Oil Prices: Have We Passed the Peak Already?

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Rising oil prices are back creating headlines in the mass media with very little consensus as to whether we have passed or have yet to reach the peak. When investigating oil price movements, it seems that almost every other market expert finds something new that nobody else has considered. Therefore, if you are considering taking a plunge into the deep waters of examining published oil price analyses, you certainly risk drowning under the load of factors, drivers and opinions built into explanations of the past and expectations for future.

Oil prices are almost never driven solely by purely fundamental or speculative factors. However, sometimes certain factors do prevail, even for an extended period of time. The trick is to not get too deeply enmeshed in trying to chart the waters from only one perspective. A successful analyst is able to see (or maybe even feel) the instant when the driving forces (fundamental versus speculative) switch their positions.

We looked at the changes in the WTI crude oil spot prices over the last four years and compared them with movements in world oil supply/demand balance.

Figures “WTI Crude Oil Prices and World Demand/Supply”[1] and “World Demand-Supply Balance (Estimated by IEA)”[2] demonstrate that there were only a few occurrences when price movements could be best explained simply by the economic law of supply and demand. The first charted episode is observed in 2007 when world demand, accompanied by insufficient supply, pushes crude oil prices up. The close of 2007 marks the end of a rather extended period where fundamentals set the pace.

Things change at the beginning of 2008 when the closed supply/demand gap fails to prevent a dramatic price jump, apparently fueled by the rather questionable premise of “peak oil”. Moreover, the price peak that occurs in mid-July 2008 coincides with the highest point of oil deliveries, which at that time surpassed world needs for this commodity.

Overheated by speculators, skyrocketing oil prices suffer the most painful collapse (almost $120/Bbl over six months) in the second half of 2008 when no more buzz can be created and supported in the absence of any solid fundamental evidence. The dramatic collapse guaranteed considerable oil price escalation over the following year despite the fact that world supply was greater than demand throughout this period.

Mid-2010, in what must be considered a time of economic recovery, marks the triumphal return of fundamental economic concepts as rising prices actually follow growing demand at a time of lagging supply. This perfect picture (at least as seen from the ivory tower) is disturbed at the beginning of 2011, marking the beginning of another rather unjustified price race.

Even though the estimates prepared by International Energy Agency (IEA) and Energy Information Administration (EIA) differ quite noticeably, they both agree that there are sufficient inventories to meet demand.  Regardless, prices have been riding a roller coaster. The spikes observed in 2011 are very similar to those from the second part of 2008 when prices moved significantly higher even with falling demand and adequate supply.

In 2011, WTI averages $89/Bbl in February, $103/Bbl in March and $113/Bbl at the end of April. It has been generally accepted that the main driver of the recent WTI oil price increase is the turmoil in the Middle East. Let’s look at it again.

Even though disturbances in the Middle East started with the Tunisian and Egyptian unrest, the beginning of a steady increase in oil prices coincides with the uprising in Libya at the end of February. As noted in the posting “Libyan Turmoil: Can We Separate the Oil Price Drivers?”, it is difficult to justify the 30% increase in the WTI oil price by expectations of a drop in Libyan exports given that Libyan exports represent only 3% of US imports.  As shown in figure “WTI Spot Prices and Cushing Stocks”[3], the 2011 stocks at the Cushing trading hub look even healthier than in 2008.

Hence, we are back to everybody’s favorite whipping boy, the speculator.

How significant is the role that speculation plays in the current oil price level? Not quite sure? Maybe we will learn something from the results of the investigation into illegal speculation in oil market by the Financial Enforcement Task Force created by the US president.

Despite the Libyan rebels’ announcement that they had no plans at that time to resume any significant oil exports, crude oil price started its decline on May 2, 2011 (some analysts however, attributed this decline to the news of Osama bin Laden’s demise). On May 5, the WTI settled down at $99.8/Bbl, marking the second-biggest one day loss in dollar terms on record. On the same day, Brent crude posted the largest one-day fall by plunging more than $10, exceeding the sell-off that followed the Lehman Brothers’ crash. This was an inevitable adjustment, which brought price in line with short-term market fundamentals. Despite several options open for speculations on growing oil prices (weakening dollar, possible reduction of refinery production due to flooding, etc…), NYMEX crude prompt-month futures declined sharply again on May 11 loosing around $5/Bbl at the time of posting.

What is the next price movement? Is it possible that oil prices will drop even lower? Most likely they will. Following a period of artificial inflation since the beginning of 2011, the price drop is very much anticipated as the pace of the economic recovery is too sluggish and weak to maintain such a high price levels. At this point, any sustained price increase will impair the US economy. Yet, crude oil prices are not likely to move to the low levels seen at the beginning of 2009. There should be  enough price pressure to provide an incentive for the incremental barrel to be developed and supplied. Unless, of course, new factors come into play…

Written with contribution from Vera Tikhomolova

[1] Supply/Demand data from the IEA Oil  Market Report < http://omrpublic.iea.org/currentissues/full.pdf> WTI oil price data from the EIA collected by ZEMA

[2] Supply/Demand data from the IEA Oil  Market Report < http://omrpublic.iea.org/currentissues/full.pdf>

[3] Cushing oil stocks and  WTI oil price data from the EIA collected by ZEMA

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