It's really hard to see where oil will go from here. I have no idea how bad the economic situation is going to get. It could be a severe recession, a depression, or a return to the Dark Ages. Nobody really knows. The fractional reserve banking system is 500 years old and it's at risk. This is the engine of the Western/growth/industrial system. Without it, sure there are still advanced technologies and medicine, but it's hard to imagine us returning to anywhere near the same level of activity. If that's the case, it'll be many decades before we again reach the limits of the oil supply.

On the other hand, if the recession is just severe enough to dry up funding for new production, when the economy comes back, oil would be set for an even bigger run-up.

Who knows?

Excellent post, Luis. The history of whale oil, indeed, has been a useful guide for me. On the basis of whale oil data, at the beginning of 2008, I predicted on my Italian blog that oil prices would stop their rising trend and collapse before the end of the year. It was a good prediction, especially considering that almost everyone was projecting oil at 200 $/barrel by the end of the year. I also made some calculations based on the whale oil price trends that told me that the "equilibrium" oil price should be now around 60-70 $/barrel. This value turns out to be similar to the cost of extraction of the "marginal barrel" as given by IEA. It seems that, indeed, we are going to fluctuate around that value.

The bottom line is that if one understands the mechanism of the market, it is possible to figure out where the market is going. Unfortunately, as you correctly point out, the vagaries of the market are chaotic and - as such - unpredictable. Too bad, but if it were possible to make correct quantitative predictions of oil prices we wouldn't be here chatting. Eh, well....

Pre-salt fields have been drilled in offshore Angola: Seeking Operatorship in Angola : Geoexpro

StatoilHydro has participated in 104 wells off Angola on a number of licenses in the offshore Lower Congo and Kwanza basins. At present, the Norwegian major has a strong position in the prolific deep-water Lower Congo Basin (StatoilHydro licenses in blue colour) with production from deep-water turbidite sands and access to potential pre-salt plays, similar to those recently proven offshore Brazil (GEO ExPro no. 3/2005). The company is also ready to bid for more acreage in the next licensing round, due early next year (open blocks in brown colour) and this time the company is hoping to get status as operator.

I had posted a comment on similar lines a couple of weeks back

http://www.theoildrum.com/node/4825#comment-439569

Nice to know that I was not totally off the mark with my line of thinking.

My own mental model matches yours - except that I see higher amplitudes as we go into the future and the boom and bust cycles happen more frequently taking into account declining net exports.

Does this not have implications for the oil futures market itself?

Global supply chains will be hit very hard as well because sourcing plans, manufacturing were built on the assumption of cheap freight costs. I personally think that the future (after a rough transition) will be more local production and consumption of mostly necessities.

Srivathsa

Thank you for this posting that I enjoyed very much. I would like to add another factor that is increasing boom and bust cycles here. All new fields and alternative energy sources - even measures taken to increase energy efficiency need energy themselves. But not only is the EROI lower than for the easy oil, but in most cases the energy needs to be invested first while the resulting energy will be received later. Take a wind turbine for example. Lets assume the wind turbine has an EROI of 5 that is yielded within 20 years. But the invested energy is needed upfront for construction. So it will take 4 years until the initial enery invested is returned.
With rising oil prices governments and investors try to switch to alternative energy solutions. If this would be done within 4 years for 10% of the oil consumption this would mean an additional oil consumption of 10% during this time. Without spare capacity it is clear that this heavily expands the boom cycle. On the other hand with energy investments cancelled or delayed, it works the other way round as well.

THE WAY IT REALLY HAPPENED

My history of posts on TOD US will demonstrate that I had repeatedly warned people against falling into the trap of believing that oil and other commodities were going nowhere but up in price. I say this not as a way of saying “I told you so” but as a way of reminding people to be very, VERY cautious about believing current projections.

The price of commodities shot up very quickly across the board, and then declined just as fast. Are we to believe that supply dropped that fast in EVERY AREA of commodities, and then recovered just as quickly? That does not seem likely. On the demand side, yes, demand has declined, but has it declined in EVERY AREA to the extent that price declines would indicate.

The fact that these price moves have been so fast, across the board and in both directions indicate that we are seeing a speculative bubble inflate and then pop, pure and simple, and price moves have little to do with supply and demand changes in the short term.

Logically we must ask, “What has caused such an acceleration in price changes over the last few years?” I think it is extremely informative that you mentioned first on your list of events “1999: Glass-Steagall Act is fully repealed”. Very perceptive observation to put this event right at the front of what would become the beginning of an accelerated increase in house prices, commodity prices and speculative investment. We must recall that another source of capital was the flood out of the already overextended tech sector.

With the repeal of Glass-Steagall and the flood of cash from the tech sector, we had a situation of huge amounts of money looking for a place to go. The banks could now jump in and play the speculative game just like the hedge funds and venture funds. Everybody, whether they knew it or not, was now playing in the casino and had money on the table, through hedge funds, banker’s investing in hedging, funds of funds, pensions, and homes, which would soon be subject to the same accelerated price swings that oil and other commodities were already subject to.

