Oleksandr

Drop in Oil Prices in 2008

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Has anybody been following on the recent and very significant drop in oil dollar-price?

The drop is pretty darn significant. In just 3-4 months, the price went down by almost a dollar.

What is the cause? (I've done some small research but haven't found anything significant to explain this.)

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I'm sure there are other major factors, but since then, the dollar has strengthened significantly relative to other major currencies; there has been a tremendous glut of oil on the market since we got through the last major hurricane; major economies around the world are suffering, leading to a decrease in demand for gasoline, jet fuel, and other major petroleum products; and since we had $4.50 gas this summer, people in America are driving a little less as a change in habit. OPEC, controlling about a third of the world's oil production, is meeting on the 17th to arrange for a major cut in output, so expect prices to move up fairly soon. I would think that the lousy economy and lousy demand will mitigate that, though.

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The downturn in the economy means less demand for oil. If this graph works, you'll see that "USO" (which is somewhat of a proxy for the price of oil) turned down somewhere in the middle of this year (2008), as people began to realize that the downturn was really here. It appears likely to stay down, as long as the U.S. economy is in the doldrums.

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I would argue that for as long as the US has not had its own price controls on gasoline and oil, OPEC has had little to no effect on the price of oil. Notice that they have, in hastily arranged "emergency meetings," been making drastic production cuts for months now yet the price of oil has fallen dramatically along with other commodities. The reason that I so far agree with is that stockpiles of oil are, since recovering from the hurricanes this past year, continuing to grow because of a steep worldwide drop in demand.

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I doubt OPEC has made drastic production cuts. Any cuts are likely to have been less than 10% of previous numbers. When OPEC members all meet, they talk the talk; but, none of them trusts the other, and they all "cheat" under the mostly justified assumption that everyone else does. If you think about it from the perspective of any one country, they find themselves in quite a soup. After selling oil for $100 and more, they now face a $50 price. That hurts; and, cutting production hurts still more.

BTW, Crude for delivery about 10 years from now is still about $80/barrel. So, the market's expectations seem to be that demand for the next year or two has fallen drastically; however, the expectation also appears to be that demand will return in a year or so, not as high as recent extrapolations, but quite "respectable" by historical standards.

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BTW, Crude for delivery about 10 years from now is still about $80/barrel. So, the market's expectations seem to be that demand for the next year or two has fallen drastically; however, the expectation also appears to be that demand will return in a year or so, not as high as recent extrapolations, but quite "respectable" by historical standards.

Either that, or they are expecting that the value of the dollar will fall.

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Some part of it is tied to inflation. However, if we compare the oil market against a commodity that is less correlated to production (e.g. gold) we can see that the future in oil is a significantly higher factor. Gold in 2013 is about 10% higher than today, while 2013 oil is about 50% higher than today. Currently, the bulk of the "premium" in future oil compared to current oil is related to current low demand.

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The downturn in the economy means less demand for oil.
Perhaps the demand is somewhat less now, but I doubt that it could have fallen as drastically as the price did. People still need to use more or less the same amount of oil to heat their homes and drive more or less the same distance to work, and we still have more or less the same number of flights flown by airlines, and so on. The economy did contract a little in the last two quarters, but we're talking about a couple of percentage points at most, putting the GDP back to around where it was last year. So while demand could be a factor to some extent, I don't think it's the primary factor or even a major one.

The two more important factors, in my opinion, are 1., the growth in the supply of oil, resulting from both the investments into production that the high price must have encouraged many oil companies to make, and also the expiration of the offshore drilling ban in September--and 2., the slowing growth in the U.S. money supply, which has caused a general decline in the dollar prices of commodities.

