Oil Price Bubble vs. Demand Destruction and Decline

The following article was first published at Al Fin Energy

The ongoing bubble in global oil prices is fighting for its life against declining demand across the developed world -- and the threat of a near to intermediate-term collapse in demand from emerging nations such as India and China.

Fundweb: Decline in Demand Occurring First in Developed World

...a volatile mix of factors is in play. There is an appetite for risk, he says, but based around demand for a futures position, the buying of paper contracts, not the physical demand for petroleum. Real economic demand for oil, by contrast, is in retreat, and a thin support for current prices.

...More generally, the International Energy Agency (IEA) has forecast shrinking demand for oil from developed nations for 2012, and modest growth in the developing world of 2.8%.

“We are seeing a bit of a bubble, understandably connected to the take on Iran and the embargo,” says Evans.

...The popularity of the Peak Oil theory...has helped to bake-in continually bullish expectations about higher prices. In other words, it has helped create an ongoing foundation for speculation.

Government intervention in the form of monetary policy also seems to have played its role in higher prices. As part of a strategy of “reflation” of asset prices after the 1990s equity collapse and economic downturn, Alan Greenspan, the then Federal Reserve chairman, lowered interest rates to record lows, leading in turn to a new phase of dollar value depreciation from 2002 to the present.

As new capital sought to hedge against a depreciating dollar and inflation, a paradox was created, some argue. As commodity prices rose, capital inflows created the inflation it sought to avoid as a certain amount of passive “buy and hold” money entered the market and rolled over contracts on a regular basis.

...Greater credit there has driven growth, in turn driving up demand for raw materials and commodity prices.

“However, there is a fairly convincing argument that the aggressive loosening of monetary policy everywhere has seen authorities shooting themselves in the foot,” says Neumann.

Consumers in the countries where quantitative easing (QE) has been introduced face higher petrol prices and inflation, for example. More generally, it is not difficult to see why rising oil and therefore petrol, fuel and heating costs, and inflation in general, are causing concern.

With stagnant or declining real wages, and high unemployment in many parts of the developed world, living standards are already coming under pressure. Inflation adds to the cost of living and, of course, has a more serious impact on the poorest of the world in the developing nations.

At the same time, higher oil prices mean higher production costs for a whole range of industries – agriculture, transport, manufacturing, and so on – which, to one debatable degree or another, may be passed on to consumers via higher prices.

Not surprisingly in this context, analysts and economists are trying to quantify the impact of certain oil price levels on economic growth more generally.

...Each type of crude oil – ranging from the heavy varieties in the Middle East, which can be easily extracted, to the lighter North American types – needs to sell for a certain price for profits to be made. The costs of producing a barrel of Canadian Tar Sands oil before profit are thought to be about $40-50.

In this context a higher sale price for oil is likely to have encouraged rising production in America, where production costs are high.

If bullish forecasts are to be believed, America is on the verge of energy self-sufficiency within a decade, given the huge shale oil deposits it has, and the possibility of using the same technology developed for shale gas – hydraulic fracturing, or fracking.

An estimate is that such oil deposits contain two trillion barrels of oil. For comparison, America consumes roughly 19m barrels of oil a day.

...One of the paradoxes about the oil and broader energy market is that, in economic, operational and technological terms, the market has been relatively successful at the basic in supplying half of the world with the energy it has been demanding to raise living standards. The future does not seem too terrible, either, for technological breakthroughs and further development.

According to the US Energy Information Administration, there is enough oil worldwide to meet demand for the next 25 years.

... instability in the [oil] market is...being introduced from the financial and geopolitical sides.

Discussions about reform in the financial area are underway. The US Commodity Futures Trading Commission is considering ways to stop excess liquidity and speculation in futures markets from distorting price discovery and affecting the physical market and real economy.

It plans to implement “position limits” in the futures markets, for example. Ex-futures traders are some of the most strident critics of the system. In his book, Oil’s Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy, Dan Dicker, an energy analyst and ex-oil trader, explores how financial markets have become more divorced from the practical and productive activities in the physical oil industry.

The problem might be broader still. A further analysis might look at what is happening with broader money creation, the excess liquidity and price instability problems stemming from the central bank objectives of “reflation”, and their impact on the oil market. _Fundweb

Read the entire article linked above for much more detail, provided in a relatively even-handed and broad overview.

The article fails to consider what will happen if propped-up and subsidised demand from emerging nations such as China and India should decline -- either gradually as in the developed world, or abruptly in the form of demand collapse.

Global demand for energy is increasing at the same time that demand for crude oil -- at its currently inflated prices -- seems to be declining. Europe, Russia, and parts of East Asia are experiencing demographic implosion, which can only lead to a future drop in demand for oil. The only parts of the world still exploding in population are the parts of the world that can least afford to buy expensive commodities -- but are instead more likely to sell their birthright commodities in order to supply corrupt leaders and their families with European townhouses and extended vacations.

Global energy markets involve far more than crude oil. Rapidly improving technologies of fuel and energy substitution are likely to further diminish the importance of crude oil as a controlling influence of national and international economies by the 2020s.

If you don't mind losing your shirt again and again, the peak oil religion may be appropriate for you. Otherwise, a bit of nuance may be called for.