Oil Price Hangover

The price of oil is an odd thing. It's watched by millions of people every day, especially when it reaches uncomfortable levels, yet no two observers agree on all the details of how it's determined. Having traded the stuff professionally, I've always given a lot more credence to the fundamentals of supply and demand than to the influence of speculators as the main driver of day-to-day price movements, though it's clear that both supply and demand are pretty complex constructs in their own right these days. For some time, however, I've also been intrigued by the extent to which current oil prices seem to be affected by their own history, something more in keeping with behavioral economics than the kind I learned in grad school. When I consider all the factors converging to yield this morning's price for the prompt (April 2010 delivery) West Texas Intermediate crude oil futures contract, it's hard to rationalize a value just over $80 per barrel any other way, without taking into account that less than two years ago it was nearly $150 per barrel-- though just a year ago it stood at $40, after a dip into the mid-$30s.

Over the weekend I happened to look back at some scenario work I did almost six years ago, when oil prices were rising steadily but before they had passed the $50 per barrel mark for the first time. Though it seems hard to credit now, at the time even that milestone seemed nearly unimaginable for the group of energy industry managers participating in the workshop I was leading. WTI had just broken through $40/bbl, which represented the highest nominal oil price any of us had seen in our careers, a record set in the lead-up to the first Gulf War. Although the prices in the early 1980s, after the Iranian Revolution, were higher on an inflation-adjusted basis, we had just lived through a couple of decades in which oil had notably failed to keep up with general inflation. Of course from our current vantage point $40 or $50 now seems cheap, and that's precisely the point. With an all-time high of $145 still relatively fresh in memory for "anchoring" purposes, $80 might not seem low, but it hardly provokes the kind of anxious political pronouncements that flavored the 2008 US presidential campaign.

Things couldn't be more different than the first time we passed $80/bbl in September 2007, when there was much talk of the risk premium on oil prices due to tensions with Iran, as well as the impact of a weakening US dollar. Most importantly, the global economy was still booming and OPEC was having trouble keeping up with growing demand, particularly from the developing economies of China and the Middle East oil producers themselves, along with the US at the tail end of the bubble. By contrast, despite expectations for a recovery in 2010, today's oil market is dominated by weak demand, with average US demand for oil and its products in 2009 down by 10%, or 2 million barrels per day (MBD) from '07. The global appetite for oil fell by 1.5% in 2009, with only Asia and the Middle East registering any growth. Inventories are ample, refineries are running at extremely low rates of utilization--partly due to some ill-timed capacity increases--and OPEC has as much spare oil production capacity as it did in 2003, when WTI was in the $30s.

So why isn't oil back in the $30s or $40s, rather than the $70s and $80s, particularly with the dollar having strengthened by almost 6% since the beginning of the year? Certainly a big part of the credit or blame, depending on your perspective, belongs to OPEC, which has managed to take 2-3 MBD of production off the market and keep it there, with minimal cheating and without triggering a price war driven by members whose national budgets needed significantly higher oil prices or sales to balance. It's also clear that since the beginning of the last decade the marginal cost of incremental non-OPEC production has gone up significantly, whether from Canadian oil sands or deepwater Gulf of Mexico platforms. Part of that is due to the fact that these are intrinsically costlier barrels to produce, but it also owes a lot to the costs of raw materials and construction involved. Those soared during the last decade, weakening subsequently but not returning to their former levels. That means that the much lower oil prices we saw briefly at the end of 2008 and beginning of 2009 aren't sustainable for any length of time, though precisely where a realistic floor now lies is anyone's guess.

Arriving at a price of $80/bbl despite slack demand, ample global supply and a refining sector that's losing money doesn't require nefarious speculation, but it probably depends on two crucial factors: Most oil deals today are negotiated as a stated premium or discount relative to a handful of grades like WTI and Brent that involve as many financial players as refiners who must process the stuff and try to make a profit on it. And for those few, correspondingly more influential markets in which traders must negotiate an actual price and not just a differential, traders' price expectations are anchored by the history of the last couple of years. Once you've seen oil above $100 without the world ending--though it came close--you simply can't look at the market the same way you did before. If the range of possible prices is now seen as $40-$150, rather than $15-$35, today's circumstances understandably yield a mid-range interpretation, backed by an expectation that OPEC would intervene even more strongly if prices began falling towards that uncertain floor--a threat the credibility of which is greatly enhanced by OPEC's remarkable cohesion and discipline over the last year or so, perhaps providing more psychological anchoring in the form of availability bias.

So in a strange sort of way, we may still be experiencing the consequences of the extraordinary oil price spike of 2007-8, which was itself either an outgrowth of the global financial bubble, or a major, independent contributor to the ensuing collapse, in classic oil-shock fashion. While the extreme prices of that period have receded, they haven't vanished from the market's memory, and so they may continue to influence prices for some time to come, until the next spike or oil-price collapse resets them again.