noutram,

+5 rating points for demonstrating how the "price" signal hides what's really going on with dwindling resources like whale parts.

A drop in price might be argued to be proof that the "peak" never happened even though we are well past peak.

Thanks.

jpods has a few more interesting graphs here

To me your confusing technology with energy. First world countries and developing countries will still consume enormous amounts of fossil fuels for many decades.

Oil is the world’s vital source of energy and will remain so for many years to come, even under the most optimistic of assumptions about the pace and development of alternative technology. WEO 2008

All the infrastructure that supports a high tech lifestyle is fossil fuel based. The number of people who can afford to work from home is limited.

Unfortunatley I don't have sufficient data to argue the point but I can't help thinking that we are decades away from any substitute for the quantity, energy density and general 'sunk costs' that our oil based economy embodies. I just have a bad feeling that we are mere years away from the decline of what may prove to be the lifeblood of modern civilisation and that worries me a bit because we're really NOT ready for the sh*t that's going to happen when it does...

Nick.

There isn't nearly enough domestic crude to make a difference.

Here is the "real" price curve to supply. I have a slightly updated curve that I have not published yet and it has not changed the nature of the curve.

For a larger image us the following link:

http://farm4.static.flickr.com/3186/2968324434_7bd464740b_o.jpg

But where is the evidence for a collapse in consumption? All the public figures (e.g. from the EIA and IEA) seem to suggest that the decline has been small, of the order of 1% or less. So I keep reading about collapsing consumption but I can't find data to support that notion. It seems to be a case of argument from incredulity; it can't be anything else!

Do you think the price drop is due to drop in demand or not?

Yes - I don't believe it can be anything else. Supply does not respond to small changes in price, so when demand drops even a little it takes a huge price drop to have any impact on supply.

All the way to zero ... or five dollars!

There is another factor. I'll keep it brief;

What prices are measuring is production capacity rather than product.

For many years there was a consistent increase in demand - and leaving out inflation - this demand increased prices for crude resulting in more funds being available to further increase production. Consequently production increased, yet it lagged the increase in demand. Production increases never caught up with demand to the point where prices would fall.

Part of this was on account of inflation, but that is not central. Production itself - not the capital cost of it - is what matters.

By 2008 there was a very high level of production. Keep in mind this production is a non- economic activity; unlike banking, drilling wells and pumping oil does not require money (or credit), money facilitates the process but steel, geologists, pipe fitters and other industrial hardware are needed for production. Production takes place on its own account with resources that are inherent to it; out of cash flow. Oil production is basically self- propelled.

By Summer of 2008, the world was pricing a perceived production shortfall. This perception was reinforced by a continuation of the preceding many- years' trend. Also, it was stoked by the media and reflected in parallel bull markets in all other commodities. Yet, perception was false. Even when prices were over $120 dollars a barrel there were other stories in the same media of surplus oil being 'stored' in tankers in the Gulf of Arabia. At the highest price levels, there was sufficient oil available for all users. In other words, there was never a shortage of product, only a perception of a shortage of production.

When the surplus of oil became obvious, and could not be rationalized away the high price for product became unsupportable. The idea followed that high prices were causing 'demand destruction'. However, what was happening was a secular supply/demand imbalance. There was structural overproduction relative to demand. Demand was indeed declining because of the recession, but neither the decline in demand nor the accelerating shortage of credit affected the level of production capacity. That level is an outcome of the process; the large investment in it having already been made. Even with the depletion of the world's oil fields, there is still a great amount of production capacity, and there is an accompanying perception of a high level of capacity.

Consequently, any 'surplus' no matter how small is an indicator of excess capacity; of the continuing secular supply/demand imbalance. OPEC can announce cuts, they can actually shut some valves on pipes and reduce the flow, and some big fields can deplete dramatically, but geopolitics and the need for a constant revenue stream leaves the producers able to put a large fraction of available production onto the market - at any time. In other words, the oil available to produce is both absolutely and relatively very great, even if it is temporarily suspended there is no 'production destruction'.

