The secret cause of high oil prices

Why do so many people find high oil prices so surprising that they invoke unusual explanations?  This perennial of the past few years appears again with Patrick Lang’s (Colonel, US Army, retired) confident assertion that “short term traders in oil futures are the fire behind the crude prices we see now” (posted at Sic Semper Tyrannis, 4 August 2008).

We can only guess at the degree of influence speculators have on oil prices. I suspect that it is probably small over periods of a year or more, given the relatively smooth rise in prices from $20 since 2001 and the expense of storing oil (derivatives have far less impact than stockpiling).  However, the fundamentals – supply and demand for oil – provide an simple explanation for the rise in oil prices.

Causes of rising prices

  1. Twenty years of low prices caused massive underinvestment, since the oil crash in the early 1980’s.  The return on investment for oil exploration was negative by the late 1990’s.
  2. Rapid growth in global gdp, the fastest since 1980 – perhaps the fastest since the invention of agriculture (we can only guess at growth before the 1970’s).

These two factors affected the entire commodity sector (energy, industrial materials, agriculture), explaining why commodity prices have risen so far from their lows in the late 1990’s (see here, section 2, for more about this).

Oil prices have “decoupled” from the commodity complex.  To see why consider the past three years and their extraordinary events.  Liquid fuel consumption is roughly flat since Spring 2005, during which time global real GDP rose aprox 14%+ (per the IMF) and Brent spot oil increased from $50 to $120.

US Energy Information Agency data on global liquid fuels production (petroleum plus biofuels):
Note:  these numbers are best-effort estimates by the EIA, approximately correct.

  • May 2005:   85,379 million b/day
  • April 2008:  85,466 million b/day, up only .1% over 3 years.

Was oil production or consumption the limiting factor?  Clearly production is the culprit.  Although the relationship between GDP and oil demand is variable, oil consumption “should be” up very roughly 6% during this 3 year period given 14% GDP growth.  Instead oil consumption is flat, with price acting as the variable — rising to produce equilibrium.

Why has oil production remained flattish (biofuels output has increased)?  We have seen rapid production declines in many areas (e.g., Mexico’s output is down aprox 14% over this period).  There are delays in bringing on new fields around the world (e.g., the Thunder Horse platform in the Gulf of Mexico).  And of course there are the problems in both Iraq and Nigeria.

Consider this from another perspective.  What increase in oil price is necessary to generate demand destruction (e.g., substitution, etc) so that real GDP can grow at over 4%/year for 3 years with flat oil consumption?  Now we know:  oil prices must more than double.  Is that a surprise, considering the inelasticity of oil demand?

For a similar perspective from an authoritative source, see “Crude Awakening: Behind the Surge in Oil Prices“, Federal Reserve Bank of Dallas, May 2008 (3.2 meg PDF) — The best analysis I have seen of what is driving up oil prices.

Larger Implications

We are experiencing the early stages of Peak Oil — or perhaps oil production has definitively peaked.  Only time will tell.  Instead of crash programs to adapt to this new reality, we blame speculators.  Surely if we can stop speculation the good old days of cheap oil will return.

Our blindness to the approach of peak oil is just one example of prevalent American thinking about the world.  Or rather, reluctance to think.  Just like our reluctance to save for the massive retirement of baby boomers, now rapidly approaching.  Just as we run year after year of trade deficits, financed by borrowing from foreign Central Banks, with no thought how how and when these debts can be repaid.

We have been often warned about these things by experts, both major institutions and prominent individuals.  Not warning should be needed, as they are largely matters of common sense.  Still we –  as a nation — refuse to prepare.  None of these things are “issues” in the November election, except our whining about high gasoline prices.

The consequence will probably not be pretty.  Unless we change.  And act.


This post discusses the long-term rise in prices.  Here is an analysis of the short-term rise, by one of the world’s top experts:  “Explaining the 2008 Crude Oil Price Rise“, Philip K. Verleger, Jr., July 2008 — PDF, 3 pages.

Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information about the end of the post-WWII era

  1. A brief note on the US Dollar. Is this like August 1914? (8 November 2007) — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
  2. The post-WWII geopolitical regime is dying. Chapter One (21 November 2007) — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  3. We have been warned. Death of the post-WWII geopolitical regime, Chapter II (28 November 2007) — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
  4. Death of the post-WWII geopolitical regime, III – death by debt (8 January 2008) – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
  5. Geopolitical implications of the current economic downturn (24 January 2008) – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
  6. A happy ending to the current economic recession (12 February 2008) – The political actions which might end this downturn, and their long-term implications.
  7. What will America look like after this recession? (18 March 208)  — More forecasts.  The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
  8. The most important story in this week’s newspapers (22 May 2008) — How solvent is the US government? They report the facts to us every year.

To see the all posts on this subject, go to the archive for The End of the Post-WWII Geopolitical Regime.

For more information about Peak Oil

Here are some of my posts about Peak Oil.

  1. When will global oil production peak? Here is the answer! (1 November 2008)
  2. Links to articles and presentations of some A-team energy experts (11 November 2008)
  3. The most dangerous form of Peak Oil (8 April 2008)
  4. The three forms of Peak Oil (let’s hope for the benign form) (23 April 2008)
  5. The world changed last week, with no headlines to mark the news (25 April 2008)
  6. Peak Oil Doomsters debunked, end of civilization called off (8 May 2008)
  7. When the King of Saudi Arabia talks about oil, we should listen (2 July 2008)

Here is an archive of all my articles about Peak Oil.

Here are other resources to learn about Peak Oil.

14 thoughts on “The secret cause of high oil prices”

  1. Speaking of Col. Lang, I might as well repeat a point I have made on his blog.

    Namely, what can you, and I, and each of us do with this information as individuals on the micro level ( as opposed to favoring some policy proposal on the macro level ) ?

    Now is the time to get voluntary screening type medical procedures such as colonoscopys and CAT scans, on the theory that, if Fabius Maximus is correct, such items will probably become unavailable in the intermediate future.

    At a certain time, I suppose it might make sense to stockpile statins.

  2. Great post, Fab. But you leave out the importance, in democracy, of a vibrant opposition — the Dem Party focus on “hate Bush” and “lose in Iraq immediately” has left them failing to address the long term problems with solutions that are better than what Bush and the corrupt Reps offer.

    Where were the Dems when Fannie Mae had accounting problems in 2003 & 2004? Why, on the payroll! and protecting those pseudo-private mortgage monsters. Where are they on SS reform? “Bush is bad, there is no problem in Social Security, it’s just Bush/ Rep scare-mongering”.
    Where is Obama on these coming problems? a) The Reps are going to run on ‘fear Obama’, and b) raise taxes.

    Raising taxes, and depending on more gov’t, will make each problem worse. Um, except raising gas taxes — which will help to change behavior of gas buyers. But hurting people’s wallet so much that they change behavior will also cause them to vote against the culprit … so ‘somebody’ must be to blame! speculators! Hugo Chavez! China! Bush/ Reps! Dems! Anybody but those who bought SUVs in the last 10 years, or bought a house farther from their work than bicycle distance.

    We need nuke-u-lar power, we need off-shore drilling, we need ANWR drilling, we need solar, and we need T. Boone Pickins’ wind farms and copy cats.

    With housing construction in the dumps, building more wind farms and more solar panels to cover parking lots should be a high Fed and state priority.

  3. Nicholas Weaver

    Especially when Econ 101 says the following:

    If supply is reasonably elastic and demand inelastic, large changes in demand (eg, from 1985 to 2005) will only produce small swings in prices.

    But if supply becomes inelastic, or outright constrained, even small changes in demand (eg, driving 3% fewer miles between last year and this year) can produce large swings in prices.

    The drop in price over the past month is hardly suprising when one considers the massive demand destruction which has occured, and the, for many people, already perminent shifts.
    Fabius Maximus replies: There is little or no evidence of global demand destruction. There is reduced demand in the US, probably some in the OECD. But the OECD has generated only aprox 15% of the increased demand for oil in recent years; the emerging nations have been the source of new demand. With their economies running white hot (for many reasons, including negative interest rates), their demand is probably still increasing.

