The Economics of Oil -- I just don't get it

I believe everyone should be informed and not allow "other people" [including experts, reports, politicians, economists, etc] tell us something without checking it out ourselves. The current situation with Crude Oil is no different. So, while I was reading this story [Can Saudi Arabia Push Down the Price of Oil] in Seeking Alpha, they mentioned this article in USA Today [Oil: Tight Supply + High Demand = Higher Prices]. There are some interesting charts and graphs to illustrate their point(s). Their source for the numbers is the Energy Information Administration website.

Demand Side:

So, I went to the source and started downloading "data" and create a quick-n-dirty spreadsheet. You know what's interesting - DEMAND for crude oil is growing (but not as dramatic as you would think from all the press), but has been slowing since 2004. Basically, from a macro perspective, worldwide consumption has increased, but only about 1.7% per year.

And all those people that keep talking about the US being "bad" - our consumption has remained flat during the period of reporting -- 2003 to 2007. How about those growing economies - China and India? China's numbers are available [but not India] and it appears that over the same period, their consumption has not kept pace with their economic expansion - and has averaged only 7% increase -- but if you look at the growth from 2006 to 2007, it is only 5%. And it would take over 20 years for China to match the consumption of the US [assuming the US consumption does not decrease].

Supply Side:

Now, lets think about the supply side of the equation. First of all, in the world of oil, the supplier [producer] has the advantage. OPEC controls how much they produce. They can artificially lower the supply [by producing less]. Which in turn will cause an increase in price [because demand is not as elastic as supply].

But, to the credit of OPEC, they have remained fairly consistent with their production. They have remained on a pace that is not unexpected -- they lag behind demand, but not dramatically or outside of historical boundaries.

From a monetary standpoint, producers have absolutely no reason to want the price to go down. In a world of decreasing demand [or fairly flat demand], their only benefit is to keep the price high, while producing less. Lets take a very simple example of this affect:

Year 1Year 2Year 3Year 4Year 5
Demand for Oil [decrease] 100.00 99.00 98.01 97.03 96.06
Price for Oil [increase] $100.00 $104.00 $108.16 $112.49 $116.99
Total Oil Market $10,000 $10,296 $10,601 $10,915 $11,238

The decrease in demand is 1% and the increase in price is 4% [matching our current inflation rate]. What you will notice is - less demand should provide an opposite affect on the prices -- the price should go down. But OPEC controls production and can in affect, control the market price. They can slow their production much more dramatically than we can slow our consumption. The total market value expanded a little over 12% while the total consumption decreased 4%.

So why the high price for crude oil?

Because we are not talking about that stinky, gooey, black crude oil that gets pumped out of the ground. The price is really about a piece of paper [now electronic data bits] that people "own". Crude Oil is a financial instrument - an investment and as such, the price is controlled by speculators, no producers. Producers benefit from the "commodity" price, because then they know how much to sell their "wet barrels" for on the open market. But it's the paper barrels that create the price, not the other way around.

Here's the round robin affect....

- Speculators create the price
- Producers sell to that price
- Speculators create their price models on production numbers provided by Producers [and other factors]
- Producers limit or increase their production based upon price

So when consumers start screaming to their politicians about all this -- Speculators say the "market" creates the price, Producers say Speculators are making the market "run up" - and in the end, it's the end consumer that buys bigger palaces, gold-plated cars, Harvard educations, private jets, and all the goodies for both the speculators and the producers.

Here's my take...

1) OPEC is actually being very nice to us [the consumer], they are matching fairly well our consumption.
2) Financial Speculators are just doing what they do -- putting money where it can make more money. Crude Oil is just one place, when it tanks, they'll take their money someplace else.
3) It is up to the consumer to decide what to do. If you want to pay more for gas [and the thousands of other products that have 'oil' as a component], then continue to consume more and more each day. If you don't, then figure out ways to consume less. It's not that different from losing weight. The only proven way is eat less, exercise more and be patient.


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