Why Oil Prices aren’t higher

Apparently recently petrol prices in New Zealand were at their highest levels in about 14 months, until a 3c a litre cut in the price. However, prices are still about 50 cents a litre short of their mid 2008 peak. As I have outlined in the past, in my opinion (which is backed up by a reasonable amount of research) the price spike that we saw in 2008 was largely the result of oil supply hitting a peak in around 2005/2006, but demand continuing to grow between then and 2008. Once we had demand reach the maximum level of supply, we saw prices go up dramatically as there was no way for supply to be increased to a level that could bring them down. Of course, this process was exaggerated by the crazy oil investor situation we saw during 2008, and a weakening US dollar.

And then the recession hit. There’s a fairly good argument that the extremely high oil prices of mid 2008 had a big role in causing the recession, but that’s not really my focus here. Basically the global worldwide recession led to a massive amount of “demand destruction”, where reduced economic activity led to much lower demand for oil – which jumped back to below the level that could be supplied. Therefore prices plummeted, which once again was exaggerated by the very same investors who had gone nuts in the opposite direction just a few months earlier. So we saw the huge drop shown clearly in the graph below: Since a low of around $US 35 a barrel in early 2009 we have seen prices slowly increase – I think to around $US 70-odd a barrel at the moment. This is largely a reflection of the global economy’s recovery over the past few months.

I was thinking a couple of weeks or so ago how I was surprised that prices hadn’t increased by more. Prices were back at around $US70 a barrel in the middle of last year, and certainly the global economic outlook had improved a lot since then, so it seemed strange that we hadn’t seen things skyrocket back more. Perhaps I had been a bit premature in thinking that peak oil has already been reached? However, when looking closer into the data of demand and supply, some interesting information emerges that explains exactly why prices haven’t increased dramatically yet, but also shows that potentially we’re heading back towards that crunch point that was reached in the early part of 2008.

If we look at supply levels first, we can see that there have been some fairly significant fluctuations over the past few years, but in general it would appear as though the production of “liquids”, particularly crude oil, has not really had a general trend of increasing throughout the 2004-2009 period. So it wouldn’t appear that prices are lower than they were in mid 2008 because we’ve found more oil. In fact, it would seem the opposite is true – that the world is producing less oil now than it was 18 months ago. It’s also fairly interesting to note that the production of crude oil between 2005 and 2008 didn’t increase very much EVEN THOUGH prices skyrocketed during that period. You would think that if there was any potential for the oil-producing nations to “pump more”, then being able to sell it for $100+ a barrel would have been a great incentive to do so. But production didn’t increase during that period. Perhaps because it couldn’t?

So if supply graphs don’t tell us much about what’s happened over the past year or two, how about demand rates? Will they provide more useful data? Well I think that it does. The graphs below show oil demand across the OECD, for North America and for the European Union. The red lines I have added in to show September/October 2008 when the global financial crisis really began. The first thing to notice from these graphs is pretty obvious – that demand decreased fairly dramatically as a result of the global recession. This led to a reduction in prices, as more supply and less demand inevitably does. However, perhaps the most interesting thing to note is that even though it’s not pretty obvious the world is emerging from its recession, demand for oil has not really picked up particularly much – and is certainly still well below its 2005-2008 levels – particularly in North America. I think this lack of recovery in demand has a big role to play in prices remaining at fairly sane levels.

So the next question that comes to mind for me at least is “how long is this going to last?” To be honest I wouldn’t have a clue about how long it might take the economies of USA and Europe to ‘properly’ recover, and I think it’s unlikely that demand from those parts of the world will increase back to 2005-2008 levels until such a time as their economies have recovered the lost ground of the past year or so. However, there is another graph that makes for very interesting reading, and is certainly a big insight into the future for oil prices:In particular the rate of increase of oil consumption in China over the past few months is quite staggering. I’m sure some of that is seasonal variation, and November 2009 tailed off a bit, but it would certainly seem as though China has shrugged off the recession and is demanding as much oil as ever to run its factories and fuel its cars. Given that oil consumption in China is now nearly 50% of that in the USA – and rising rapidly – it might not be that long before China pushes worldwide oil demand back up to a level that can’t easily be matched by supply. It is then, and probably not before then, that we will see oil prices skyrocket once more.

It is only a matter of time though. How well prepared is Auckland for $3 a litre petrol I wonder?

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