As Phil indicated, the industry is very large with a large investment base. This capacity functions even at low product prices. Product can even be made available even at an economic 'loss' if only for a producer to maintain market share.

Against this background, any surplus on the market has the effect of continually forcing sales; product is sold at whatever price ... in order to clear the market. The perception is that tomorrow will bring increased supply OR that reduction in demand will have the same relative effect. As demand falls, the structural imbalance between capacity and demand increses; less oil sold and burned is oil that remains on the 'supply' side of the balance. It becomes reserve - or excess - capacity. Going forward, the less consumption the greater the imbalance.

Until there is an actual structural reduction of oil production capacity, not temporary cuts ... prices will drop. As demand continues to fall, the forcing mechanism of marginal oil surpluses - real or perceived - will become more and more powerful ultimagely pressing prices downward ... all the way to zero.

New ... there are other non- energy feedback mechanisms that come into play, but the short version has all these loops amplifying declines in price - making the forcing mechanism stronger still! Higher prices, to paraphrase Ronald Reagan lift all boats. Falling prices eventually leave all the boats aground. After this grounding point is reached, there is little that can raise the prices as only small amounts of money will be risked (or be available to risk) for higher, but still very small returns. Even if there are actual shortages, the price will only rise a little as higher prices will deter consumption. There might be long term $8 dollar oil.

The same mechanism is at play in other sectors of the world's economy. Deflation is a bitch ... I will leave to others the amount of economic activity which $8 oil reflects. It may be substantial or may be very reduced, but it will certainly be much less than in 2008.

After all, if they were off by even a small fraction, the price impacts would be severe. I don't think this information exists.

That is why the market is so unstable. Even looking back a few months, it is difficult to be accurate about either demand or supply.

You have the wrong idea about speculators. Speculators invest based on information and their view on fundamentals. The function of market (and speculators) is to try the get out the right price. Everyone trying speculating in something probably learned the hard way how to loose lots of money in very short time. As easy as you can speculate on rise, you can speculate on the fall. Every long position is always matched by a short position. There is no imbalance in the futures market. What determines the price is the current information.

Speculators generally reduce price volatility. If you take a look at net positions of large speculators (those who probably carefully plan their investment), you'll notice that they closed their long positions as price was going up. They were right and they pushed price lower that would otherwise be. Long position closing started on March, 2008. and ended in August 2008.

Thanx gregvp for the differentation of demand and supply elasticity. We (peak oilers) often argue that long term supply elasticity for oil is very limited. No matter how high the price of oil might get, it is not possible to increase the oil production when it is in terminal decline. Even tar sands, coal to liquids and bio fuels will not be able to reverse the trend in the long run.
Concerning demand elasticity there is good and bad elasticity: A shrinking economy is seen as undesireable whereas increased efficiency is seen as good. However increasing efficiency takes much longer than just shrinking the economy.

Demand is usually expressed a function of price. But yeah, you've got the convention right.

Quantity on x-axis seems to be pretty standard. Am I missing something?

Phil,

Yes you are.

From a pure math point of view, the x-axis (Quantity) goes on smoothly to infinity and beyond.

Similarly, in the pure math world, the y-axis (Price) goes down smoothly all the way to zero and up smoothly to infinity and beyond.

However, in the "real" and finite world, certain forbidden zones exist in the PQ plane.

Price (P) cannot go below the costs break even points for their respective Quantity (Q) verticals and those cost break even points are functions of economies of scale.

Quantity (Q) values cannot extend to the right towards infinity due to geological rate-of-production limits.

If global Peak Oil is truly here and the number is 74-75 mbbl/d, then the PQ graph is exhibiting the effects of hitting up against one of the forbidden zones as prices rise to $140/bbl and above.

On the other hand, when prices drop below the cost break even points of the present day technologies, we are going to see a discontinuous drop towards Q=0. There won't be a smooth region between say, P=$20 and P=$0. The collapse will be a catastrophic one.

This would never work, because OPEC is not a single entity or a perfect monopoly.