Needless to say, the new flood of free flowing money brought out the “adventurer” in bankers (now freed up by the repeal of Glass Steagall), hedge fund managers, market advisors and gurus and even mutual fund and pension fund managers. The “Lords of the Universe” now had the chance to show what they could really do, and investment vehicles tied to underlying commodities, interest rates, and collateralized debt obligations could become ever more complex, multi layered and “hedged” six ways from hell.

The main point of all this is that price swings which would have in past years happened much more slowly now happen with whiplash inducing speed. The flood of money, the complexity, the speed of the internet has accelerated the “Queuing Theory” past a point that allows for comprehension by most humans. If you add in the pure irresponsibility and outright fraud of managers and financial firms who purposely complicate things for the purpose of obfuscation, you have a recipe for disaster.

Oil, like real estate and houses and other commodities are simply the vehicles to which the financial manipulators tied their wagons. The real value of the commodity simply does not matter to the speculators and financial managers at banks and hedge funds. What matters is that people can be convinced to pour money into the investment firms on the belief that the price will change, hopefully to the investors advantage.

When the economy is growing and things are going up, the tool used to recruit investors is greed, i.e., “look at the return you can get on this, you don’t want to be left out”, and when they are going down the tool used to recruit is fear, as in “we have a hedge against losses that can protect you”.

Finally, there were too many people playing the same game. Everyone wanted double digit returns, and everybody was pouring money in, and there was plenty of money to go around at first, with the money that had fled the tech boom available, the massive returns made by the banks on the prior rises in real estate available, and the depositors money now available if it were need since the repeal of Glass-Steagall, and a new fast moving almost completely unregulated group of funds, the Hedge Fund, and then the “fund of funds”, which could pretty much do anything they wished without oversight, but, and this turned out to be very important, without insurance or government protection.

So when the U.S. invaded Iraq in 2003 oil prices were already rising after the price decline caused by the 9-11 terror attack, and the war further accelerated the price gains. Production was starting to flatten because in the 1990’s investment had slowed to a crawl because oil had been so cheap as to be beyond belief (we’re talking about prices below $20.00 per barrel) and the OPEC nations and others had simply stalled on investment in E&P. The rumbles of “peak oil” were just beginning to get into the media. This was a DREAM RECIPE for those who wanted to suck investors into investing in oil, gas and commodities. As you say, “The Rest Is History”, as money flooded into the commodities markets. When the housing market started to show signs of weakness, investors began to get scared, and the ones that were able to bailed out, selling houses. More sold, the market was getting full of houses, but now there were fewer buyers. A few foreclosures became a few more as some of the “house flippers” could not unload at a profit. Again the rest is history, and the money from the real estate boom needed somewhere to go. Commodities, yes, said the investment gurus, commodities were safe!

Brokerage firms who know almost nothing about oil production, consumption and pricing began to talk about $200 per barrel oil (the disgrace that was Goldman Sachs), and retired geologists were on every channel telling the public that the end was near, we would be lucky to get through the next summer (whichever of the last three or four summers they were referring to) without a catastrophe. And the money just kept pouring in, and the commodities skyrocketed.

And then, like all bubbles, the bubble popped. The financial gurus were in trouble and they knew it because frankly they had not gotten it right for their investors for too long. From the collapse of the S&L’s they had herded the investor from one short lived bubble to another, from Asian bonds to the tech bubble, to the real estate bubble, to the Euro bubble, to the commodities bubble. But the acceleration of the cycle of promotion, inflation, extreme high prices and then bursting of these bubbles had become too fast. Even the banks and hedge funds could not stay up, and the investors themselves were either become scared or had been so cleaned out by the gurus they couldn’t keep adding money. Again, the rest is history…

A story of a friend of mine who is in the business, by which I mean the financial sector: She had her clients in the stock market, well diversified, funds, ETF’s, mutual funds, and Index funds. She saw the bad news getting worse, so she persuaded them to move to something “safer”, a mix of REIT’s and, yep, you guessed it, commodities funds. She had become persuaded that oil and gas were only going to get more and more expensive. Do I have to tell you the results of what happened? Her investors are now down by more than 55%. Some of them are getting rather close to planned retirement, and are horrified. Even if the market returns to 10% annual returns, it will take years for these aging boomers to regain what has been lost, post taxes and fees it may take even longer than they may live, and how likely do you think it is that the market will soon deliver double digit returns?

Many in the Peak Oil community have embarrassed themselves badly by making wild claims about short term prices. The same thing has happened in the climate change community, where people have made wild predictions about short term weather changes. The Oil Drum has been unfortunate, in that it is a very open forum, and has posts from both of these movements, peak oil and climate change. This means that people come to TOD and see streams of posts which are based on the two most unreliable and unpredictable patterns in the world, weather patterns and market patterns. This is not TOD’s fault, and long time visitors to the site know that these projections/predictions must be taken with a HUGE grain of salt, but newcomers to the site do not grant this license and the whole cause of peak oil and climate change thus lose credibility in the larger public because a few posters have essentially decided they are prophets.

