiat FRN's? Legal tender? Risk free government bond levels?

The peak oil arguments are to me less about quantities of crude miles below the bedrock than they are about how the questions get framed because there is an algebraic nature to them, there is an = sign and everything I have ever read about peak oil deals only with one side of the equation.

And that ties into another major argument that is not totally unrelated, global warming. I refuse to participate in that mess and the global economy will not adequately address the issue until the whole debate is rationalized into one that can actually be addressed. It just is not good enough to say that human carbon use is responsible for all warming on planet Earth, it is false and even if you could economically find a way to end human contributions of greenhouse gas (you can't) that does nothing to repair the damage already done. The question of human contribution to the atmospheric greenhouse gas is one of both margin, and not the per capita carbon footprint but the total number of footprints, that is to say, it is not about the atmosphere at all but rather it is a question of population control and humanity having LONG ago surpassed the carrying capacity of the planet. You can flounder around taxing every human into poverty with carbon credits and other bullshit schemes till the Antarctic becomes the next Brazil but till you address population you will simply fail, and failing to put human population on a sustainable path means we will have ceased to exist from other more pressing issues long before the planet gets too warm for comfort.

As to peak oil or warming being hard stop type issues they are not, proponents are guessing. As with the global warming arguments both depend on the conditional phrasing "...if current trends in production and consumption are maintained..." for all we know there is a five hundred year supply in the Arctic or the unexplored coast of Ireland, laying undiscovered. For all we know science will discover a cheap and easy process for synthesizing petroleum, and for that matter we could find a way to easily and economically sequester greenhouse gasses. Will population rise? Or, will a pandemic take out 85% tomorrow? Perhaps we will find a very cheap room temperature superconductor that will make storage and base load supply of electricity practical as a replacement for oil. As of now there is NO economical replacement for oil even if the dollar price doubles this afternoon.

Thu, 09/06/2012 - 16:49 | Link to Comment hannah
hannah's picture

when the sp500 falls to 400, peak oil and global warming will be long forgotton catch phrases.

Thu, 09/06/2012 - 11:47 | Link to Comment DaveyJones
DaveyJones's picture

When I hear folks say the problem is gradual and the is US is making great intelligent strides, I always laugh trying to match that with our geopolitcal games.

Your sage geological fact is joined with one other, oil is not a fungible commodity. Every aspect of modern society is built upon it, and vulnerable to it.

Thu, 09/06/2012 - 11:21 | Link to Comment Diet Coke and F...
Diet Coke and Floozies's picture

Dr. Albert Bartlett. End of discussion.

http://www.albartlett.org/

or

http://www.youtube.com/watch?v=F-QA2rkpBSY

 

"In growth we trust"... LMAO

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