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Tilting at Windmills

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December 4, 2007
By: Kevin Drum

OIL PRICES....Dan Drezner is surprised that oil prices rose yesterday. After all, shouldn't the Iran NIE have reduced the chance of military action or additional sanctions against Iran, which in turn should have reduced political uncertainty and thus the "risk premium" built into the price of oil? Dan brings up and dismisses three possible explanations for this paradox (traders are really dumb, traders have better intel than the CIA, Bush is going to bomb Iran anyway) and ends up with this as the only one left:

Political factors are not as important in influencing oil prices as some commentators believe.

Dan says this explanation "seems inadequate to me," and it's worth noting that a single day isn't enough to draw any conclusions in a volatile market like oil futures. Let's wait at least a week to see what the fallout from the NIE is.

That said, I've long been skeptical of the conventional wisdom that the current risk premium built into oil prices is on the order of $30 per barrel. My own guess is that the real figure is $0-10. After all, demand is up and prices are way up, and yet production isn't. This is very peculiar if there's really any significant amount of spare pumping/refining capacity left in the world. Occam's Razor suggests to me that the real answer is that spare capacity is close to zero and that's why prices are going up. Political risk might play a role too, but I'll bet it's a fairly small one.

As always, this kind of speculation applies only to long-term trends. Whether the price of oil will plummet or skyrocket tomorrow is a game for commodities traders to play. But I'll be pretty surprised if the nominal price of oil doesn't increase 50-100% by 2010.

Kevin Drum 12:49 PM Permalink | Trackbacks | Comments (26)

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Comments

How stupid can Drezner be?

Oil prices rose because some OPEC members said they're reconsidering the idea of raising production.

Geez, doesn't he even pay attention to the news?

Posted by: SocraticGadfly on December 4, 2007 at 12:52 PM | PERMALINK

Kevin has always been ahead of the curve on Peak Oil, which is what he's describing here although he doesn't mention the actual words.

I continue to be astounded by the level of ignorance on this subject by most commentators (see Yglesias, Matthew). Peak Oil will be The Issue of our time, yet we are collectively sleepwalking into a disaster.

Posted by: Nathan on December 4, 2007 at 12:58 PM | PERMALINK

Longer term (weekly and monthly) light crude futures are down. The weekly contract is down in excess of 10%. The daily market price will begin to reflect these changes in a few days.

What the commenters at the top, as well as Kevin's non-surprise statement, are saying about the long term are true. The futures speculation and the day markets are just noise on these more fundamental trends.

Posted by: Greg in FL on December 4, 2007 at 1:04 PM | PERMALINK

we are collectively sleepwalking into a disaster

Sleepwalking my ass. That's for wimps. I'm charging ahead in my Ford Extinction, and you pansies better stay the fuck out of my way.

Posted by: thersites on December 4, 2007 at 1:05 PM | PERMALINK

Dan Drezner is surprised that oil prices rose yesterday.

Drezner is an idiot if he thinks that the oil futures market is a) rational, and b) focused solely on Iran.

Posted by: F. Frederson on December 4, 2007 at 1:08 PM | PERMALINK

I think Kevin is right to be skeptical about the role of the risk premium in oil prices. One thing I would add to the mix though is the impact of speculation within the commodities market in bargaining up the price of oil. If we split the difference between Kevin and the conventional wisdom as say that $20 of the increase of the price of oil is due to a risk premium, that takes us from about $25 in September 2003 to $45. But they jumped from $60 to $90+ in 2007 alone. Surely the demand for oil did not increase 50% in that time nor did we "undiscover" oil assets. So the huge increase in oil prices must be coming from some additional sources. I suspect the biggest contributor is speculation within the market itself and that oil has been bid up into a bubble.

Posted by: Hacksaw on December 4, 2007 at 1:10 PM | PERMALINK

Over the past few weeks or so oil has come down something like $10. Perhaps word of the NIE got out ahead of time?

Posted by: Dave on December 4, 2007 at 1:11 PM | PERMALINK

Actually I believe there has been some 'undiscovering' of oil going on.

I recall that many large oil companies have
had to revise their estimates of proven oil
reserves DOWNWARDS.
I have speculated that the reason
that they initially overstated their reserves
are what you might expect, their market cap
are proportional to their proven reserves,
so the more they can exaggerate them, them more $$$.

Here is a linky ....

http://www.nytimes.com/2007/04/12/business/12shell.html?_r=1&oref=slogin
Shell Settles With Europe on Overstated Oil Reserves - New York Times

Posted by: rms on December 4, 2007 at 1:25 PM | PERMALINK

I've had my nose in the books . . . but did anyone really believe that we were going to have a showdown with Iran? Does a lame duck vice president really have that much power. I've figured it's just going to be the status quo with various amounts of inconsequential posturing.