As for the future, I agree with you Luis, I would not dare to predict future prices. I will say this however: I would be happy to live the rest of my natural life with oil and gasoline prices as much as twice what they currently are., inflation adjusted, meaning I will accept gasoline prices of $4.00 to $5.00 per gallon U.S. (I have survived worse than $4.00 and I was poorer then) So obviously I could hedge by buying oil and gasoline futures at ANY PRICE CURRENTLY AVAILABLE and still be happy! I am not seeking massive returns, just a stable price for my lifestyle. I would be amazed if the very wealthy are not hedging their oil price futures just this way, but I could be wrong.

On the other hand, I have been astounded by how many wealthy people and families have pissed away their money with this Ponzi hedge fund scheme run by Bernie Madoff, and wonder how many more of these type of funds are out there. With apologies to De Niro, “Ah markets, I love the smell of default in the morning!”

Roger Conner Jr.

Hi Luis

Thx for an interesting post. I've been thinking about this years volatility for some time and this thread seems a good one to post my tuppence-worth;

Is the main reason inelastic supply? On the upside we got to the position of almost zero spare capacity and we know creation of new supply takes time - far more time than the rate at which demand was growing. So once demand hit capacity the price shot up to the point at which demand was reduced. We get a brief glimpse of how much consumers are prepared to pay for oil, at least short-term.

The dramatic fall in price is just as easy to understand if you assume that supply holds up in the face of reduced demand. And I think it does unless OPEC manage to reduce it - history suggests they struggle thanks to the prisoners dilemma;

http://en.wikipedia.org/wiki/Prisoner's_dilemma

For oil producers it pays to keep pumping for all they are worth because, even at lower prices, they are better off covering part of their OPEX even if they can't cover all of it. The price point at which pumping is no longer cost effective is far lower than the point at which total costs are not covered (better to have some income to offset costs rather than none!).

Reduction in longer-term supply will happen as projects get delayed. But, as for the argument on the way up, this effect is on a different time-scale than the current rate of demand destruction. So a temporary gap opens up under the supply ceiling and prices head south rapidly.

So we have the possibility for fluctuations in demand that are not time-matched with fluctuations in supply. Maybe just a re-wording of others thoughts on here but sometimes it helps me to get my thoughts down even if just to clarify them for myself!

If this argument is correct then as soon as demand recovers to meet capacity, presumably with global recovery, then prices will once more shoot up. The only question (admittedly it's a big one) is when this recovery will happen.

TW

Great Post, Luis!

Your timeline is the best explanation of the relationship between monetary policy, war in Iraq, rising oil prices and the financial crisis today I have read so far.

Yergin was right, although his timing was off.:

So was Mike Lynch:

Instead, we appear to be experiencing a financially-driven oil price bubble, which will eventually burst and leave oil prices much lower than the current $110/barrel. (Prices might not go below $80 this year, but longer term, $45 is more likely the norm.) The industry will once again lament that they “screwed up the boom,” companies with deep pockets will buy up those who are cash short, resource nationalism will recede as will upstream costs, while investors in alternative energies flock to Washington in search of ever more government support.Source

So was David O'Reilly:

"We're a cyclical business," David J. O'Reilly, chief executive of ChevronTexaco, the second-largest American oil company, said in a telephone interview, "and at the high end of the cycle it makes sense to get the company in good shape and strengthen our balance sheet. "History tells us that what goes up also goes down."Source

Jerome "Countdown to $200 Oil" Paris was wrong.

Westexas (Jeffrey Brown) was mega-wrong:

From this point out I think we'll see a geometric progression in prices… you know, $50, $100, $200, $400, whatever. The only question now is how short the periods will be between prices doubling again”. -- Jeffrey Brown, June 5, 2008Source

I have no doubt many of the concepts raised above play a role in the psychology of oil pricing; however, I am left feeling a much simpler explanation is being given short shrift. Oil is prototypical product with an inelastic demand curve. When demand exceeds supply it takes a large increase to reduce that demand back to the level of supply. When demand falls below supply a market glut develops and the increasing stocks of oil drive price down. This behavior is based on very short term responses to the problem.

Luis de Sousa, very good points. JD....you also bring up some good points, but to say West Texas was MEGA WRONG, might be somewhat premature in your assessment. There is a GEOPOLITICAL FACTOR that many are not factoring in. Basically it is between the Great American Bull (along with England) and the Huge Russian Bear (including Iran and Venezeula). The Orchestrated Collapse of LTCM (Long Term Capital Management) back in 1998-99 helped collapse the price of oil which destroyed the Russian Economy. We have to remember, because of the collapse in the price of oil, Russia Devalued their currency overnight and Russian Citizens got wiped out overnight.

