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July 19, 2008

Inside the Oil Problem

…And Why Oil is Not Being Speculated

Oil has become a term that has struck fear and anger in the hearts of millions of Americans over the past few years. Since the summer of 2005, oil has made a nearly parabolic move upwards in price. What was once $30 per barrel oil and $1.15 per gallon gas has turned into $145 per barrel oil and $4.15 per gallon of gas.

Like many, I believed that trader speculation had to be a partial cause to the dramatic increase in prices. Over the last several months, several points have come to light to show that oil is not being speculated. In fact, the rise in oil prices can be blamed on a combination of supply, demand, and currency issues. Also, at the writing of this blog, oil has fallen by 11% this week and I would like to explain/predict what I think will happen in the future.


The global oil supply has sustained long-term growth over the past several decades until 2005. In 2005, some traders noted that global demand from developing nations like China and India would outpace the increase in global production. To make matters worse, production from 2005 through 2007 did not increase while demand growth remained sustained. Eventually, demand outstripped supply, crossing the 85 million barrels per day mark.

By this year, demand increased to 86 million barrels per day while supply remained at 85 million barrels per day. At this point, crude inventories worldwide began to decline. Different from a shortage, crude was still able to meet the demand, however, since production was so difficult (if not impossible) to increase, demand had to be decreased. This could only be done through an increase in prices. Since oil is not an elastic commodity, the price must move upwards by more than what demand is required to drop by. (In plain English, the price must increase a percentage much greater than 1% in order to pull more than 1% off of demand).


In 2005, before the run-up in the price of oil, the dollar index was around 90. Thanks to the latest decreases in the Federal Reserve rate and the subsequent increase in the money supply, the dollar index has fallen to around 75. This means that 17% more dollars are required to buy foreign oil (which is 70% of the consumed oil in the US) than what was required less than three years ago. This means at the recent high of $145, $25 was attributed to the recent decline of the dollar! At the current price of $130, oil is actually valued at $108 in terms of 2005 dollars.


I have come to find out over the past couple of months exactly how oil is traded. Oil trades on 30 day contracts one month in advance. For example, the August contract for crude oil expired today. The September contract will become the front (current) contract on Monday. The argument in support of speculation states that hedge funds, ETFs, and other speculators are buying up oil contracts and futures, thus bidding the price up, but this argument has one fatal flaw.

On the last day of the front contract (such as today), delivery takes place. On this, the delivery day, buyers must pay for the oil and take physical possession of it. Therefore, if you are a speculator, you must take possession of the oil. Those who believe speculation is at fault will counter that speculators will simply “roll” out of the front month and into the back (future) month’s contract. By examining the mechanisms of the oil trade a little closer, the flaw of this logic is also revealed.

In order to “roll” out of the front contract and avoid taking delivery, a buyer must sell his/her stake to someone who is going to delivery. This means that when the contract expires, every speculator has to sell their holdings to a buyer that is taking delivery or take delivery themselves. If oil’s price was over-exaggerated, we would see a radical shift in price on that final day to the market equivalent of what all buyers would be willing to pay.

The bottom line is that the markets are in a period of price discovery. While I have my opinions of what is going to happen to oil and traders have their opinions, as long as production is not increasing at the rate of demand, oil prices will have to rise to maintain equilibrium.



Tonya~TNGOP said...

I agree with you, all you heard from the news was its the speculators. I think we should have been drilling wherever oil was productive 10+ years ago! Maybe we would not be in such a mess now.

abogue1 said...

Well, I think you did a good job scratching the surface of the issue, and I will explain why. I think you are absolutely correct when you say that this is a supply/demand issue. Also basic economics says that if a scarce resource is in high demand, price will increase on any market.

The real issue is why hasn’t production increased? This is where my opinion comes into play. The Middle East (and various other countries) gets most of its major revenues from oil. At the same time, there is not any infinite supply of oil in any of these places. What happens when the oil runs out before these nations are able to shift their economies from oil producing to some other industry? They will slip backwards pretty quickly, and most of the power they have today will fade away. Their leaders know this.

At the same time, they understand the laws of economics, and that there is an equilibrium price out there, where demand and supply curves cross, leaving them to become most profitable. My theory (and many other people’s theory, as well) is that OPEC is currently trying to find that equilibrium price, where consumption and production will yield the highest return, and allow the nations to hold onto their oil for a longer period of time.

Up until now, we have been paying well below the equilibrium price, but now that we are probably getting closer to it (I’m guessing $5.00 per gallon is going to be the absolute breaking point, when people will really begin to change their habits), OPEC can continue to produce as it has, but reap-in much more profit, without having to compromise their long-term oil=power strategy.

Last week, President Bush gave a speech where he said that we will begin drilling offshore and producing our own oil. This is where you saw the 11% drop in oil prices. Why? Because competition has just entered into the former oligopoly that is OPEC. Since oil is just oil, no matter where you get it from, whoever sells it the cheapest, will receive the most demand. OPEC knows this, and I predict that they will do whatever it takes to keep the pressure off the U.S. government from drilling at home. That is just my two cents.

Jeremy said...


Your theory could very well be true. However, it should be important to note that some demand destruction has occurred at $145 oil. This is why Saudi Arabia offered to increase production. If the Middle East allows prices to stay high, countries will begin adopting alternative means of energy to replace oil for increased energy demand. If this is done, the price of oil would drastically fall with revenues. While OPEC is making huge profits off of the recent move in oil, it is in a precarious situation.

AaronIL said...


I'm not disagreeing with you. In fact I agree entirely. This is my point. In the past, they have been just selling oil for way-below the equilibrium price, and have been perfectly happy with that (not sure why.) Now that we have other players heavily entering the marketplace, such as India and China, they realized that maybe their oil supplies won’t last as long as they thought, and they better get their prices in line with what people will in fact pay.

As they reach higher prices, and demand starts to shift to alternative energies, they will be forced to decide on either lowering prices or deciding if less demand may still result in higher revenues at higher prices. For instance, selling 10 gallons of gas at $3.00/gallon is still less profitable than selling 9 gallons at $4.00/gallon. It is all about finding that equilibrium point.

Now, I think a bigger threat would be if the United States started pumping its own oil, as we may just be. We then become competition to the OPEC countries, and could drive prices much lower than OPEC has now grown accustomed to. That’s why I think that even TALKING about drilling is a good thing, because us drilling would change EVERYTHING on the world market.

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