Speculation and the Oil Price

According to press reports, France, the UK and the US want to limit speculation in oil futures to reduce price volatility.

Two questions:

1. To what extent can speculation actually influence the oil price?

2. Is it bad if "speculators" drive up the price?

Let's see:

ad 1:

As discussed in previous posts, the way it works is like this: If people expect the oil price to go up, they can drive up the price for future deliveries, thus encouraging others to store physically available oil as opposed to selling it to end users. This reduces the oil available for consumption today, and therefore drives up the spot price. It's hard to say what the effect on price is, but in a tight market, rather marginal supply changes can have big price effects.

ad 2:

So we established that "speculators" can potentially drive up the price if they think prices will anyway rise in the future. In theory, they can create a "bubble" on the spot market, but only if they encourage enough people to put oil into storage. But if so, is this a bad thing?

I would argue it isn't: If we all agree that oil is a finite resource, and will become progressively more scarce in the future, then it is the job of a functioning market to drive up today's price so that people use oil more efficiently today and leave more of it unused for tomorrow. Arguing for a low price today is shortsighted (and selfish, if the argument is made by people beyond a certain age).

In other words: "Speculators" that drive up the oil price don't cause harm. Quite the opposite: They help to achieve efficient intertemporal decision-making.

Though of course there's always the "us vs. them" argument: "We" (the people from oil consuming countries) don't want to pay too much money to "them" (the people from oil producing countries), even if that means inefficient intertempral allocation.

Oil

Naked Capitalism quotes "veteran oil analysts" which are sure that "oil will drop to $20 a barrel by the end of the year because this situation just cannot be sustained". The reason? Huge oversupply.

A price correction is certainly possible, but 20$/barrel? I just cannot imagine that this will happen. Well, we shall see.

Oil

BP's chief economist apparently believes that 20 years from now, 80 % of the world's energy needs will still be met by burning fossil fuels. Let's hope he's wrong.

Coincidentally, after a two month hiatus, I decided to buy oil futures again. No clear reason really, other than the price being under pressure lately, and my continuing conviction that in the longer run, it can only go up. As for the short run, no idea. Except that I consider it extremely unlikely that oil will again fall below 50$/barrel for a prolonged period of time. In other words: IMVHO, mid-term upside is bigger than mid-term downside.

America's Strategic Oil Reserve

According to Mish, several influential Democratic congressmen are currently pushing for the US to sell some of its strategic oil reserves to bring down the excessive oil price.

What a bizarre proposal:

The oil price is still 50 % below its peak, and they want to sell the strategic reserve because prices are so terribly excessive. Has nobody told them that the marginal cost of developing new oil supply is roughly equal to the current market price?

Oil Price

Oil keeps edging higher. Brent reached 72 US$ earlier today. In other words: It has more than doubled from its low just a few months ago. Can't really offer any meaningful analysis, as I'm as mystified as everybody else. Only explanation I can think of is unusually high OPEC discipline (though recent press reports seem to indicate that more and more OPEC members are getting tempted).

Though I do think that a moderately higher oil price is good. If people have to pay more, at least they won't forget that oil is a scarce commodity. 5-10 years from now, we'll be thankful for every drop of oil that wasn't used today.

The European Airline Industry

The airline industry is in big trouble: Passenger numbers are falling, losses are piling up, and companies are fighting for survival.

All of them?

No, there is one exception:

Ryanair just announced the results of the year ending 3/09. Passenger numbers were up strongly, and according to its investors presentation, Ryanair is now Europe's biggest airline both by passenger numbers and by market value of its equity (though I am not sure if they included the various subsidiaries of Air France and Lufthansa when calculating their total passenger numbers). Ryanair did post a moderate loss, but that was mostly due to oil hedging contracts, which were hard to get right with the oil price fluctuating all over the place.

What's their secret?

The traditional players rely heavily on their business class passengers. Unfortunately, their numbers have been declining rapidly, whereas leisure trips have held up reasonably well. But traditional airlines cannot compete with budget airlines on the price of economy class tickets if their business class seats are half empty. Their business model does not work that way.

Another part of the reason is Ryanair's aggressive use of low-cost secondary airports. These airports struggle to cover their costs, and are willing to accept cut-throat pricing for their landing fees.