The Russian Govt would start to get in trouble at $80 a barrel oil. At $60, the Russian Ruble comes under severe pressure and the govt starts to prop up its currency. At $40...GAME OVER for Russia, as Russian Ruble is now in Danger.....Govt spends a great portion of its currency reserves to hold off a collapse of its currency. When Russia went into Georgia, it proved to the powerful entities that they did not learn their lesson from the 1998-1999 LTCM takedown. Thus, to keep the Russian Bear in check, the price of oil was taken down by the very institutions that held the opposite trades from their own customers. JP Morgan, Goldman Sachs to name the larger players, took down the very hedge funds they represented who were long commodities....while JP Morgan and Sachs were short.

People need to remember, the Russian Bear is not just fighting against the American Bull, but entities within it. JP Morgan, Goldman Sachs, the Fed, The Treasury are just as powerful in destroying a country as is its military. After the United States won the war in Iraq, JP Morgan was given the task of putting together the new National Bank of Irag in 2003. After the new National Bank was put in place, JP Morgan was able to start trading medium term Oil Contractsin Dec 2003 through the National Bank of Iraq along with the new control of 2 million barrels a day oil.

Many in this blog do not realize that JP Morgan is the FED. JP Morgan has the largest Derivatives exposure of any Bank in the United States. Furthermore, the way to control the price of oil, is to control the price of Gold. Ever since the United States withdrew its policy of backing the US Dollar with Gold, a new regime of World Fiat began. For the US Dollar to survive with out any backing, manipulation of commodities had to take place.

Lately, Antal Fekete, Professor Emeritus of Mathematics has been writing for years about how GOLD is MONEY. According to Fekete, Paper gold contracts started to trade in 1975 after Nixon unpegged the Dollar to gold in 1971. Ever since 1975, Gold has been trading in Contango. Contango means the futures price is higher than the present cash spot price. For the first time in history, Gold went into Backwardation on Dec 2, and continued to do so, and even got worse. Fekete has been writing about Gold going into Backwardation when the world starts to lose faith in FIAT PAPER MONEY. Instead of investors trading paper contracts, making risk free profits, they rather pay a premium for spot cash gold and take delivery. Fekete states that when gold goes into permanent backwardation, there will be no one willing to sell gold at any paper price. This means the end of Fiat Money....also the destruction of world trade.

There is a historic example of this. Back when the Roman Empire was starting to collapse, Gold went into hiding in Private hands. Basically Gold left the public arena and was bought up and taken into private hands. Thus after the Roman Empire Collapsed, the Dark Ages enused for over 1,000 years. On the other hand, the eastern Roman Empire, Constantinople allowed to keep their MINT open to gold and their Civilization remained vibrant for another 1,000 years.

The United States took Gold from its public back in 1933 by order of FDR...and only allowed trade through Foreign govts. US public citizens were not allowed to own gold until 1973. This was the beginning of the end of the US EMPIRE. Even though American citizens were allowed to own gold....this was the start of funneling gold from the public sector to private hands. Thus we had the beginning of the same situation that ended the Roman Empire. Today, with the Bailouts and the huge inflationary policies of the FED and US GOVT, gold is being taken off the shelves with alarming speed. Small denomination gold like small bars and coins are hard to find and if so may take months to receive. The only gold still easy to get are the 100 oz bars on the COMEX. And that is exactly what the smart investors and wise public are doing. They are buying contracts of Gold on the Comex and taking delivery. This is putting pressure on the shorts, thus backwardation is threatening the Gold Window. There is a great deal of talk about a Gold Default either in Dec or Feb 2009.

If the Gold window closes and defaults, this will end the Hedgemony of the US DOLLAR. Without the trust in the world Paper currency, world trade will plumment as foreigners will no longer take US PAPER MONEY for goods and oil. The United States has a Leech and Spend Economy...which can only survive on imports of oil. According to Antal Fekete, if Gold goes into Permanent Backwardation....there will be no trust in PAPER MONEY, even though there might be an attempt to reissue a new world currency or regional currencies. The only money that would put trust back in the market are gold and silver. If the world govt's backed their currencies with gold or at least a part of it, trust could have been put back in the markets, but when gold went into backwardation on Dec 2, all bets are off. It is too late for this to be an option. It is just a matter of time before Gold goes into permanent backwardation and the gold window closes. Thus the end of the Great United States Empire will take place.

When the US Dollar loses its place as the world currency.....imports will dry up into this country as the facade of paper money is destroyed. The lack of imports will put immediate shortages in this country. Their will be delfation of worthless assets such as real estate, most stocks, and paper assets as US Treasuries, Bonds and Retirement accounts...but inflation and hyperinflation of real goods that citizens will need to survive: Food, energy and clothing.

This is the end of the United States as we know it. Unfortunately....the public has no clue that the rug has been pulled out from underneath them. But...it time, they will

interesting analysis
but you have left out panic hoarding
i think in the next round the psychological & emotional factor will be different

that is, if export capacity declines rapidly, there is a shock to the system. people react irrationally (or more irrationally than usual)

i believe that a 5% decline rate on total 86 MBD, when applied to export capacity of 47 MBD, results in a 12 MBD loss of exports in 3 years, or 25%
the question is, when does this start. i think 2010 is the first year

the pessimistic view is 9% decline as mentioned by IEA, which results in 21 MBD over three years, or 45% of export capacity by 2012

then the system siezes up

It was and is a misreading of peak oil theory to conclude that prices only go up from here.