    US news coverage of the world is absurdly US-centric. US events, like reduced oil consumption, are described as global events. That is a pathology in our thinking, one common to hegemon’s — like the legendary but perhaps Fabius Maximus replies: There is little or no evidence of global demand destruction. There is reduced demand in the US, probably some in the OECD. But the OECD has generated only aprox 15% of the increased demand for oil in recent years; the emerging nations have been the source of new demand. With their economies running white hot (for many reasons, including negative interest rates), their demand is probably still increasing.

    US news coverage of the world is absurdly US-centric. US events, like reduced oil consumption, are described as global events. That is a pathology in our thinking, one common to hegemon’s — like the legendary but perhaps apocraphal London Times headline: “Fog in channel — continent cut off.”

    There are many other factors at work. To mention just a few:

    The global economy is slowing (but from a high speed), which reduces the growth in demand for oil.

    Some countries are increasing their prices on oil (controlled prices). This usually decreases demand, but not always. When the prices are far below market, supply disappears — returning when prices rise. This is probably happening in China, so that consumption increases as prices rise towards market levels.London Times headline: “Fog in channel — continent cut off.”

    There are many other factors at work. To mention just a few:

    The global economy is slowing (but from a high speed), which reduces the growth in demand for oil.

    Some countries are increasing their prices on oil (controlled prices). This usually decreases demand, but not always. When the prices are far below market, supply disappears — returning when prices rise. This is probably happening in China, so that consumption increases as prices rise towards market levels.

  4. Nicholas Weaver

    Very good point about the demand-destruction that we know about being US centric. However, with the fraction of the world oil consumption thats accounted for in the US, nearly 25%, if US usage dropped 4%, this would be a worldwide 1% drop.

    But the basic point stands: Even very small (1%) shifts in supply or demand can produce wild price swings. If we had better numbers on both consumption, production, and storage, it might be possible to estimate. IF we are in a supply-constrained regigm, wild swings (both up AND down) can be expected.

    My other worry, is that when you ARE in a supply-constrained, inelastic demand situation, you can get NON-collusive market manipulation (eg, Enron), where a single supplier holds back suppy to create enough of a price hike to make up for the lower volume. We haven’t seen that yet.

    And yeup, supply shortages in China, so you’re right, there may be a increase in chinese internal demand if the refiners/government were holding off due to mandated low prices. is the second hit from Google.

    Or it could be due to refining capacity not being available, which would imply slower changes if prices are desubsidized.

  5. Hi Fab
    You are right that in the LONG term oil is in trouble. But in the SHORT term speculation does have an impact ( $40/barrel was my technical calc whatever that’s worth). But the rampant speculation we have seen would not be possible without a lot of fear and loathing out there about “peak oil. rapacious Chinese demand” etc.

    I would like to clarify the term “peak oil as you guys use it. Yeargin aleays says that the problem with “peak oil” is above ground not below it. And the emerging US reserves story would seem to bear that out.

    The natural gas finds in NE Texas/La have shaken my perspective a bit. The sideways drilling technology seems to have turned the Nat Gas picture upside down.

    Now I know true believers in peak oil will downplay these things but I think we should keep an open mind about the real situation and there could be a ripple effect over the next few years as gas is a versatile energy source.

    I prefer to call oil “sticky” as opposed to inelastic, because as now know there IS a level at which the consumer will react big time.

    Not to say we won’t run out (we will) but I would like a clear picture as I agree with most of these comments that we need to do something now!! I don’t want to see us lulled back into somnolence by a dip in prices and a few gas finds. And if we cry wolf as in the past and the price goes down then the public will think “ah well more Paul Ehrlich B.S. to sell books or get attention”.That is the last thing we need. As the previous poster said we need Nuclear!!
    Fabius Maximus replies: I do not understand much of what you are saying.