Anyway: For the moment, leisure trips are very affordable - even for penny-pinching consumers - due to the low oil price.

However, if (or rather: when) the oil price goes beyond 100$/barrel again, ticket prices will have to rise, and the low end of the market will also suffer.

Mexico

Lately, just about everything seems to be going wrong for Mexico:

- It started with collapsing oil revenues. Not only did the oil price collapse (an event that will probably be temporary), but much more worryingly, oilfield output is declining at ever steeper rates.

- Exports to the US have fallen sharply, and workers' homeward remittances are also dropping.

- American multinationals have slashed their investment budgets, and are repatriating as many profits as they can to strengthen their balance-sheets.

- Escalating gang warfare among drug traffickers has claimed 6,200 lives last year, and some cities (most notably Ciudad Juarez, across the Rio Grande from El Paso, where 1,800 people have been killed since January 2008) are so unsafe that thousands of troups have been moved in, and nobody dares to venture outdoors after nightfall.

- And if all this wasn't already enough, swine flu shut down Mexico City for several weeks, and has caused the country's tourism industry to collapse. As of late May, occupancy rates in major tourist destinations are still down by more than half compared to last year, even though prices have been slashed by 50 % and more.

Latest forecasts now project 2009 GDP to drop by 8.5 %.

Edit: According to latest news, the US now insists that US citizens travelling to and from Mexico carry a passport. This is expected to deal a further blow to the economies of border towns such as Ciudad Juarez, as most Americans don't even have a passport.

Does Scraping Old Cars Lead to Reduced Energy Use?

In the comment section of a previous post, reader Taurus ponders the effect of the car scraping bonus on overall energy use.

Here are my thoughts on this topic:

- The car scraping bonus subsidises 2 million new car purchases with a total amount of 5 bn €.

- Assume half of those new cars would have been bought anyway, whereas the other half was bought earlier than otherwise intended, reducing their useful life by 10 %.

- Assume the lifespan of a car is 150,000 km, i.e. a reduction by 10 % equals 15,000 km.

- Assume that the new cars consume 1l/100km less than the scraped old cars (my new Toyota replacing a 14 year old car of a similar category needs roughly 1l less).

- Assume that the energy needed to produce a new car is 23,000 KWh (based on calculations made by Volkswagen for a VW Golf).

How much fuel is saved by the scraping?

1 million cars * 15,000 km * 0.01 litres saved = 150 million litres of oil saved

How much energy is needed to build the new cars ahead of normal schedule?

1 million cars * 23,000 KWh * 10 % of lifespan = 2.3 bn KWh of additional energy used

Based on current prices, 150 million litres of oil cost roughly 50 million Euros on the world market. 2.3 bn KWh for industrial use cost around 200 million Euros.

=> Based on the assumptions I used, the scraping bonus leads to significantly more energy use, not less.

You can play around with the assumptions (e.g. the average car bought under the scraping bonus is smaller than a VW Golf and therefore needs less production energy; also, if people trade down to smaller cars, the savings on fuel consumption may be bigger), but I don't think you can come up with a realistic set of assumptions that implies significant net energy savings.

US Oil Consumption

According to the FT, experts expect Obama's policies to have a major impact on mid-term US oil consumption. Apparently, Obama wants to reduce US oil demand by "the combined consumption of France and Canada" (note: those two countries have a combined population equal to 30 % of the US!). According to some analysts, the change will be so big that "the US is expected to become a net exporter of petrol by 2023".

Yeah, right: The US currently produces 50 % of the oil it consumes, and domestic production is falling. So oil consumption would have to drop by more than half until 2023 for the US to become self-sufficient. Ain't gonna happen. (Unless of course prices rise dramatically enough to force people to consume much less.)

As of 2007, the US consumed roughly twice as much oil per capita as Western Europe. So obviously there is scope for a significant reduction. However, the way US society is organized, Americans will continue to use their cars much more than Europeans do. So all that can be hoped for in the mid-term is a switch to more fuel-efficient cars. Factor in demographics (population grows at nearly 1 % p.a.), and the fact that US oil consumption has already dropped 10 % from Q1 2007 to Q1 2009, and the conclusion is: Reducing absolute oil consumption much further will prove quite a challenge once the current crisis is over and the economy starts growing again.