Instead, the plateauing of production (where we seem to be now) implies extreme price volatility.

Volatility means going up AND coming down.

My price prediction for oil?

Extreme price volatility.

Which is still a very good reason for reducing one's exposure to petroleum -- households, companies and countries.

on February 21, 2008 - 1:03 am I wrote one of my first comments ever on the Oil Drum. It addressed oil pricing, but wandered over into finance as a corollary issue that seems equally appropriate today. Here it is, with a few updated phrases marked in square brackets like these: [ ] .

Given the choice, would people rather start starving to death immediately, or quite a bit later?

That’s really what is at issue here, isn’t it?

Back when most folks were subsistence farmers (and the world’s population was a tenth what it is now) day to day living was a practical and direct activity. You grew food, or hunted it, provided your own transportation and shelter, and really understood the importance of staying on good terms with [your neighbors and] the tribe or land lord.

The means of survival were not abstract, and they were seldom distant.

Now they are both.

For most of the six billion souls currently on earth survival requires money and the overwhelmingly complex systems that money runs. The ‘stuff’ we live on [including the ultra necessity, oil] comes from the other side of the planet, as often as not, and the various elements that comprise the system of creation, control and delivery are as distant as you can get on a spherical rock such as ours. That these systems are completely dependent upon shrinking supplies of fossil energy [and availability of credit] is somewhat hidden from those who don’t make a deliberate effort to figure it out, and it’s daunting even for those who do.

When Peak Energy arrives, death cannot be far behind, but for those who just hate to wait, there is a faster way to the same end. Break one [of the other two or three] other life support systems and the dying can start immediately.

[Climate is the biggest, of course, but it moves so slowly! Let's go for the fast ball]

The hands down easiest and most quickly devastating one to break is money. Not only is it both the craziest and the most abstract, it’s also the one we use to regulate and control all of the other things that we are capable of regulating or controlling.

[I would stress that we now use money as the primary control system for all of our other systems... all of which are now driving above redline on the 'engine of civilization' tachometer]

How crazy is the modern way of making money? Barking mad. Suicidal.

Just look at the mainstream way of making money. Borrow too much money to acquire an overpriced thing no matter how ultimately destructive it might be (macmansions where farms used to be, new weapons systems, packaged subprime mortgages, whatever) on the assumption that in the near future that overpriced thing can be re-sold at an even higher price. The players know that the biggest fastest bucks happen when the deal is signed. Once they’ve got the money the question of fair value is someone else’s problem. [they are willfully oblivious to the damage they cause in this manner, just as they were willfully oblivious to the murder and mayhem financed by their investments.]

Ever larger loans mean ever larger profits (and net worth) so Banks are eager to drive the process. It is a world-wide Ponzi scheme gone haywire, and like all such scams (pyramid sales, multi-level marketing, chain letters) it hits the wall when there are not enough fresh suckers to go another round. Suckers are a renewable resource, [of course] but when that next ridiculously huge loan can not possibly be repaid, Lenders turn off the money spigot and pray for a government bailout… because they know that what happens next is really going to hurt. But turn it off they do anyway, because lending every penny they’re worth on a dead certain loser would hurt even worse. They know a thing is a dead certain loser when they are dead certain they won’t lend anyone that much money to buy it.

That brings us back, remarkably enough, to the problem of getting our leaders to do something about the impending peak energy disaster [or financial disaster, or Climate disaster, or any other disaster for that matter.]

Any energy [or financial] policy capable of adjusting consumption [or lending against asset value] downward to bring it in line with projected supply, will have the immediate effect of destroying the world’s economic system because that system, lamentably, is utterly dependent upon growth. Less energy consumption [or less lending] means less everything… and especially less credit based ‘growth.’ Such a move would end the Ponzi scam. It would cause world wide economic recession on a scale to make the Great Depression an insignificant blip.

Without ever-expanding credit to regulate and control production, distribution and security, the nearly instantaneous consequence would be chaos, starvation and violence. Train wreck on a global scale.

Actually, since the poorest are the most vulnerable it would be a ‘caboose first” sort of wreck.

[The caboose end of the train is currently being evicted in America, throwing molotov cocktails in Athens, and planning the next suicide attack in India. I don't think anyone low enough on the socio-economic ladder to be caught dead reading the Oil Drum is far enough forward on the train to escape. Just keep a close eye on your personal balance sheet. When net worth hits a year-on-year decline of greater than 50% then it's time to cash out and buy farming supplies... if they're still available.]

To carry the train analogy one more step. It’s a little late to be flagging down the engine to warn that the bridge is out. The 'engine' is doing exactly what it was designed to do: [trying desperately to] make more profit for its owners next quarter than it did last quarter. Feeding them facts and expecting sensible results is working about as well as talking to a train.