    Yeargin’s comments about peak oil should be considered in the light of his rather poor forecasting record (not that many experts have good records, given the difficulty) over the past decade, esp about that massive oil glut we are experiencing now (per his forecasts). The “high prices result from refining capacity limitations” theory IMO should be well-exploded by now. The coming excess of refining capacity will definitively test this theory.

    I do not know what you mean by the “US reserves story.”

    Regional natural gas (e.g., N. America) is a special case, esp over short (a few years) periods, due to the difficulty of storing and transporting it — and its highly weather-dependent usage.

    Oil is inelastic in the full meaning of the term, as used by economists. In fact it is the classic example of an inelastic good.

    I agree with your last point, and have written several posts about these things.

  6. Even here in the comments the argument is over price and reserves. Fabius your point is being missed completely.

    By the time oil and gas run out it will be much too late to change! It doesn’t matter if Peak Oil was in 2005 or will be in 2050, we need new sources of energy and a national policy instead of letting markets and other countries determine the price of energy. The paralysis of profit and politics is pushing America over a cliff and the vast majority of citizens are treating this as an amusement park ride instead of the crisis it is. Everything should be in play.

  7. what can you, and I, and each of us do with this information as individuals on the micro level ( as opposed to favoring some policy proposal on the macro level ) ?

    One thing one might do is to quickly cancel any subscriptions, memberships, online accounts. If possible, cancel your credit cards and inform the companies that you do this in protest against government surveillance.

  8. Hi Fab
    Again I said “I” prefer the term inelastic. That means as it is normally used the term is a little too generalized for my taste. You or whoever can call it anything you want.

    Secondly, the point Yeargin is making is that peak oil is POLITICAL not GEOLOGICAL. Many reserves, like the oil shale deposits in Colorado/Wyoming are not even counted in most calculations. (New finds in Saskatchewan are estimated to have a $50-70 breakeven with current technology) And what of the reserves of our various coastlines. Now some may not be “proven” but that is because exploration was brought to a screeching halt after the Santa Barbara spill, what, 40 years ago? So how can you “prove” or “disprove” when you are not even looking or drilling? And is all the new drilling technology which made the Texas “Shelf” exploitation possible being taken into account?

    It seems to me “peak oil” is a possible canard that is used by the “instant” alternative energy guys like Gore and Obama (if you can believe what he is saying this week) I realize that serious geologists have signed on to PO but I also saw a lot of “serious” scientists signed on to AGW.

    Being an Economist by training I am not qualified to make geologic judgements. But I do recognize partial truths when I see them.

    I read a quote recently by one of the framers of the IPCC report. He said (paraphrase) that we scientists need to exaggerate threats in order to get people to do what is in their best interests. (I will find it for you if you like). The problem with that is they lose credibility with the public if they push a false assumption assuming the “end justifies the means”. Maybe there is some of this in the P.O. claims.
    PS I don’t see where Yeargin has gone that wrong. Can you enlighten me there?
    Fabius Maximus replies: I stand corrected on your use of the term “inelasticity”.

    I have seen no analysis suggesting that drilling of America’s currently off-limts conventional reserves will make a significant impact on medium or long-term oil prices. As for non-conventional vs. conventional reserves, the political restrainst are minimal. I — and many others — have discussed the potential and severe limitations of unconventionals at length. For a summary, see “Good news about oil, but for our grandkids – not us.”

    Non-conventional reserves are not comparible to conventionals, except perhaps on a net BTU basis (net after extraction costs). In general unconventionals (biofuels, deepsea, polar, bitumen, kerogen, coal-to-liquids, etc) are production-constrained — not reserve-constrained. Two examples:

    (1) Bitumen (akak “Oil shale”) is mined and extensively processed (requiring major energy input) to become a liquid fuel, in no way comparible to a field like Ghawar. It has taken 20 years to get output to 1 million b/day; their goal for 2020 is 5 million b/day — which might not be feasible due to resource limitations (water, natural gas) and ecological impacts. Neither of these are “political” in any meaningful sense.