As soon as they set price higher than the equilibrium, some capacity will go unused. This would likely affect some OPEC member countries more than others (that is, buyers will choose to buy only from those that are closest to them, or what not). Those countries will suffer disproportionately, and thus have an incentive to lower price albeit only a little, to encourage buyers to come back to them. Then that starts the price wars again and the scheme falls apart.

In sum, unless OPEC can somehow strictly enforce quotas as well as prices for EACH member country, they won't be able to set a fixed price like this.

This is why they have used quotas, not a fixed price, in the past. That way they achieve roughly the price increase they want, while making sure that individual countries still get "their share" of the pie. But even so, they have historically had trouble enforcing their quotas.

The futures market is closely tied to physical market it's easy to spot. I have almost never seen in the last few years that future contracts go beyond arbitrage conditions. It can happen only on very distant expiration dates due to lack of liquidity of those contracts.

PH, HF, Thanks for the comments and insights. (If anyone wonders what the *recent super-contango with insane spreads* is, have a look here)
I know little finance so excuse my candid approach, but real world commodities seem to be more complex than what textbooks say.

1) You mention no room for arbitrage (and I assume the arbitrage from buying tankers to store oil, playing with production, etc should be eliminated by the sheer number of other players).

2) The relationship between incomplete information (or group denial) and speculation is however very confusing to me, and definitions of what is arbitrage, supply and demand, etc seem to change depending on the time frame considered.

I'm not sure how much of the group psychology is captured in the models about options or futures, so just for me to understand let me imagine a simple model. Say we have 10 speculators, 5 producers and 5 consumers. The consumers are making lots of money because of a housing and credit bubble, they are growing, happily consuming. Producers can't exactly keep up with this consumption. So prices rise.
Say at $80 producers have good margin profits and consumers can expand the real economy (not forever, obviously).

But speculators + consumers + producers don't know this. That local equilibrium point is hard to identify, so the speculators are confused. 8 out of 10 think that the economy can expand forever and that production is tight. So even though there was a temporary equilibrium at $80, they start going long on their way to $140. The whole roller coaster $80 - $140 - $80 takes less than a year. Then, in this zero sum game, money changes hands between those who understood (or guessed) the timings and those who didn't. In the process prices changed wildly.

That's a reason why "manipulating" or "artificial" prices are hard to define (I think). After all if we knew the timing for peak oil and had a clear picture of the resources left, the prices would be very different, so all the money and guesses made now would be pure group behaviour making the market swing with no relation whatsoever to real future availability of commodities.

.... but I'll need to research the question a bit more.

I'm not so sure Nick. The production/demand numbers for the 4Q 2008 are beginning to be verified. During the period when oil prices collapsed the supply/demand dynamics changed very little. What did dramatically change was the vast number of futures contract owners who bailed out of the market at an unprecedented rate. That doesn't directly point a big finger at those folks for the price run up but it's clear that their efforts to unwind so quickly was a significant factor in the price collapse.

As far as there being a conspiratorial effort: I don't think so either. But that doesn't mean their combined efforts didn't affect the market. When 60,000 fans in a stadium start cheering their team simultaneously it doesn't mean they had conspired to do so. Widespread common motivators are well known in many markets. Remember the Cabbage Patch Doll? Everyone one that wanted to buy was able to in time. But the collective fear of missing out led to a crushing demand and ridicules pricing. What would have happened to the doll prices had, for some unknown reason, almost everyone who had bought a CPD had put theirs on EBay? I know the comparison sounds silly but the dynamics are the same.

There were commodities for which future contracts were not available which also spiked - how was that "speculation"

In reply to Rockmans post:

Although the supply/demand situation - the so called "fundamentals" didnt change much in August-September remember that to move the price - the market forces need only to percieve the future change. What we saw was not a real change in supply and demand, but the market saw the recession unfolded and quickly joined the dots. Hence everyone sold their contracts and ran for the hills. You dont need an actual supply glut to burst the bubble (or an actual shortage to cause one) you just need the conditions to ripen a little.

As Matt Simmons is fond of saying "$147/bbl is still cheap" what we saw as a massive spike is actually quite small - its small because speculators were able to see the future before it actually happened. By seeing a future shortage they drove the price up (thus softening demand and bolstering investment and supply). By foreseeing the oversupply situation the collapsed the price quickly.

