| Submit your comments on this article |
| Home Front Economy |
| The new math of oil - why high prices are a good sign |
| 2007-11-01 |
| The high oil prices today are because of high demand, not like in the past when OPEC reduced production to decrease supply. The high demand is because of increasingly productive/growing economies worldwide. If oil prices go down, that may actually be a bad thing in the current environment! We're hard-wired to tremble when oil prices rocket, and the past few weeks have looked like another example of why. Whenever stocks fell sharply, as they did several times, traders blamed the fast-rising price of oil. But that chain of logic is misleading. The bigger picture shows that the relation between oil and the economy is changing, and we'll have to rewire our brains to understand what's happening. Watching oil prices rise and fall is no longer enough; the key now is understanding why they're moving. You know something strange is going on when you step back and examine the stock market's performance not of the past three weeks but of the past five years. As oil prices have surged, they haven't knocked down stocks or hobbled the economy. Instead just the opposite has happened: Oil has tripled, yet stocks have roared ahead to new records, and the U.S. economy has grown smartly over the whole period. That is not how things work, or so we learned after oil spikes triggered recessions in 1973, 1980, 1981, and 1990. The critical insight into what's happening comes from Daniel Yergin, chairman of Cambridge Energy Research Associates and a longtime authority on world energy. "This is a demand shock, not a supply shock," he says. "What's causing it is the extraordinary economic growth of the past few years." Previous oil spikes happened when OPEC closed the spigots; the resulting high prices were a tax on the world economy and slowed everything down. But today's situation is the opposite: Strong global economic growth is pushing oil prices up. As Yergin puts it, "The economy is having a greater impact on oil prices than oil prices are having on the economy." Of course demand isn't the only factor pushing oil up, as Yergin and every other analyst understands. The price rise of the past few weeks, from the high 70s to the high 80s, seems clearly a result of fear that supplies will be disrupted by a possible Turkish incursion into northern Iraq or some kind of crisis with Iran. That makes this latest rise an old-fashioned supply shock, or rather a fear of one, which is why it has hammered the markets. But the fear factor is responsible for only part of today's high price. The real culprit is broadly growing global demand. We're in the midst of a virtually unprecedented period in which nearly every major nation's economy has been expanding. So to figure out how we feel about rising oil prices, we must now ask why they're rising. If they're caused by constricted supply, they'll probably trigger bad news, like a recession. But if they're caused by strong demand, they're probably the result of good news, a growing world economy. Here's one more part of the puzzle: Markets clearly expect the price of oil to decline. Specifically, crude oil futures reflect a price that falls further for each additional month they extend. In addition, the stock prices of Exxon Mobil and other giant producers reflect investors' expectations of falling oil prices. If you take the profits of these companies over the past four quarters and capitalize those profits at the appropriate capital cost, you get what each firm would be worth if it were to continue cranking out the past year's profits every year. But in each case the company's actual market value is lower; that is, the market expects each company's profits to fall, for which the only plausible explanation would be declining oil prices. Now for a real-world test of our new mental wiring: Should we be cheering or crying over the fact that prices are likely to head lower? A decline of 10% or a bit more, assuming it reflected vaporization of the recent fear premium, would certainly be good. Beyond that, we can expect downward price pressure from basic, predictable economic forces: increased supply induced by today's high prices, though bringing it online takes a while, and substitution as alternative energy sources start to make sense vs. expensive oil. More downward pressure will come from the world economy continuing to become less energy intensive, producing more GDP per barrel. That's all good. But we need to remember that recessions in some or all of the world's major economies would also bring oil prices down. So if the market is right and prices do fall, let's check our instinct to cheer and first ask why. It's possible that in today's economy, a declining price of oil could truly be cause to tremble. |
| Posted by:gorb |
| #15 See? Glenmore actually knows what I thought I was talking about. ;-) |
| Posted by: trailing wife 2007-11-01 20:39 |
| #14 "There will be a push to increase wages to keep up with increasing transportation costs" There may be a push, but there won't be any increase in wages due to increasing transportation costs. Heaven forbid. |
| Posted by: Anguper Hupomosing9418 2007-11-01 19:51 |
| #13 Old Spook, At current projected prices of above $60 per barrel a LOT of projects are being funded. Several oil shale pilots are underway in Colorado and nearby. Oil and tar sand production in Alberta has expanded to what the infrastructure and environment can manage (and maybe beyond). Offshore production in over 5000' of water is underway. Etc. I bet 20% of new North American oil production is the direct result of high prices. What that means is - take away the oil company profits and lose substantial supply next year and the year after. High projected prices are also funding some intriguing long-term science. Chevron and some government agency are just starting a research project on developing strains of algae to create cost-effective biofuels. Long-term, but I suspect this direction (whether Chevron or not) will be essential in a few decades. |
