Economics and the mid-life crisis have much in common: Both dwell on foregone opportunities

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Wednesday, August 17, 2005

Why Are Oil Prices So High?

Tom Hanna has suggested that one reason oil prices are so high is the U.S. Federal gubmnt's stockpiling of emergency reserves.

The Strategic Petroleum Reserve is now at 699.8 million barrels with another .7 million scheduled for delivery. After that the Royalty-in-kind oil deliveries to the SPR of 1-200,000 barrels per day will be on the market. With the reserve full and private reserves, we have several months import protection, so if not only the Middle East but also Nigeria, Venezuela, Mexico, Canada, Russia, Norway, the North Sea and every other source of imported oil dried up overnight, we’d be months from needing gas prices in the $3/range to deal. The futures market is out of whack. Something has to give and my secret hope is that when it does these oil traders get burned bad.
Of course if all the sources of oil are considerably smaller than people had previously been estimating, then expectations of shortages in the future would drive up prices today. That seems to be the position of Matthew Simmons in this interview [h/t to MA for the link]:

Let me tell you what the numbers were all about, because I had not thought about this until yesterday and today. In 1990 the United States was still producing 7.3 million bpd of crude oil, today it’s 5.1; the 7.3 was after a drop over the previous 5 years of 1.6 million bpd; our refineries only needed to run at 13 ½ million bpd; and we only needed to import 5.8 million bpd of crude oil imports to balance our system. Today we have to run our refineries at 100% or we have major product shocks; today, we have to import 10-11 million bpd, or we lose crude oil stocks; we have to basically create almost 3 million bpd of finished product imports; we have to run the system on a 24-7, all Summer long. And we still liquidate stocks.

So we have actually now created a pending domestic embargo, and we’re going to be lucky to get through the Summer without some periodic shortages. We probably will, but the odds are probably as high we will have some shortages, and then if we get through the Summer we have a fabulous respite from Labor Day to Thanksgiving, until we hunker to try to figure out how the world gets through the Winter of 2005 and 2006 because oil demand globally could easily go to 86-88 million bpd during the Winter, and that could easily exceed supply by 2-5 million bpd.[38:53]

[Interviewer]: If that was to happen we would almost be looking at $75-80 oil, I suspect.

MATT: No, no, no. Oil prices could easily go up 5-10 times.

If he is correct, there is a LOT of money to made in oil futures, where such projections appear to be heavily discounted. Some additional thoughts about the Simmons interview:

I found it very engaging. Simmons' major argument is that oil reserves have been overstated for years, and that, as a result, oil prices are too low, encouraging too much oil use (relative to what would happen if everyone believed Simmons' numbers).

Subsidiary point 1 (by implication) is that the Saudi royal family has had an incentive to over-pump in order to generate enough revenue to try to buy off the local opposition, including Wahabis.

Subsidiary point 2 is that when the rest of the world recognizes that oil reserves are smaller than we have been told, we won't necessarily leave it to the market to sort out the short term adjustments -- we will want our gubmnts to grab the oil -- and we're in for more serious wars that are more explicitly about oil.

If you think Matt Simmons is right, and if you do not expect futures markets to prepare us for the future, there might be a good reason to tax oil a whole bunch more in North America.

But the question keeps gnawing away at me: why aren't futures markets driving oil prices even higher??

And here is a strong possible answer from James Hamilton: Despite Simmons' research, oil supplies are likely to increase over the next 10 to 15 years. Be sure to read the entire piece because how much demand will continue to grow, how much supply will increase, and the impact of volatile (and unexpectedly high, for most of us) oil prices are all open to wildly varying interpretations.
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