(To be fair, I suppose the FT's "net exporter of petrol" claim was referring to refinery capacity, i.e. the US would still import oil, but would become a net exporter of petrol. Not that this has any relevance whatsoever.)

China's Skies

According to a Boeing executive, China will need to buy 3,700 new jet airliners over the next 20 years.

Current stock is 1,330, and it is projected to increase to 4,560 by 2027. In other words, an increase of 240 % over 18 years, or close to 8 % annual growth.

(For comparison: Lufthansa, one of the world's biggest airlines, currently operates 500 aircraft. That includes its subsidiary Swissair, as well as the small regional jets of its regional arms.)

Personally, I think this is not a realistic projection. China's air traffic will not keep growing at 8 % for the next 18 years. But of course it will grow, and quite substantially so.

Which once again leads to an inevitable conclusion: With all these additional planes and cars in China (and India, and Vietnam, and Indonesia, and...), where is all the oil going to come from? Much higher prices and crowding out of saturated markets (i.e. Europe, but also US) are sure to follow. The only question is: When?

Frankfurt Airport

While we're on the subject of air travel:

Fraport, the listed operator of Frankfurt Airport, is eager to start the construction of a new runway. The legal battle isn't over yet, but they are already in the process of clearing the forest ahead of schedule.

According to their Q1 financial report, they will invest 7 bn € into the new runway and a new terminal building.

No idea why they are in such a hurry:

Passenger throughput is down sharply: -9.2 % yoy in the year to April. Long-haul routes are down even more, with North American routes losing 14 % and Far Eastern routes losing 13 %.

However, the FTD reports that Fraport is worried about competition in the Gulf (I suppose that means Dubai), and needs to provide more capacity once travel volumes start booming again (expected from mid-2010 onwards). Going forward, Fraport expects travel volumes to increase at 4 % annually, in line with long-term historic averages.

Roland Koch called the beginning of construction activity a "historic day", and was happy that the "next generation" will get "a chance to compete internationally".

I cannot understand why so much money is being spent on infrastructure that will not be needed. It is absolutely impossible that German air traffic will see high growth-rates during the next few decades. Not enough people, not enough economic growth, and not enough kerosene.

Does a falling oil price boost the world economy?

According to the FT's Lex Column, the falling oil price provides a much bigger economic boost than all the various fiscal stimuli combined (or, as Lex puts it: "government handouts are peanuts by comparison").

The calculation goes like this:

- 2008's average oil price was 100 $/barrel

- This year it's likely to be around 50 $/barrel

- Based on total consumption, the world saves roughly 1,600 bn $

That's a lot of money.

Germany, for instance, saves 50 bn $ (35 bn €), as it consumes roughly 3 % of the world's oil. 35 bn € equals 1.5 % of GDP. Lots of additional money in consumers pockets.

But is it actually correct to say that "the world saves 1,600 bn $"?

True, oil consumers save 1,600 bn $.

But oil producers lose the same amount of revenue.

It's by definition a zero-sum game as far as income is concerned.

For the world as a whole, there can only be a net demand boost if the marginal savings rate of oil consumers is lower than the marginal savings rate of oil producers.

Let's see:

Some oil producing countries have large cash reserves. Saudi-Arabia, the Gulf countries and Norway can afford to cut spending much less than their revenue shortfall. They anyway didn't know what to do with all their 2008 oil revenues.

But others, such as Russia, don't have this luxury. They need to cut, and cut badly. And as a consequence, the world's exports to Russia have plumemted. They wouldn't have plummeted if the oil price had stayed at last year's levels.

As for the US and the UK, which produce a large proportion of the oil they use: Consumers save money on their oil spending. But they also lose money because oil-producing companies in their 401k have lower profits and a lower market-value. True, those that hold a lot of shares probably have a higher marginal savings rate than those that don't. But that's a secondary effect.

And when analyzing total demand, we also need to take into account that oil companies are cutting back on expensive exploration of new fields, as such investment becomes much more risky and less profitable at a low oil price. Fewer investments equal less demand.

And last but not least, consumers in most countries are pretty worried about the future right now. So their marginal savings rate on "windfall gains" is probably rather high.

In short, the net demand boost from lower oil prices can only be a small fraction of those impressive-sounding 1,600 bn $. For a country like Germany that exports lots of stuff to Russia and the Middle East, the positive effect is probably quite small (especially if consumers keep the oil savings in their pockets instead of spending them). And for all major oil-producing countries, it is clearly negative.