    (2) There is no proven large-scale commercially feasible process for mining and refining kerogen (aka “oil shale”), although some are under development.

    I have a drawer full of CERA’s work. Beautiful, lavishly researched, excellent data. Unfortunately their analytical framework has not changed with the world over the past 10 years, generating consistently wrong answers. This is a common phenomenon in the oil world — indeed, any field experiencing such a large discontinuity.

    I have not calculated CERA’s results, but my impression is that for many years they have tended to overestimate output for N. American natural gas and global oil. Consider CERA’s May 2005 liquid fuel forecasts for 2008: 93.86 (“delays and disruptions”) to 96.49 (“supply expansion scenario”). Since the actual will be aprox 86 – 87 million b/day. They estimated an annual growth rate of 2.2% – 3.2%, vs. the actual of zero. Their estimates for 2010 were 96.62 to 101.51, which I suspect are even more optimistic.

    Also, estimates of “break-even” numbers given in the press are useless. Breakeven numbers are a complex combination of intial capital costs and operating costs, plus assumptions about the resource value and cost of capital. Everybody uses different numbers, making reliable comparisons impossible. And in retrostpect they are usually found to be far too low. Esp with both capital and operating costs rising rapidly.

  9. Okay Fab
    Whatever about Yeargin but “lavish” brochures full of excellant data is what its all about. There is a consulting firm called RISI that has become a laughing stock in our industry for their forecasting. They use a model that is 30 years old. So I wrote an article touching on this and happened to talk to an economist friend of mine who actually wrote the program. He and others have said that it is not the model it is the 20 something’s from HBS who are CLUELESS about the industry who screw things up.

    Now before you go ballistic on me about off topic,. let me give you the point. RISI’s data is invaluable and very expensive. But nobody and I mean NOBODY buys it for their lousy forecasts. Broad data in one package is what its all about. And if you look for forecasts you are better off with your own “SWAGS” because they would just as reliable. I NEVER believe forecasts as the are ALWAYS twisted by agendas.

    On my other point I was noticing how hard the average individual is striking back on AGW. A bad economy is all it takes to open the eyes. Not much of an excuse when the claims for not dealing with it are no less than apocalyptic. I blame bad science and public backlash. (London Times article).

    One last thing. If you look at the annual report for SUNCOR, one of the Alberta tar sands pioneers. you will see OPERATING breakeven in the low $20s. Fifteen years ago it was in the mid $30s and people were writing off companies like SUNCOR and Can Natural Res. Last year SUNCOR’s ROCE was 40%!!! Now does this count as “non conventional” now? If not it sure was 16 years ago.

    PS RISI did not like my article much.
    Fabius Maximus replies:

    “brochures full of excellant data is what its all about.”

    I do not understand your point, as it ignores what I actually said: CERA’s forecasting record is poor. I did not say that their reports were useless. Their data and analysis are interesting and valuable.

    Nor do I understand your point about Alberta. I said that returns were dependent on capital and operating costs. My posts on this subject, which discuss this in more detail than I will do in a comment, note (like everyone familar with the subject) that unconventional resources tend to have far higher capital costs than conventionals.

    Alberta mining perfectly fits the typical characteristics of unconventionals: high capital costs, high environmental impacts, production (not reserves) as the limiting factor. The high return of Alberta mining results more from oil going from $20 to $120 than operating costs from $30 to $20.

    This also illustrates my comment about the useless of comparing “breakeven” costs from different sources — esp from different time periods and types of resource extractions. They are usually not comparable. And seldom consider environmental impacts. I have heard the miners make grand promises about restroring conditions when they are done. Have they adequately reserved for this future expense, or are these empty promises?

  10. BTW spot oil (not futures) is down almost $10 from three weeks ago.(Avg $127 to $117) And of course cash prices move much more slowly than futures in a huge market like oil. It seems that the speculators do have some impact. And now the so-called “forecasters” are calling for $100 oil. {snip}
    Fabius Maximus replies: I do not understand the relevance of what you are saying to anything on this site. The subject here is geopolitics, hence the discussion is about long (at most medium) term price moves. Price movements of the past three weeks are out of this site’s scope, as a general rule.