In other words, we can (and shall) slam into the wall when declining energy supplies trigger collapse, [which will propagate so chaotically that the precise chain of well understood causes and effects will only become completely clear in retrospect] but just forget about any leaders slamming their nations into the wall voluntarily prior to that event. No leader ever achieved power by promising unbearable hardship and death, nor lasted for long by delivering it. [They will pull any trick, tell any lie, perpetrate any violence rather than surrender their privileged positions. That is their nature. That is both how and why the achieved power in the first place.]

This is all ‘In Plain Sight’ sort of stuff. World events and the otherwise inexplicable obliviousness of our government to Peak Oil, [and their professed shock and amazement at the 'unforeseen economic meltdown] makes sense,in a criminally negligent sort of way, when viewed from this perspective.

The world’s leaders [and our new president must be included] aren’t ignoring the problem. They see the situation clearly, have carefully estimated consequences and they are vigorously responding … by getting as far away from that caboose as they can possibly get.

Luis,
the Queueing Theory may explain the "speculative" and "nervous" a part of the strong oscillations. But I think here the major fundamental mechanism is due to the good old Cobweb Model (or pork cycle):
For the producing industry, the consumers and the policymakers the time lags to react to the changing reality are too long, which regularly leads to overreactions.
This might be avoided by a policy that is targeted to balance these oscillations, e. g. by energ taxes or supports for alternatives. But for this the policymakers need to know the future development to be balanced - which, as you wrote, is now very hard to predict - let alone to communicate.

BTW: Our current location:

Coincidentally, Satyajit Das published a long examination of global capital flows and their current state of decline. This is another one of Das's articles that everyone here should read carefully;

http://www.prudentbear.com/index.php/commentary/featuredcommentary?art_i...

There are several highlights, one focuses on the difficulty of large holders of US assets such as Treasury securities to access the cash money value these represent:

It is also not easy to tap this liquidity pool. Given the size of the portfolios, it is difficult for large investors such as China to rapidly mobilize a large portion of these funds by liquidating their investments and converting them into the home currency without substantial losses. This means that this money may not, in reality, be available, at least at short notice. If the dollar assets lose value or cannot be accessed, then China must still service its liabilities. It can print money but will suffer the economic consequences including inflation and higher funding costs.

This reduces that amount of reserves available to restart the credit machine both here as well as in the 'reserve countries' such as China, Japan and Saudi Arabia. Additionally, large sales if US securities by these countries would certainly put downward pressure on the dollar.

The substantial buildup of foreign reserves in central banks of emerging markets and developing countries, as identified by David Roche (see David Roche and Bob McKee, 2007, "New Monetarism," Independent Strategy Publications), is really a liquidity creation scheme that relies on the dollar’s favored position in trade and as a reserve currency.

Many global currencies are pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that is driven by excess U.S. demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase U.S. debt with dollars to mitigate upward pressure on their domestic currency.

The large buildup in reserves in oil exporters from higher oil prices and higher demand from strong world growth was also recycled into U.S. dollar debt. The entire process was reminiscent of the "petrodollar" recycling of the 1970s.

This is certainly happening with the local currencies in the oil producing countries, the unwinding of this "liquidity creation scheme" is having an effect on crude prices. The currency pricing mechanism is stronger in its unwinding than the crude pricing mechanism at this point as it amplifies other deflationary forces that exist within the consuming countries such as the 'New Frugality'. The bustup of capital flows and the flight to 'safety' in US treasuries further amplifies the effects. The idea is there will be severe deflation so all non- treasury assets are questionable with the treasuries being less so. So all funds flow toward treasuries causing asset prices to fall which validates the deflation mindset causing further flight out of assets and into treasuries.

With the Fed setting a high floor for treasury prices it is a hard paradigm to overcome; the creation of a credit bubble in credit itself.

For the short term oil prices will decline; you can't fight the Fed.

Markets placed great faith in the volume of money available to support asset prices and assist in alleviating shortages of liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage as well as the structure of global capital flows. As the financial system deleverages, it is becoming clear, unsurprisingly, that available capital is more limited than previously estimated.

None of us were as rich as we wanted ourselves to believe.

I have repeatedly been reminding people here on TOD that oil is a commodity, and like all commodities its price will fluctuate in the short term. Long-term, as we move unambiguously past peak and start the long trip downslope, scarcity will become the rule, and supply will continually fall behind demand. Thus, the long term trend will be that prices will rise. Be careful, though: it is quite possible to be perfectly right in the long term, but to still lose your shirt on the short term movements.

Long term, oil will still have its ups and downs, but there will be more ups than downs and the ups will be up more than the downs will be down. That is about all that one can predict with any reasonable degree of confidence, and I'm not sure if that is enough of a basis for an successful investment strategy.

Can anyone tell me the actual value of a dollar? For that matter can anyone say with certainty that ten dollars are actually valued at 10 X $1?

In fact there is no inherent value in currencies. There is no inherent value for fiat currency. There is no inherent value for gold or any precious metal.