Germany's Oil Consumption

How much is Germany's oil consumption affected by the crisis?

To analyze this question, we need to break down Germany's overall oil consumption into its main components. Based on analysis I did a year ago using 2006/07 data, this is a rough outline:

1. 30 % gasoline used by cars
2. 20 % gasoline used by trucks
3. 6 % airplanes
4. 3 % shipping
5. 13 % heating of private residences
6. 15 % petrochemical industry
7. 15 % other industrial use (heating/energy/asphalt/lubrication)

Let's go through it one by one:

ad 1: gasoline used by cars

Roughly 1/3 is commuting to work. The number of jobs has so far hardly decreased, though shorter hours and mandatory holidays have been introduced by some manufacturers. Decline in commuting-related car-use should be moderate (1-2 %)

The rest is private use. As overall private consumption has been stable, I would assume that private car use hasn't declined either. So let's assume no change here.

ad 2: gasoline used by trucks

The volume of transported goods has contracted sharply, though domestic transport was far less affected than international. Let's assume a 5-10 % reduction of total truck use.

ad 3: Airplanes

Airplane passenger traffic is down 10 % yoy, though the number of flights has decreased less (load factors went down instead). Air cargo is down much more, but is comparatively less important. Let's assume 5-10 % total reduction.

ad 4: Shipping

International shipping volumes are down sharply, possibly as much as 20 %. Domestic shipping is less affected, but rather unimportant. Let's assume 15 % reduction.

ad 5: Heating of private residences

Presumably unchanged. Based on anecdotal evidence, it seems that many people are filling up their tanks more than they usually would, to make use of low prices. But not sure if that translates into a significant inventory build-up. Let's assume constant use.

ad 6: Petrochemical industry

Plastics are mainly used for/by packaging (33 %), construction (25 %), car industry (9 %), electronics industry (7 %), furniture/household goods (8 %). A significant part of German production (more than 1/4) is exported. I understand that the big chemical companies (BASF, Bayer, etc.) have significantly cut back production, though consumer-goods packaging and the construction industry aren't affected particularly badly so far. Let's assume an overall reduction of 10-15 %.

ad 7: Other industrial use

Considering the sharp drop in overall manufacturing, a reduction of 10-15 % sounds appropriate.

=> So what does this all add up to?

Quite a large number: A massive 4.8 - 7.8 % reduction in total German oil consumption compared to pre-crisis level.

Oil - Update

Since I sold oil on Monday, the price has shot up by another 5 %. It's now up 12 % in barely one week. The futures curve has also flattened, and now only prices in an increase of 10 % until year-end.

At the same time, there is ongoing news flow about continued weakness of demand, and according to this article (hat tip Naked Capitalism), the world is quickly running out of storage capacity for all the excess oil that is being sold by oil-producing countries. And the FT (print edition) tells us that oil tanker rates continue to fall.

According to the WSJ, the IEA expects 2009 oil consumption to drop by 3 % compared to last year. And Bomlat has a table on US oil consumption, which shows a massive Feb 2009 drop of 13 % as compared to two years ago.

So why is the price up so sharply?

It seems that the market is interpreting vaguely positive economic data from the US (or should I say "somewhat less negative economic data"?) as an indication that the world economy is recovering, and oil demand will begin to increase.

I'm not sure what to think. If demand starts to increase, I'm convinced that oil will go up very substantially, and quite quickly. But I'm not exactly sure where demand will go in the short run.

(This is an update on this post.)

Oil - Update

...and sold.

It always seems to turn out this way: Whenever I invest in oil "for the long run", the oil price shoots up and the forward curve steepens, and I end up selling again a few days later, because I can't help but think: "This is too much, too soon!" Not really the intention, but if it earns me a short-term return of 7 %, I can't exactly complain.

(This is a follow-up on this post.)

Peak Oil Revisited

On Thursday, I invested in oil again.

Not really sure myself why I did so exactly now:

None of the fundamentals have changed since I last sold a month ago. Prices are a little lower (in €-terms), and the forward curve is a little less steep. But there's still huge oversupply and no indication of demand picking up in the short run.