    Is there anyone who says that speculators have no impact on short-term prices? I said “I suspect that it {effect of spec’s} is probably small over periods of a year or more”.

    As for forecasters (why “so called”?), their estimates range far more widely than you indicate. Verleger’s report mentioned above says “The price of crude oil in the summer of 2008 should be $70 per barrel, not $140.”

    Reliable forecasting of oil prices (or any prices) for next year or longer is almost impossible. Global gdp, substitution and conservation effects — these and other factorss are unknowns. Even more unpredictable are changes in inventories (primary, secondary, tertiary) — a massive factor over short and medium term horizons.

  11. Hi Fab
    Me again. Picking nits gets you nowhere. And saying “you don’t understand is a little obtuse. Again what I am saying is that today’s “non conventional” are tomorrow’s conventional. And my break even figures came straight from the SUNCOR annual report. Not the newspapers or agenda-driven analysts.
    There is no evidence of huge offshore because they are not LOOKING for them.

    Secondly the Haynes Shelf announcement ( as well as T. Boone’s sneaky but brilliant marketing strategy) shows that grousing about political arguments like “peak oil” or AGW are inherently circular. The core issue is where do we go from here to get away from the Middle East and all the baggage handling we have been doing for the last 50 years or so. (Ever since the 1956 Suez crisis)And personally I love what Pickens is doing. It is the most effective alternative campaign I have seen so far (seld serving or not) including any government in the OECD.

    Utah is already going bonkers over Nat gas autos and the NE US is converting from oil heating to gas as rapidly as possible.(5-6 month conversion backlogs for most major utilities)

    I guess we will have to talk about “Peak Gas” pretty soon to keep the chicken littles happy even though there is currently a surplus.

    BTW the recent mega fall in oil prices PROVES to my mind that much of the price (roughly 30% rest due to tighter supply/demand) was due to the spec community. The fundamentals have NOT changed in the last 30 days but the PERCEPTION of the fundamentals has. And spec markets are all about perception. It was obvious, at least to some of us, that inflation was not the problem asset deflation was and the Euro economy showed signs of tanking months ago. JLK
    Fabius Maximus replies: Let’s deal with the chaff first.

    “And saying “you don’t understand is a little obtuse.”

    I do not care if you believe my statement is “lacking in insight or discernment.” If I do not understand something, I say so. What do you do? There are many things I do not understand. I congratulate you if you are different from the rest of us in this respect.

    Moving on. Pls note that you jump from discussing natural gas to oil. They are very different animals, esp over the short to medium term, so this makes responding to you comments more difficult.

    “There is no evidence of huge offshore because they are not LOOKING for them.”

    As I said, I know of no study suggesting that US offshore oil deposits are significant vs. global demand (although they might prove to be financially significant to the US). If you believe that nobody has looked for them, you are mistaken. That they are not now looking does not mean no surveys have been done. Studies such as USGS 2000 have collected geological data from almost the entire world, including Greenland, in order to estimate available petroleum deposits.

    “And my break even figures came straight from the SUNCOR annual report.”

    I don’t care if the number came from God. My comment about the impossibility of comparing these numbers still holds, as they generally do not include explanation of how they are calculated. Even if this did (which we cannot tell as you did not provide a link), we could not compare it with other.

  12. Pingback: Energy research is just inspired guessing, since America prefers being blind « Fabius Maximus

  13. Moves by the CFTC to try and regulate the oil trading market and prevent the kind of speculation which has seen crude oil prices rise from $30 per barrel back towards $70+ this year took an interesting twist yesterday when it was announced that the weekly COT data would now include new details on the aggregate holdings of the big Wall Street dealers, hedge funds and other financial participants. COT data is a useful market sentiment tool but as many of the market participants both hedge and speculate it has become increasingly difficult to analyse. According to the CFTC the new format will be making its debut next Friday.

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