There is inherent value in foodstuff. There is inherent value in any form of energy that keeps us moving. In short, the only real currency we should attend to is the net energy at high potential that is available to do useful (economic) work. Paying attention to prices in dollars will never tell us what something is worth.

The only numbers that really matter are these: fuel production, fuel quality, and EROEI (as compared to energy consumption rates). It takes energy at high potential, produced in a sufficient flow rate, to drive our industrial economy, including our production of food. To haggle over the dollar value of oil as if it were a meaningful number is not productive, nor does it tell us anything meaningful in its volatility other than that our control systems for managing the flow of energy have gotten out of order. Price is not a meaningful parameter any more. It is just the convenient one we've gotten into the habit of paying attention to. Like magicians distracting our attention the bankers and politicians can use the dollar prices to fool us into thinking they are in control. They are not. No one is.

Our economy is a physical process. It requires an influx of high potential energy and a dissipation of low potential heat to keep the engines running. Money is an invention of convenience to help regulate the flow of energy through that system and nothing more. But since it is now completely divorced in value from the energy it was meant to regulate it can no longer be used for that purpose.

I urge TOD writers to focus on the meaningful numbers since that is what will tell us what is happening. The mess in the financial markets, the markets in general, are all due, I suspect, to a reduction in influx due to the peaking of oil production (or at least its entering into a plateau phase) and the decreasing EROEI, which means net energy flow is declining at an accelerating rate. We have been building more useless junk with what we have (letting infrastructure and investment in new energy technology go to hell). We were borrowing against a presumed future where we could always have an increasing energy influx to pay it back. We always have had one, haven't we?! Only the peak of oil production, followed shortly by the peak of energy production in general and the energy cost of having what flux we can get, means we have no future to recoup. I suspect that if we do a good job of tracking the real numbers we're going to find that the future is contraction.

Of course if we were wise we would value money on net exergy (energy available to do useful work).

Question Everything

George

Probably these "boom-and-bust" cycles will henceforth perpetuate until at least one of two things happens:

a) A "bust" phase permanently erases an important part of Demand;

b) A "boom" phase eventually takes place supported mainly by alternative energies;

I'm hoping for b).

Why are you hoping for b)? If human beings are going to be around for the long term we are going to have to get over boom phase of economic development. The OECD nations do not need X decades more of economic boom times. We should hope that alternative energy will expensive enough to put and end to boom economics for the richest nations, but cheap enough to support a comfortable but modest style of living.

If two hundred years after the start of the industrial revolution the richest nations on earth are unwilling to consider the end of growth based economics, what makes you think that X decades more of growth will do anything to change this attitude? Grow until you collapse is the strategy of yeast.

I am a simple minded kind of person. My attitude is that if you want to make infrastructure investments that are conducive to the long term health of the human community (which coincidendtally implies the long term health of biosphere) then this goal has to be part of the job description of people with responsibility for making such investments:

If you make investment decisions which benefit the long term health of society you will be well rewarded and honored. If you make investment decsions which are detrimental to the long term health of society then you will be out on the street looking for a new job.

This kind of economic focus will never take place in boom phase of private finance capitalism.

Well, my hats off to all of you who saw a collapse coming. I for one felt that while the prices might decline to $100, I did not see under $80 as a possibility. However, as we discuss the magnitude of the oil price collapse, years of bad U.S. fiscal policy outside of the oil industry seem more to be the culprit. Yes, $140/BBL prices were causing a global slow down, but it took the U.S. housing bubble create a global collapse that’s now threatening to become a global depression. (BTW, does anyone have detailed knowledge of the dynamics and policies in place during the previous oil price spikes? Obviously, the ‘67 and ‘73 oil embargos were not driven by market forces, and I would argue, neither was the magnitude of this one. I’ve read about supply and price spikes before Rockefeller took over, but I don’t have detailed knowledge about them. Another market to look at would be timber. It’s more of a pure supply and demand driven system. One of the sayings in the industry is that it can rapidly kill any good market (higher prices) in short order, because demand over stimulates supply, leading to a supply overshoot and then a price collapse.)

In any case, I think that if in June 08 you had asked Yergin, Westexas, Louis, Khebab, DBS, JD or anyone else who has discussed price models & projections what would happen given the unfolding events, you would have found unanimous agreement that the price would fall dramatically. The only disagreement would have been just of low it would have gone and how long it would stay there. While queuing theory provides a model that has similar reactions, I don't think its a good physical match for what's actually going on other that it says when things get tight, any small perturbation can create chaotic reactions. I'm not familiar enough with it, but cellular automata mixed with Chaos theory would be my next step for trying to model the petroleum industry (SimOil?). Neither logistic depletion curves nor market-driven models can account for oil platform attacks, resource wars, a once per century financial meltdown, unknown oil reserves, hidden futures contracts, and resource nationalism.