However, any meaningful recovery of the world economy, whenever it happens, is bound to let the oil-price explode. Supply simply cannot go far beyond 2008 production levels. Right now, world oil demand is probably 5 % or so below its 2008 peak due to the severe production drop in most energy-intensive industries. But I don't think the world economy will keep falling off a cliff. Rather, I believe it will start stabilising soon and then return to moderate growth, particularly in emerging markets. And this will mean that oil demand also stabilises and then starts to increase a bit. Once that happens, supply constraints aren't far away.

It might already happen next year. Or it might happen a bit later. But unless the world will be stuck in a really bad depression, it won't take more than 2-3 years, IMHO.

Oil - Update

This seems to be turning into a habit: For the second time now, I bought oil futures with the intention of holding them for the longer run. Then oil rallied over the next few days, and on impulse, I sold them again.

Not exactly very helpful for the purpose of long-term hedging. But somehow, I have the feeling that it's too early for a sustained rally in the oil price, so when the price goes up 10 % in just a few days, I'd rather take my profits and wait for the price to dip again. Though of course there is the possibility that it will not dip, and the rally will continue. In which case I won't be hedged the way I wanted to be...

The reason for the latest rally seems to be mild optimism about the state of the world economy. I'm not sure this is sustainable:

- For all we know, the world economy will continue to shrink in coming months. Probably only a bit, as compared to the severe contraction over the last half year. But it's rather unlikely that we will see significant output growth anytime soon.

- To some extent, oil consumption lags the real economic cycle: Unemployment will continue to rise sharply just about everywhere during the rest of this year. People without a job don't need to commute to work. They don't go on business trips. And unless they are wealthy ex investment bankers, they are less likely to fly off for expensive long-distance vacations.

- There's a deepening sense of gloom in Russia, where domestic oil consumption is likely to go down sharply, and the government will be happy eager to sell as much oil as it can abroad to raise money.

Oil Price

I used to be a firm believer in an ever-increasing oil price not too long ago, based on the rather unambiguous data concerning availability of supply. However, I did not expect the sharp reduction in demand that has unfolded since last fall.

Now I don't know what to think:

If/when the world economy starts growing again, demand will soon bump into a hard supply constraint. From what I understand, the marginal cost of bringing new supply on line is higher than the current oil price, and in addition, the amount of new supply that can be brought on line without needing too much time and effort is limited. As existing wells decline, total potential supply will stay at best stable, it might even start declining.

However, demand may continue to contract or at best stay stable for quite a while, depending on how the crisis works out. In particular, if worldwide unemployment goes up sharply, the need to commute to work (one of the main reasons for using a private car) will decrease noticeably. There are signs that the US is finally weaning itself off the worst aspects of its petroleum-addiction: Gas guzzling monster-cars no longer sell, and outlying suburbs are suffering worst in the real estate disaster. And there's lots of excess oil being stored in all available ships and storage facilities, just waiting for a time of higher demand and higher prices (and China has apparently also used the low prices to sharply increase its strategic oil reserves).

On the other hand, China, India, Southeast Asia and the Middle East will inevitably see growing demand for oil. Maybe not so much this year and next, but thereafter, demand will grow again, even if developed countries' economies stay sluggish.

So this is what I predict:

In the short-term, there is excess supply, and the oil price will depend mostly on the behavior of oil-producing countries (to what extend can OPEC succeed in bringing production down?), and I won't even try to predict their politics.

But in the mid- to longer-run, supply-constraints will become binding again, and then the oil price will go up very sharply (if it triples from today's level, it will only be back to last summer's highs in US$ terms).

So I have gone ahead and once more invested a few thousand Euros into oil futures, in spite of the rising forward curve (to break even on the rolling futures contracts based on the current curve, oil will have to rise at least 20 % this year, and another 10-15 % next year, i.e. a flat oil price implies significant losses).

I think of it not so much as speculation, but as an inflation hedge.

Oil - Update

It was intended as a long-term bet, but after seeing the oil price rise dramatically during the last 4 days, I sold my oil certificates again. Not the original intention, but a very nice profit nonetheless.

Oil Price

So today, I finally put my money where my mouth is, and invested 6,000 Euros in an oil futures certificate. The only thing I don't particularly like about it is the Goldman Sachs counterparty risk (would have been willing to invest a much larger sum in a world without counterparty-risk...).