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$80/barrel for delivery in ten years doesn't say as much about a higher price of oil ten years from now. This is because of the time value of money. Part of that $80 price is basically "rent" for using capital today to buy oil that the purchaser won't use until 10 years from now. Just think if there was no financial market and one had to buy oil and store it. Well, one would have to pay for storage space, security... everything that is required to physically store a barrel of oil. With a financial market as we have in the US we no longer have to store the oil we don't want until 10 years from now; we just pay speculators, who are willing to take the risk of price changes, today's price plus a premium for "storing" the oil for us.

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$80/barrel for delivery in ten years doesn't say as much about a higher price of oil ten years from now. This is because of the time value of money. ... Well, one would have to pay for storage space, security... everything that is required to physically store a barrel of oil.
All true. Therefore, from the spread between the current price of oil and the future price we can compute an "implied" value for the time-value of money [plus storage costs which are very significant for short durations, but minimal for long durations].

While the ratio of the future price to current price reflects the time-value of money, there is a problem in assuming that it reflects only the time-value of money. If the time-value of money is the the primary component of that ratio, then one would expect to see approximately similar time-values show themselves across various commodities. As mentioned above, this is not so if we consider gold. It is also different from the ratios being seen with some other commodities today.

The fall in the price of oil reflects mostly the same factors that have caused the stock market to turn down so sharply. The world was humming along extrapolating large growth rates for countries all over the globe. The demand for oil-futures is the result of the estimates of future demand for oil, and the estimates of future inflation. The estimates for world growth fell off, causing stock markets to tumble all over the world, and the oil market with it (as illustrated by the graph linked above). The market estimates for inflation going out 5/10 years is also down from what they were before the downturn. In other words, estimates for both real and nominal demand have been scaled back.

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$80/barrel for delivery in ten years doesn't say as much about a higher price of oil ten years from now. This is because of the time value of money. ... Well, one would have to pay for storage space, security... everything that is required to physically store a barrel of oil.
All true. Therefore, from the spread between the current price of oil and the future price we can compute an "implied" value for the time-value of money [plus storage costs which are very significant for short durations, but minimal for long durations].

While the ratio of the future price to current price reflects the time-value of money, there is a problem in assuming that it reflects only the time-value of money. If the time-value of money is the the primary component of that ratio, then one would expect to see approximately similar time-values show themselves across various commodities. As mentioned above, this is not so if we consider gold. It is also different from the ratios being seen with some other commodities today.

The fall in the price of oil reflects mostly the same factors that have caused the stock market to turn down so sharply. The world was humming along extrapolating large growth rates for countries all over the globe. The demand for oil-futures is the result of the estimates of future demand for oil, and the estimates of future inflation. The estimates for world growth fell off, causing stock markets to tumble all over the world, and the oil market with it (as illustrated by the graph linked above). The market estimates for inflation going out 5/10 years is also down from what they were before the downturn. In other words, estimates for both real and nominal demand have been scaled back.

The question you asked is very interesting and it should be answered. The answers from all quarters (in this thread and by modern liberal and conservative journalists) is to catalog all of the forces that could possibly drive the price of oil down and then conclude that one has explained it.

But that doesn't.

The reason why oil prices dropped in the second half of 2007 is that the forces that drove the spectacular price rise in the first half of 2007 left the stage:

1. Vast sums of capital loosely invested in commodities based on enthusiasm and momentum-buying -- vast sums of capital that were created by Greenspan/Bernanke easy money policies of the '00s. (Check out Yaron Brook's comments on this topic. He's right on the money.)

2. Demand rising to within approx. 5% of the engineering limits of the world's oil pumping capacity -- in a world in which most of the oil pumping capacity is controlled by criminal regimes, at least one of whom (Iran) repeatedly threatened to start a war by "militarily" disrupting the oil shipments of all of its neighbors.

In the 2003 - 2006 time frame, speculative investors jumped from a real estate market that had been driven to reach high temporary gains through momentum buying to the stock markets in order to get better returns. But, in making the jump, they created temporary momentum-driven gains in the stock markets. By the beginning of 2007, these temporary gains in the stock marked had played out (i.e., the supply of greater fools -- like me -- had dried up). So, in search of double didget annual appreciation rates, speculative investors jumped into commodities and into credit default swaps.

