Middle East Economic Survey
VOL. LI
No 30
OIL PRICES
The Real Oil Price Story
By William R Edwards
The following article was written for MEES by Mr Edwards, who is President of Edwards Energy Consultants, Katy, Texas (wre@texven.com).
It is truly amazing how people are able to accept, without question, ideas that ‘sound right’ and that are ubiquitously repeated. One such idea, prevalent in the petroleum world, is that price is an indicator of the supply/demand balance. Thus the explanation for a rise in price is limited to either an increase in demand or a deficit in supply, or both. It seems unnecessary to examine the data. The world ‘just knows’ that the price doesn’t lie.
If one is so impertinent as to take a look at the actual data, the situation gets very confusing very rapidly. Historical data do not present a correlation between price and any of the fundamental factors of supply, demand or inventory levels. For example, for the year 2007, the most recent on which we have worldwide data, demand for oil grew 1.1% over 2006, a normal year’s growth, but the price of West Texas Intermediate grew more than 70%, starting at $56/B and rising to $96/B. Ten years earlier demand grew a whopping 2.9% between 1996 and 1997 and prices fell 40%, from $26/B to $18/B during 1997. Spare producing capacity was 2-3% in both 1997 and 2007. Any objective analyst would immediately discard the proposition that either demand growth or spare producing capacity determines prices.
OPEC tried for decades to control the price of crude by adopting production quotas. The thinking behind this approach ‘sounded right’. If there were just enough supply, then, magically, the price would be just where it was supposed to be. When the price never performed as expected, the blame was put on ‘cheating members’. Had anyone taken the time and effort to examine price behavior in a logical manner it would have been apparent that there is no instantaneous cause and effect relationship between the quantity of oil loaded on ships on a given day and crude futures prices on that day. To suppose that such a connection exists is preposterous.
The only conclusion that legitimately can be drawn regarding the price-setting mechanism is that oil prices in today’s world are simply the transliteration of NYMEX futures prices. Oil prices and futures prices can reasonably exhibit the same number, but a critical distinction is whether the price of oil sets the futures price or, alternatively, the price of futures sets the oil price. The evidence proves that futures prices determine oil prices.
As proof that futures prices, not fundamental supply/demand factors, set oil prices, we need only to observe a recent day of oil futures trading where the price of WTI futures changed more than $10/B in a single day, and reversed the move a few days later. A rational mind can, by inspection, determine that neither the oil supply nor the oil demand experienced a step-change function from one day to the next. Actually, nothing of significance occurred in the world of real oil. Apparently, however, something of significance changed in the speculative world that day and the real world of oil immediately adopted the new price.
Although there are still many proponents who cling to the idea that oil prices are determined by supply/demand fundamentals, there is no logical basis for that stance. Note the presentations made during the Jiddah meeting by the energy chiefs of the US and the UK. It is interesting that, directionally, the consuming nations hold fast to the idea that the world needs more production to force down prices while the producing countries insist that they are producing all they can sell. The producers happen to be correct. It is something other than the supply situation that is responsible for the uncontrolled prices. However OPEC has not yet defined, even for itself, what is the price controlling mechanism. Thus OPEC preaches “stability” without providing even a hint of how it might introduce stability into the oil price arena.
It is possible for oil prices to be both stable and at a pre-determined level. But for this to occur the proper control mechanism must be applied. Until the OPEC producers actually grasp an understanding of the mechanism by which oil prices are formed, the world will be forced to endure the economic instability associated with the wild and illogical swings of prices set by futures trading. And the unenlightened analysts and reporters will continue to attempt to explain the unexplainable.