NOTE: This is an article I originally wrote in 2008, but has been slightly edited to explain the current situation regarding oil. The mechanics remain the same.
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.
SUPPLY AND DEMAND
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 2008, 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 between 72 and 81 over the past year. This means between 10-20% 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 high of $145, $25 was attributed to the recent decline of the dollar! At the current price of $110, oil is actually valued at between $88 and $99 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, if the August contract for crude oil expired today, the September contract will become the front (current) contract on the next trading. 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, 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 take 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.
http://www.cnbc.com/id/15840232?video=753754816&play=1 http://peakwatch.typepad.com/peak_watch/peak_oil/index.html http://peakwatch.typepad.com/photos/research_images/oil_supply_and_demand.jpg http://gailtheactuary.files.wordpress.com/2007/06/north-sea.jpeg http://omrpublic.iea.org/DashBoard/demand.gif
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