210. The price of oil: 3 – energy economics and the financial crisis

storm in the north seaThe highest ever oil prices.

The fastest and greatest fall in energy costs in economic history.

A lot has happened since early 2008 and my last essay on the oil price.

This article will explore events in the oil markets since then, and in the next I’ll take a look towards the future.

* * * * *

Early last year the oil price lay close to historic highs at almost $100 a barrel.

Supply was tight, I said, and getting tighter. Prices could fall to $60 later in the year if the credit crunch really bit. But long term, the trend was clearly upwards. And a world of $100, $200, $400 oil prices was not that far away.

world oil price jan 2006 to may 2009 energy information administration

Perhaps it’s rash to make predictions about the future. And according to Nassim Nicholas Taleb, it’s not clever to review the past if we insist on constructing linear narratives from chaotic and essentially random events.

That’s a healthy warning to historians, but for now let’s take the risk.

So what did happen next? The oil price kept on rising, all through spring 2008, and speculation drove it higher. It reached $147 in July, leading several analysts to say that $500 oil was coming.

Forgive me if that reminded me of 1998, when the oil price stood below $10 and The Economist looked out on a world awash with oil to predict prices of $5 just ahead. They never happened. Because sometimes when the analysts buy a trend, you know that the bubble (for that’s exactly what it was) is almost over.

speculators knock opec off oil price perch may 2008 barrybar flickr

The downturn was manageable, we thought then. Far East demand would suffice to keep the global economy turning. But it wasn’t, and it didn’t.

Once the trend was turned, a horrifying slide began as those long oil positions unwound. By early August, the oil price stood at $120, and the following month it fell through $100. After Lehman Brothers collapsed in mid-September, the oil price steadied for a while, but two weeks later the dizzying plunge renewed.

The scale of the pending economic meltdown was vast but as yet unknown. Amidst The End Of The Financial World As We Knew It, the shaky, scary $70 of mid-October looked like mere illusion as prices fell through $50 in November. On such a downward trend, who ever would buy oil futures?

No one. Traders shorted oil. Downward movement pushed the slide still further.

$4 gasoline Richmond California USA june 2008 by RevTimMedia flickrFalling consumer demand made an impact, too.

With gasoline prices bursting through $4 a gallon, Americans had driven 10 billion fewer miles last summer. And as the year progressed, declining consumer confidence offset the falling prices.

The result ? A new mindset amongst consumers — a reluctance to buy new cars and especially the larger gas guzzlers built by US manufacturers.

American car makers began to fall apart, reaching a collapse later in the autumn. More jobs were lost, across the industry. Consumer confidence fell still further. We bought less, around the world, and manufacturing production plummeted, leading to yet lower energy demand from consumers and industry alike.

The oil price fell further, and by year end US inventories stood completely full.

world oil prices falling half empty dec 2008 by lot4a flickrThe US oil price (West Texas Intermediate) recorded a $10 discount then to European oil (Brent Crude), instead of its customary $2-3 premium. In mid-December, WTI fell to $34, and hit that level again just three months ago on February 15th 2009. All that time, Brent crude hovered around $40.

Looking back now, it seems that $40 was the floor. Once the slide was halted, with downward speculation unwound, there was only one way for the trend to reassert itself. Upwards. And that’s exactly what has happened since then.

Oil has climbed quietly to $58 today — almost 70% above its winter lows.

The rally still looks uncertain, and there’ll certainly be more shocks to come. But longer term, if we can think that way, a $40-60 range seems sustainable. And although a return to $147 looks some way off, modest gains are likely.

world oil price 1997 to may 2009 energy information administration

The oil price has seen a horrifying peak and slide as the economic crisis has played out. But that rollercoaster hides a simple truth. Cycle to cycle, the oil price floor stood at $10 in 1999, $20 in 2002, $30 in 2005, and $40 in 2008.

Through the past decade, the oil price has risen $10 around every three years and from trough to trough. That’s a doubling every five years, more or less. Today’s ‘low’ oil price remains higher than in nearly all of economic history.

So that’s the oil price past. Next week, I’ll assess the outlook going forwards.

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7 responses to “210. The price of oil: 3 – energy economics and the financial crisis

  1. Thanks a lot for the very useful and thought-provoking info…

  2. Yes, it’s quite amazing how $60 oil looked enormously high in 2007, and yet how that same figure looks so much lower today.

    It’s interesting and instructive to ponder that the oil price only remained above $70 for twelve months. That period seemed to be much longer at the time — which goes to prove just how short our memories really are.

    Those higher oil prices will likely be back before too long. The oil price shock of 2008 has given us all pause for thought about where the oil price is heading in the future — and despite the pain of paying more for our gasoline for a while, a timely wake-up call in that direction is surely no bad thing.

  3. Pingback: 175. The price of oil: peak petroleum production and energy economics in a thirsty world « roads of stone

  4. It’s excellent to hear from you, RC, and I’m glad you found this post thought-provoking. Gambling with pension funds isn’t such a great idea, but as our banks and employers are doing it …

    There’s certainly money to be made in speculating on commodities, but there’s a lot of cash to be lost as well.

    A problem with predictions here is that the long term ‘signal’ of rising oil prices from cycle to cyle (doubling every five years or so) is easily hidden (some would say ‘practically invisible’) behind the high amplitude ‘noise’ of recent short-term wild oscillations.

    And that’s exactly my point. In looking at energy costs, it’s too easy to lose sight of the bigger picture of steadily depleting reserves behind the dramatic surge and fall in oil prices we’ve seen over the past year or so.

    The sheer volume of commodity speculation and the influence of quixotic market sentiment makes it rash to make predictions across the short-term. But long-term, higher energy costs look a rising certainty, at least until we can dramatically reduce demand or significantly diversify our supply.

    There’s still been astonishingly little progress in either of these areas, and paradoxically, easing demand in response to the economic downturn has recently made that situation worse.

    In many ways, the past two years have seen a massive missed opportunity in the energy market. But there is also evidence that the recent oil price shock has catalysed real changes in consumer attitudes and behaviour.

    I’ll explore all this further in my next post. In the meantime, many thanks.

  5. Interesting stuff, Roads, thanks.

    So would I be wise to gamble a chunk of my pension fund on the oil price rising? An extra 20% or so would be most welcome.

    It’s a sort of serious question. Seems to me that an investment on oil is quite a banker for anyone who wants to make a few quid, and is able to be patient. Would you agree?

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