BTW, if supplies are really tight the risk premium (if a risk exists) should rise accordingly. Iranian politics were irrelevant to oil prices in 1965. Now we care about Nigerian tribal unrest and storms in the Indian Ocean.

Posted by: B on December 4, 2007 at 1:25 PM | PERMALINK

Why is the mainstream media/corporate America ignoring the issue of Peak Oil? It's like the whole country is sound asleep in Cinderella's castle in Disneyland.

Posted by: Speed on December 4, 2007 at 1:32 PM | PERMALINK

>"demand is up and prices are way up, and yet production isn't. ... suggests to me that the real answer is that spare capacity is close to zero"

'Peak Oil' or not, the oil producers (both states and corporations) have constrained production to drive prices up. If they increase production, prices will drop.

Other news at 11.

Posted by: Buford on December 4, 2007 at 1:34 PM | PERMALINK

Buford makes a good point. I, too, believe that oil resources are finite and that diminishing pumping capacity may be at least in part responsible for the run up in oil prices.

Yet, the oil market is the farthest thing from a free market. Oil-producing countries openly collude with each other to control output. And there are only something like five oil companies in the world. Obviously it wouldn't take much effort for them to make a gentleman's agreement to restrain access to oil.

I know the arguments for peak oil and find them credible. But at the same time, the lack of a real free market and the opacity of collusion between monopolies makes it very difficult to assume rational pricing.

Posted by: CKT on December 4, 2007 at 1:44 PM | PERMALINK

IMHO risk perception, and speculation can only have a transitory effect on price. Unless speculators are purchasing and storing oil for use during a future rainy day, they can't have a longterm effect on supply/demand.

The near term (say up to two years) supply/demand seems to have eased a bit in the last few weeks. The economy is weakening, which is expected to dampen demand. A bit more oil production than expected seems to be becoming available. The latest IEA monthly production numbers show 86plus million barrels /day -a new record, surpassing the peak set one or two years ago -depending on accounting. Longer term, it will take a large steady stream of new production just to make up for the decline of existing fields -not to mention nominally increasing demand. Kevin's prediction of painfull near future price increases would seem to be a good one.

The MSM doesn't want to burst the bubble, a huge portion of their revenue is advertising for gas-guzzlers.

Posted by: bigTom on December 4, 2007 at 1:52 PM | PERMALINK

The decline in the value of the dollar is also a significant factor to be considered, probably more of a factor than fear that the U.S. might attack Iran.

Posted by: chasmrich on December 4, 2007 at 1:52 PM | PERMALINK

...So the huge increase in oil prices must be coming from some additional sources. I suspect the biggest contributor is speculation within the market itself and that oil has been bid up into a bubble.
Posted by: Hacksaw on December 4, 2007 at 1:10 PM

I agree. I just think the cause of the "bid up" is primarily political speculation. I think it is rather obvious that any significant disruption would cause serious price spikes. When we talk about triggering a potentially signficant disruption, the market will respond in kind. Also, people are playing commodites a lot more as the dollar is falling. The often talked about $30+/barrel "terror premium" IMO *does* exist, but it is a stew of various political risks: Iraq, The Kurdish situation, Nigeria, Chavez in Venezuela, Russian games with Central Asia. Bottom line: Most of the oil is in very unstable places-simple as that.

Posted by: Doc at the Radar Station on December 4, 2007 at 2:31 PM | PERMALINK
Peak Oil will be The Issue of our time, yet we are collectively sleepwalking into a disaster.
Not to, erm, rain on your parade, Nathan, but just you wait until we hit Peak Potable Water. Posted by: kenga on December 4, 2007 at 2:51 PM | PERMALINK

"But I'll be pretty surprised if the nominal price of oil doesn't increase 50-100% by 2010." Kevin Drum

In the early 1980's the oil bubble of $28-30.00 a Bl evaporated with a decline to $12.00Bl. A whoosh was heard in the oil patch, the sound of Southwestern banks' equity disappearing.

This is a fungible commodity that at $100Bl invites heretofore uneconomic competition from sun, wind, conservation, tar sands etc. This correction period has been inevitable for a long time. (Oh, and by the way, if you want to predict the percentage decline in housing prices feel free but you had better have a crystal ball as to what European inflation is going to do to interest rates because home prices are all about interest rates, my friend.)

If the Iraqis some how bow to Bushco bribery, with an oil accord and permanent bases, by 2010 we'll see Iraqi production at 3-4 mill bl a day and climbing and America will effectively have an OPEC seat.