But commodities and credit default swaps are a pure zero-sum game. The trillions that these speculative investors threw into these markets pushed prices up by pure momentum. In 2008, in less than six months these investors created trillions in unreal self-referential "wealth" on paper by force of the masses of their own enthusiastically pledged captial.

A good indication of this was the fact that the price of oil did not go up all by itself. Oil and copper and beef and chromium and corn and just about every other publically traded commodity doubled in just a few months. And the non-publically-traded commodities? Well, the prices for steel and concrete and many other mundane commodities took a giant leap upwards, too.

What is it that we call a general rise in prices?

Inflation.

These prices rises indicated that there was too much paper money out there. The dramatic fall of the dollar against other national currencies over the period 2003 - 2007 proved that the primary driver of this world-wide inflation in commodities prices was inside the United States.

Implicitly government-backed mortgage lending -- mortgages purchased or that had the potential to be purchased by Fannie Mae and Freddy Mac -- and their securitization and use in the general global credit markets (a practice also led by or backed by Fannie Mae and Freddy Mac) led to the inflationary production of debt in the private capital markets. And the Fed under Greenspan and Bernanke happily accommodated this inflationary spiral with low federal funds rates for bank reserves and by pilig on their own increases in the money supply through the purchase by their Open Market Committee

Some of the most dramatic, inflation-driven prices rises in commodities occured with oil. But the most dramatic was copper. While the whole culture was abuzz with concerns about "Peak Oil," there was also talk of "Peak Copper."

As it turns out, the world will not see peak oil for at least 15 more years (and that is likely to happen so soon only because of the incompetence and malfeasance of state-controlled and state-operated oil companies that possess three-quarters of the earth's proven reserves). But the fact of the matter was that in the summers of 2007 and 2008, world oil consumption reached 82 - 84 million bbl/day at a time when oil analysts believed that peak oil production capacity was only about 87 - 90 million bbl/day.

This approx. 90-95% capacity utization rate in a world in which most production was in incompetent or malevolent hands raised rational financial concerns over where oil prices might go in the future. And the threat of war over free passage of oil shipments throught the Strait of Hormuz added a rationally-calculated $5 - 10/bbl premium to the price.

The engineering limits and political concerns -- something that I informally dubbed "Geopolitical Peak Oil" -- caused oil prices to rise at rates slightly above those of other commodities that were, themselves, climbing upwards at hyper-inflationary rate driven by too much paper money created by the glut of (implicitly) government-backed mortgages and mortgage-backed securities.

THAT paragraph, I'll admit, was quite a mouthful...but it sums up the explosive rise in oil prices from the winter of 2007 - 2008 to the summer of 2008.

The collapse of world credit markets led to a sudden $15 trillion shrinkage of world-wide credit (and the paper money that government-backed credit illegitimatly generated). The destruction of all this paper "capital" in the months of September and October erased momentum-buying in oil futures and led to the immediate and total collapse of oil prices.

The general disruption and economic slowdown caused by the collapse of the inflationary credit bubble will, of course, lead to a reduction of world-wide oil consumption...and has decreased the utilization rate of the world's oil pumping facilities to below 90%. This is a secondary effect of the collapse of inflationary credit. After the collapse -- now and for the next year or two* -- weak demand will be the dominant issue for oil prices going forward.

* or three or four or five years...if our government continues to destroy the privately-controlled economy with "experiments" in government ownership.

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What is the cause?

