Price of Oil Doesn’t Appear to be Affecting Worldwide Demand

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Houston investment banker Matt Simmons likes to say about oil, “Supply does not know demand.” That is, in a world of Peak Oil output is going to be whatever it is. New supply is always in a race with inexorable depletion, and depletion will always win. It’s just a matter of time.

Matt Simmons or no, oil has been trading between $90-95 per barrel for about three straight months. This is an unprecedented high for the price of oil in nominal terms (adjusted for inflation, the price of oil was higher in 1979 and 1980).

But at least the black liquid has lately been trading within a defined range. Earlier in the spring and summer of 2007, oil steadily ran up from below $55 to over $90.

Why?

Demand from the developing world has been increasing, of course. And there is a growing awareness within oil trading circles of the issues affecting future oil supplies. Depletion is the other side of the coin of extraction. Depletion never takes a holiday.

Then something interesting happened. Toward the end of 2007, oil started to trade at a price plateau, drifting down as low as $85 per barrel and spiking as high as $100. Yes, the price of oil went up and down. But in general, the base price for oil has been in the low $90s since about the end of October.

What halted the oil price increases toward the end of 2007? Lots of things.

Kevin Kerr and I have discussed this back and forth, with input from numerous experts in the oil business. Everyone has their own answer.

The August subprime meltdown in the U.S. was probably the first macroeconomic phenomenon to break the upward pricing momentum for oil.

In August, a lot of people who needed to raise cash could not sell their mortgage-backed securities. If you cannot sell what you want to sell, you sell what you can sell. So people sold the most liquid things they owned, which often as not were oil and oil futures (if not gold – another story entirely).

Then, as if picking back up on the spring momentum, oil prices took off again in September and soared some more. But by late fall 2007, the second wave of the credit crunch came home to roost. Consumer sentiment went sour. Demand for refined products actually fell in the U.S. in the fourth quarter of 2007…

How long will this pricing breather last? Will the current price for oil lead to some of that so-called “demand destruction,” and will the U.S. economy ever use less oil?

Well, I recently participated in a conference call with several representatives of the American Petroleum Institute. One API economist stated that the data indicate that doubling the price of oil will reduce demand by about 6%. Looking back, the price of oil has about doubled in the past year. This means that under the API model demand should have been restrained by 6% in the U.S., or more than enough to account for prices no longer rising in the past couple of months.

So for now, the price of oil has about doubled in the past year, and demand is restrained by about 6%. But will demand continue to slow down?

Our old friend Jim Rogers has his own take on things. Jim recently remarked that “It doesn’t look like $90 or $100 is going to do it” (meaning, restrain demand growth). Of course, in the short term it will take a while for people to adjust to the new reality of $90 oil.

But even in the short term some economies are craving oil regardless of a price increase.

In China, for example, there is not enough pier space for the tankers to dock and unload their cargoes of crude oil – even at $90 per barrel the imports into China aren’t slowing down.

Eventually the supply issues will come back to the fore. Jim Rogers believes that $200 oil – or even $300 oil – is possible within the next 15 years.

If you don’t believe Jim Rogers, how about the U.S. Department of Defense? No less an oil-burning institution than the DOD is planning for a future of $225, and higher, oil.

The U.S. Navy, for example, is currently designing future ships using $225 per barrel as a baseline for the price of fossil fuel. In fact, the Navy, under the direction of Congress, is also planning to use nuclear power for all future large surface combatants. And the Air Force is designing engines and fuel systems to work on synthetic jet fuels derived from coal and natural gas.

There is an astonishingly complex engineering process for qualifying synthetic fuels to work in military-grade engines, at high altitudes, high G-forces and supersonic speeds. But all of that is happening even now. The Air Force knows that it cannot lose any time in getting this done. And the Army and Marine Corps are looking hard at the fuel-efficiency of ground combat vehicles.

Post-Iraq, the Army and Marines will be re-equipping their forces with much new gear. So the planners are hard at work figuring out how to design and procure “mobility systems” that have the best possible fuel-efficiency. This is all because the DOD planners are forecasting oil prices of $225 per barrel and more.

At $90 per barrel, refiners around the world have been processing less crude oil. It is fair to say – and the ministers of OPEC have stated it repeatedly – the world’s immediate needs for crude oil are amply covered. (Well, amply covered if you enjoy paying $90 per barrel.)

In fact, one survey indicates that at least 400,000 barrels per day (bpd) of worldwide refining capacity is currently offline. On the face of it, this is the equivalent of four major refineries shutting down, at 100,000 bpd each. But in reality, it is more like 20 refineries in different regions of the world closing down partway.

What is driving these refinery closures? Refiners have idled parts of many units that process crude so they can perform routine maintenance, repairs and upgrades. This is a seasonal phenomenon. The refineries of the world have already processed the supply of heating oil for the Northern Hemisphere winter. That is, just about all of whatever heating fuel people are going to use between now and the end of March has already been processed. That fuel is in the transport system, headed to a terminal near you. So there is no large demand for more heating fuel right now.

Meanwhile, there is still time before the refineries have to start building up motor fuel stocks for the late spring and summer driving season up North. Thus, the refineries are engaged in rolling closures for maintenance. Without the maintenance, the refineries tend to blow up and burn down. So don’t complain.

Until next we meet,

Byron W. King
for The Daily Reckoning Australia

Byron King
Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. Byron is also co-editor of Outstanding Investments.
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Comments

  1. A good analysis, but may be it is all a whole lot more simple.

    Oil supply is completely inelastic and what ever is available will be taken at any price – up to a point. It seems that $90 is that price (for the present). Lots of people in Afica and a few other places have quietly dropped out of the bidding (and the age of oil).

    When the next lurch upwards will be and what the precise cause is I have no idea, but it will happen sometime in the next few months and years.

    Reply

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