Oil will average less than $75 bl in today's dollar over the next 15 years: my prediction.

Posted by: cognitorex on December 4, 2007 at 3:18 PM | PERMALINK

Cognitorex, not at all so fast. Think again.

Sun and wind aren't fuels. Until/unless plug-in hybrids come out in mass quantity, or full-blown electric cars have long-distance capabilities, sun and wind don't mean a thing.

Tar sands? Low EROEI. High environmental damage. Costs of production going up as we speak.

Your prediction is wrong.

Posted by: SocraticGadfly on December 4, 2007 at 4:00 PM | PERMALINK

"Peak Oil will be The Issue of our time, yet we are collectively sleepwalking into a disaster."

Mot really. It's more like we are about to drive over a cliff. The road seems smooth until the moment you go over the edge. After that, it's way too late to do anything about it.

Posted by: Pocket Rocket on December 4, 2007 at 4:03 PM | PERMALINK

cognitorex,

I think you better cognito a little more. What in the WORLD do you think can replace the energy we are currently getting from ancient oil?

Posted by: Tripp on December 4, 2007 at 4:25 PM | PERMALINK

If the Iraqis some how bow to Bushco bribery, with an oil accord and permanent bases, by 2010 we'll see Iraqi production at 3-4 mill bl a day and climbing and America will effectively have an OPEC seat.

Screw it. Why not just make an SUV that runs on fucking blood --prefererably the blood of Scary Brown People -- and have done with it?

Posted by: thersites on December 4, 2007 at 4:56 PM | PERMALINK

Okay, time for some consipiracy theory.

In late summer 2006, the price of oil came off its peak of $77 and trended down through the November 2006 congressional elections. At the time this drop in price was attributed to reduced tensions because Israel's assault on Lebanon ended. But what also happened around this time is the Mark Foley scandal, and prospects dimmed for Republicans in the upcoming elections. Lower oil prices before the election might be considered to soothe a disgruntled American electorate. [And note the price is much higher now than it was in August 2006 even though there have been no new wars in the Middle East]

Then in November, the Democrats took both houses of Congress. Noises were then made about how the Democrats might investigate oil prices or impose new taxes on all those profits oil companies were making. And so prices drifted down again in December-January, and right about the time the Democrats were sworn in in early January 2007, oil prices bottomed around $50. Perhaps oil interests were trying to take the political hear off themselves? Soon, when it became clear that Democrats weren't going to take action against oil companies, the price began to rise again.

So oil prices dropped more than 33% from August 2006 to January 2007. Did oil demand or supply change by 33% within that time? No. But, political conditions were changing, and a lower price of oil during that period would have been in the political interest of oil companies and Republicans. Since oil company execs in this country are almost uniformly Republican, they perceive their interests as aligned with the Republican party. In addition, the Saudi government has closer ties to the Republicans than to Democrats.

There are many gaps in this theory, but keep an eye on oil prices between the Republican convention next summer and election day November 2008. If oil prices decline noticeably, there may be something to the theory.

Posted by: fidelio on December 4, 2007 at 5:00 PM | PERMALINK

I know you guys don't pay attention to news stories or anything like that but an oil pipeline from Canada to the U. S. caught on fire yesterday. It supplies almost one and a half million barrels of oil a day to the U. S.

Posted by: Gandalf on December 4, 2007 at 5:07 PM | PERMALINK

One word - CHINA. They are eating our lunch, economically speaking. They have bankrolled our overspending on military crap, which buys us nothing, and they are now using our dollars to bdi up the price of basic commodities like oil, fertilizer and metals.

We are hosed.

Posted by: The Conservative Deflator on December 4, 2007 at 5:28 PM | PERMALINK

Thanks Gandalf, interesting story:
Oil prices end higher after pipeline fire: Crude prices rebound from two days of sharp declines, rising 39 cents to settle just above $91.

What I thought was interesting was this statement in the story:
An offer by the government to release oil from the Strategic Petroleum Reserve, if needed, helped calm markets.

Hmmm. I wonder who makes the decisions to "release oil", how much to release, etc. It seems that you could sell oil from the SPR to refineries at lower than market prices to provide cheaper gasoline when needed, too.

Posted by: Doc at the Radar Station on December 4, 2007 at 5:33 PM | PERMALINK

Hmmm ... let's see ...

The people who produce the oil, sell the oil.

The more they produce, the less money they make.

The less they produce, the more money they make.

Throw in a risk premium and some Peak Oil fear-mongering, and you have mind-boggling profits by 2010.

Posted by: BombIranForChrist on December 5, 2007 at 2:05 AM | PERMALINK




 

 

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