In reading about the crisis, I stumbled upon some essays by an economist of the Austrian school, Antal Fekete, who has a unique analysis. He says it is possible to have inflation and deflation at the same time. There are dollars, and then there are dollars, as in this essay:

http://www.kitco.com/ind/fekete/sep282007.html

Federal Reserve notes (the physical paper money in your wallet) must be collateralized in part by gold, whereas dollars derived from federal reserve deposits (electronic money) are merely collateralized by the borrowing bank's notes. Because creation of FR notes is limited by the fed's ability to come up with real assets (gold, which they can't print), FR notes are scarce, while electronic dollars can be created with the click of a mouse, and are not scarce. The relative scarcity of FR notes makes for a good dollar, bad dollar scenario. The bad dollars (electronic money) inflate, while the good dollars (FR notes) deflate. So the common notion of the fed "running the printing presses" is flawed in its literal sense. Creating paper notes is precisely what they cannot do (without coming up with collateral first); they can create arbitrary amounts of electronic dollars though.

In this essay written in May of this year:

http://www.professorfekete.com/articles/AE...ystemFlawed.pdf

I think he predicted what we are seeing right now and which befuddles the pundits: the continuing deflation of all assets except treasury debt. In the last few months the commentators on CNBC are mystified as to why the fed's added "liquidity" has not reflated commodities, but appears to just flow directly into treasuries. He described the phenomenon as the "black hole of zero interest". It was fascinating for me to read how a debased currency can lead to a hyperdeflation instead of a hyperinflation, a scenario I've not heard anywhere else from anyone.

Elsewhere he says the trend ends in collapse of the international system of payments and the fiat currency, and leaves society denuded of capital. How's that for a bit of Christmas cheer?

Most of his essays are here:

http://www.professorfekete.com/articles.asp

This is all just the tip of the iceberg as far as what could be said his writing. Better for you to read it yourself if interested.

By the way, if you're using the Chrome browser, his page doesn't render correctly. You need to drag/select the links along the right, which makes them more visible.

I'm interested to hear what you all think of Fekete's analysis.

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I couldn't find a source for the claim that the "Agent" will insist on part of the collateral being in gold. From Googling, the sections of law that come up indicate a much wider choice of collateral. Indeed, it appears that whatever paper -- junk or otherwise -- the Fed takes to create accounting entries, is also acceptable to the "Agent" when creating paper notes.

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What is the cause?

In reading about the crisis, I stumbled upon some essays by an economist of the Austrian school, Antal Fekete, who has a unique analysis. He says it is possible to have inflation and deflation at the same time. There are dollars, and then there are dollars...

This is the usual approach from Austrian school. According to them the major damage that a government can do to the economy is always and must be coming from the printing press (real or virtual as in your quoted article). And that is plain false.

Printing money sure causes problems, but my questions was about a drop of price of a concrete product in the market.

Not every single product out there is dropping as oil did in the past few months.

Printing real or virtual money does not answer how come oil is the one that got hit the most.

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I couldn't find a source for the claim that the "Agent" will insist on part of the collateral being in gold.

Oops I did say that didn't I. I meant that part of it is collateralized in gold, not that the agent requires any part of it to be.

From Googling, the sections of law that come up indicate a much wider choice of collateral. Indeed, it appears that whatever paper -- junk or otherwise -- the Fed takes to create accounting entries, is also acceptable to the "Agent" when creating paper notes.

Interesting, thanks. Yes I see that: Title 12, chapter 3, subchapter XII, paragraph 412: "The collateral security thus offered shall be ...[lots of stuff omitted]... or any other asset of a Federal Reserve bank." A bit more searching and I find what they are actually collateralizing notes with:

http://www.federalreserve.gov/releases/h41/

"Gold certificates", "Special drawing rights certificate account" (whatever that is), "U.S. Treasury and agency securities", and "Other assets".

So I guess the "other assets" includes the commercial paper they've recently started accepting in their new role as "lender of first resort."

It was a revelation to me that the fed can't just print notes to their heart's content. There is some discipline imposed via the collateralization requirement. And I think Fekete's more interesting thesis is his "Black hole of zero interest" in the other essay.