| Posted by: Glenmore 2007-11-01 19:29 |
| #12 Apparently the Canadians are surface mining the oil shale/sands (I don't remember the details of the article I read some time ago) as fast as they can get the equipment out into the woods. |
| Posted by: trailing wife 2007-11-01 17:34 |
| #11 Oil is in limited supply. Prices will continue to increase as supplies decline. Oil is like the new antibiotic that is the only cure for some disease--it is the only game in town. Demand for the antibiotic is high and people are willing to pay whatever the price might be. The elasticity of demand is relatively low for oil; changes in supply greatly affect price although demand does not diminish with increases in price. The only way out of the problem with oil is to find substitutes for oil, i.e. have a paradigm shift in the way we power automobiles, e.g. hydrogen fuel cells. We could also increase the fuel efficiency of automobiles. Consumers will suffer in the short run. There will be a push to increase wages to keep up with increasing transportation costs Businesses will pass on the costs to consumers of increases in oil prices resulting in inflation. We need an energy policy that is realistic. We are going to have to accept some of the environment-energy tradeoffs. We need a long-run energy policy that is not based on sound bites that sound good on television and are voiced to get votes and get elected. |
| Posted by: JohnQC 2007-11-01 16:02 |
| #10 Nobody is going to put up the several billion $ to build these plants as long as oil prices can be dictated by OPEC. Investors got burned in the early '80s when oil prices plummeted. The only exceptions are Canadian oil sands producers who can make a barrel for less than $20. If you want CTL, Shale, marginal fields, then the gov will need to guarantee a stable minimum price. Solar is growing, not because of value, but because the German government buys solar electricity at 0.50 Euros/kWh (73¢/kWh) and then sells it to consumers at 0.20 Euros/kWh. Huge amounts of PV panels are going up in overcast Germany to take advantage of the subsidy. Contrast this with US wholesale electricity prices of 5-6¢/kWh and my electric bill of 10-12¢/kWh. |
| Posted by: ed 2007-11-01 15:47 |
| #9 Old Spook, there must be some truth in what you say about the price of oil. Kinda answers a question I had a couple of weeks ago. 20 years ago, my husband put quiet a bit of money in some oil stuff. Checks were regular for a long time. Then, I haven't had one in 10-12 years! Out of the blue, one came a couple of weeks back! Wasn't much, but it did buy me a new pretty! |
| Posted by: Sherry 2007-11-01 15:35 |
| #8 While it's true that the demand increase is driving the cost of oil, it's also true that higher prices have a dampening effect that even a strong economy can't fight forever. Dampening is the effect the Fed tries to get when it raises the short rate. Note the recent reduction in the short rate. As for shale and oils sands, I believe (don't quote me) that oil sands are cheaper, therefore oil sands will be tapped first. This takes years and billions though, so it makes perfect sense for companies to be reluctant to make the investment if it's effects will eventually combine with a decreased demand and drive down the price oil far enough to make oil sands a big fat loser. |
| Posted by: Mike N. 2007-11-01 15:31 |
| #7 From what I've heard the oil bidness in the intermountain area is booming. I suppose that includes the sort of things you mentioned OS. |
| Posted by: Abdominal Snowman 2007-11-01 15:23 |
| #6 Demand push - but much of it is from China. How long until the Spratleys heat up? One other question - I have always heard that sustained prices above $60 makes oil shales, lower quality oil fileds, and capped wells here in the US economically viable, as well as alternative sources of energy, such aas solar and coal gassification. Well we are half again over that amount. When will we start seeing those coming on line to feed our domestic refineries, feed power demans (alternative energy) and cut our need for petroleum imports? |
| Posted by: OldSpook 2007-11-01 15:00 |
| #5 I'm with ed on this. Also, Exxon-Mobil had a relatively bad quarter because the price of crude was high while the margin on refinery products was low (even slightly negative for some products). |
| Posted by: mhw 2007-11-01 14:49 |
| #4 It just means we are enriching our enemies. $5 oil (bankruptcy) or $40 oil (economic to produce CTL oil under sensible laws) is good for us. $90 oil just gives greater than drug smuggling level profits to islamic imperialists, Russian fascists and Venezuelan racists. |
| Posted by: ed 2007-11-01 14:31 |
| #3 It is hard to figure that rising oil prices are good for U.S. when it means rising prices for everything consumed. It seems inflationary. Oh well, the new math was never my strong suit. |
| Posted by: JohnQC 2007-11-01 10:44 |
| #2 Maybe not so much. Dumping to hurt us will in turn hurt them. One thing I like about globalization is that it tends to make war a bit more difficult when bombing the other guy damages your lines of supply. To bad the muzzies don't make anything (other than grief). |
| Posted by: kelly 2007-11-01 10:43 |
| #1 The high oil prices today are because of high demand And don't forget the devalued nature of the dollar. This ain't a fy2000 dollar anymore. The Chinese have billions rotting on the books. It's easy to dump them for something they need to keep the pending revolution at bay. |
| Posted by: Procopius2k 2007-11-01 09:19 |