I think the worry now is what the long-term impact of low oil prices will be on all of those expensive natural gas and oil megaprojects. The ever-optimistic IEA (08 report) basically depended on them to make up for the impending shortfall from established fields that they predict will start this year.

http://www.theoildrum.com/node/4792
http://europe.theoildrum.com/node/4829

Many of the projects depended on $60/BBL and above oil and will probably get shelved. Meanwhile, the past peak fields will continue to decline, leading to potential short falls when the world economy rebounds. For example, if we have 20% lower production for 5 years, you’ve essentially pushed the peak off by one year (I know its not strictly linear but bare with me). However, if the existing fields decline at 4.5% per year (as CERA has acknowledge), then after 5 years, you’re down 16% to 20% in production. As demand increases, there won’t be the capacity to support it and it will take 3 to 5 years to spool up the mega-projects, resulting in another 12% to 20% reduction in capacity. Depending on how things play out, and what policy governments follow, the oil price collapse could create a much worse situation in terms of future oil supply than we have been anticipating.

Something few seem to understand or appreciate:

Sure: $150 bbl was absurd. The economy tanked and now we're down to $40 a barrel.

After $150 we think it's a bargain, but let's be clear:

Oil was $10 bbl in 1998. So, in 10 years it has gone up 400%.

I don't consider that a "bargain".

Assuming $40 bbl is the "new" bottom, then we're looking at $160 bbl as the "new" bottom in 2018, if it follows the pattern. That still sounds like a lot of wreckage to me. I don't know if it will follow the curve, but I thought $150 bbl was about where it belonged today, so I would think $160 bbl in 2018 would be a bargain...

A couple of comments.

Excess of light sweet crude should result in oil prices returning to 30 dollars a barrel or below. I.e if oil really is in excess supply we should see prices continue to drop 40 is not a bottom. Next the decline should result in the collapse of expensive oil production projects this should even impact current projects i.e some may be left unfinished as they simply don't cash flow. The is effectively a repeat of the collapse of Texas in the 1980's.

Given the recent market moves the chances of us hitting 30 esp for any length of time seem improbable.

Next the oil market has remain in contango if we have excess oil sufficient for a real glut then the market will go out of contango and into backwardation esp as we leave the high demand winter months and look into the spring.

Right now April 2009 futures are at 52.14 this is some serious contango and makes storing oil for future delivery profitable.

Next if you look you will see that as each new front moth roles in we have seen the front month fall pulling down futures prices but not removing contango this is in my opinion probably the best evidence that the futures market is really telling us that it is looking short term. Its acting like a spot market with a short term glut. Coupled with the contango its still not telling us we have a long term glut.

Bottom line is the market is not pricing in any long term glut of oil it is telling us that its finding plenty of buyers every month but generally to date at a lower price point. There are no shortage of buyers for 40 dollar oil thus oil but we have enough of a excess right now to keep prices from rising strongly in the front month.

So either the market must go into backwardation across the futures curve or we will see the front month price begin to rise the current situation indicates to me at least that the market is still in a temporary short term glut mode.

Its not something you can make any long term conclusions from. If oil becomes constrained I suspect the market will discover plenty of willing borrowers up the price curve. How it moves will then depend on supply and demand.

So we need one of two scenarios to happen before I believe the market is back looking longer term ie its a real futures market it has to go into clear backwardation.

This is either via a increase in the front month price or steep decline in the long term futures prices esp in the Spring.

I think to force the long dated futures market down we would need to see the front moth price dive to 30 or below then rebound a bit it needs to send a very strong signal that honestly we don't need more oil. Then it should rebound a bit and put the market in backwardation representing the expectation of excess oil. The oil market may become slightly in contango but it should then be moving back and forth between contango and backwardation at the very least.

Or it goes into backwardation because of a strong price increase in the front month. Given the current steep contango my opinion is we may well see the steepness expand not decrease i.e as the front month rises the outer contracts rise even more putting us on a vicious price spiral.

The other possibility is the one I think the Saudi's have guessed which is a strong rise in the front month contract putting the market into backwardation will move up the future months but with contango lessing fairly quickly they are guessing that it ends at about 75 a barrel and thats their stable price point they have quoted.

I don't agree with there result but regardless until the market finally shows clear backwardation I don't believe you can use the current price of oil as any sort of economic indicator outside of a short term supply glut and the condition of the glut is determined on a month by month basis.

Your mental model of oil prices struck me as almost identical to a drawing I did the other day based on a different idea. In the 30 year update of Limits to Growth, Randers & Meadows note that stock brokers call overshoot "bubbles". So I looked at oil prices as having gone into overshoot, followed by collapse, overcorrection, to be followed by the usual oscillating wave, as the price finds its way back to the "k" line, what might be called the natural, or logical price.

But k is only flat for a sustainable resource like wind (assuming the sun doesn't go out, on top of our other problems); for oil, k must be rising as oil depletes. So you get an oscillating series of overshoots and undershoots around a rising line, exacerbated by the usual psychological, physical and military factors. Just thought the tie-in to overshoot is interesting, as a way of looking at this - I suspect the mechanism of overshoot is at work around us all the time, in ways we don't think about.