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.

Update

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.