I'm just a lay person trying to understand what's going on, so I appreciate the help in understanding this.

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It was a revelation to me that the fed can't just print notes to their heart's content. There is some discipline imposed via the collateralization requirement.
However, what happens if we drop the fiction of the Federal Reserve as being separate from the Federal government. Now, we have this curious situation: Fed (govt) sells bonds; Fed (res) buys those bonds from people. In effect, the Fed can issue bonds and then buy those bonds itself. I've heard it called "monetizing the debt"; more honest to call it the "printing of money". Since the Fed has the power to create its own collateral, there is basically no external discipline except what the voters will allow, and no internal discipline except what the Fed chief and other politicians will impose on themselves.

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The question you asked is very interesting and it should be answered. The answers from all quarters (in this thread and by modern liberal and conservative journalists) is to catalog all of the forces that could possibly drive the price of oil down and then conclude that one has explained it.

But that doesn't.

...

The general disruption and economic slowdown caused by the collapse of the inflationary credit bubble will, of course, lead to a reduction of world-wide oil consumption...and has decreased the utilization rate of the world's oil pumping facilities to below 90%. This is a secondary effect of the collapse of inflationary credit. After the collapse -- now and for the next year or two* -- weak demand will be the dominant issue for oil prices going forward.

* or three or four or five years...if our government continues to destroy the privately-controlled economy with "experiments" in government ownership.

I agree with most if not all of what you say in this post. Thank you for your discription of the matter.

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This is the usual approach from Austrian school. According to them the major damage that a government can do to the economy is always and must be coming from the printing press (real or virtual as in your quoted article). And that is plain false.

If Fekete is right, the regime of irredeemable currency is the cause of a depression into which we are headed, as well as your drop in oil prices. If it does end in the collapse of the international payments system (possibly within the next few years) as he predicts, will you reconsider your contemptuous dismissal of his ideas?

Not every single product out there is dropping as oil did in the past few months.

Nor is oil all that extraordinary among commodities. Copper went from a peak of $4/lb to $1.30/lb, corn from $8/bu to $3.30/bu. I didn't read your question as asking why oil dropped a bit more than other commodities. I thought it was fair to give a reply addressing the general drop in commodities.

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According to [the Austrian school] the major damage that a government can do to the economy is always and must be coming from the printing press (real or virtual as in your quoted article).
I'm not too familiar with the Austrians, but based on the ones I've read, this is not a fair characterization. They are happy to point out the problems caused by wage-controls, unions, environmental regulations, the lack of the enforcement of property rights, government deficits, welfare programs, protectionism, and so on.

I suspect that those who want top blame everything on the government printing press actually trace their intellectual roots to Chicago (monetarists) rather than to Vienna.

Not every single product out there is dropping as oil did in the past few months. Printing real or virtual money does not answer how come oil is the one that got hit the most.
I've not seen data to support this idea, but this is what I've heard some economists say: it is the norm, rather than the exception, that an unprecedented rise in money-supply affects some sectors more than others. Once a certain increase in money becomes the norm, it gets "baked in" to prices across the economy; but, if a lower increase is baked in, and the government starts to inflate, then it affects some goods more than other, for some period.

For instance, an unprecedented increase in money can appear just like a real increase in productivity and wealth. Faced with the new data, an investor might look out at the world and figure that there are enough Chinese workers still waiting to migrate to factories, but that exploiting new sources of natural resources will take years. Therefore, it might be logical to conclude that natural resources will be the area where there will be temporary shortages. So, capital is more effectively deployed there. The new set of evaluations might therefore change the value of natural resources relative to other parts of the chain of production. Then, when the assumptions are shown to have been false, those who rose highest have the most to fall.

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Has anybody been following on the recent and very significant drop in oil dollar-price?

The drop is pretty darn significant. In just 3-4 months, the price went down by almost a dollar.

What is the cause? (I've done some small research but haven't found anything significant to explain this.)

Global Warming

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