If they hadnt driven the price up with their crystal ball - a REAL shortage may have occured, forcing prices to ridiculous numbers (many times higher than $147/bbl) - of course laymen would describe that as gouging - in supply demand economics no such thing exsists.

Stopping the speculation is like taking an important damper out of a system. Anyone familiar with controls/dynamics can see what i mean. Speculation is a damper than can see the future and react before it happens. Without it the market would jerk all over the place and make that "spike" look like a pimple.

Grain inventories hit 30 year low in 2008, we were consuming more than producing for years. Also, inventories of metals were also historically low. For example, steel was not traded on future markets until recently and did most of it's price run before that.
Interestingly, during great depression, speculators were blamed for food price fall. And also for crash of onion price so onions were banned from future markets. It didn't help, of course. Speculators were blamed for drop in stock market prices, most notably financial firms. So short selling was banned and prices did still fall. Stallin blamed speculators for famine in Russia, yet it was his "reforms" that turned one of the biggest crop producers in Europe into famine. So when politicians cry "speculators", I turn skeptical.

Speculating or investing certainly played a major role in running up the oil price in 2008. This is obvious because all commodities increased in price at the same time. Are you telling me that we had a sudden hard shortage of corn, gold and other commodities too?
...

That is spelled "monetary inflation" in my dictionary. I wonder who was the cause of that? Oh, coincidentally, it was the same people screaming "speculators".

while some people simply went out to purchase houses for a places to live, many people did purchase houses using ARM loans expecting to flip it a year later and making a handsome profit. These investors drove up housing prices. When the housing bubble burst, these speculators were left holding the bag owning a house that they could not afford. These were speculators and their actions are a prime reason why we now have a financial crises.

You forgot the policy which produced the flood of buyers pumping up the prices.  Bank lending policy got riskier and riskier, because of government incentives.  The incentives consisted of both FNMA purchase policies and CRA-induced incentives for issuance of loans to people who never would have qualified before; because of the CRA, bank managers willing to make shaky loans were allowed to buy up more risk-averse banks, but not the reverse.

This process caused bad management to drive out good.  The bad management allowed and encouraged the impression that there would always be a "bigger fool", and the whole thing was the product of do-gooders in Washington.

One of the tweaks I think about, to better account for wants versus needs....

As it stands, the growth in "appetite" is a linear function of consumption. There is some steady state level of consumption, where appetite stays constant. Maybe as consumption drops below that steady state level, appetite should shrink more and more rapidly, since at first the lower priority items get dropped, then more vital items. On the other hand, as consumption rises above the steady state level, maybe growth should accelerate more slowly. Eventually folks will just be draining champagne bottles into the streets, i.e. consumption with no growth.

I think it is premature to say we are past peak. Much depends on whether or not capitalism survives the current crisis, if it doesn't then it is difficult to see circumstances that will push demand back up to the 2008 highs.

Assuming we get through the current trouble, which I think we will, then we have a complex interaction between natural decline, project scheduling, delays and postponements, and the building of reserve capacity in OPEC. OPEC have cut around 3 mmbpd thus far, and so presumably given demand, we could easily have hit new highs this year. Cuts in capital expenditure and decline will eat into that reserve capacity going forward.

Another important factor will be how psychologically damaged the major oil cos are. It took them a long time to respond to the higher price signal this decade. On the next price run up, I think they will be even more reluctant to commit investment to ever more expensive projects. Shtockman will be an interesting test case to see if StatoilHydro and Total are willing to risk billions developing reserves in the Arctic in a country with a poor corporate legal record.

"The term Demand is used interchangeably with the terms Consumption and Products Supplied." -EIA

Sinopec and Petrochina signed a deal loan for oil with Russia. The price of Russian oil these China companies get access to in return for a $25 billion bailout loan for a bankrupt Russian Oligarch is fixed to $20 a barrel for 20 years.
Both are happy with the deal, the Oligarch, and the Chinese.
No good news for oil permabulls.