December 8,  2004

A year ago, most oil experts thought oil prices would average less than $30 per barrel in 2004.  In fact, OPEC actually curtailed production early in the year to absorb what they thought would be an oil surplus. 

No surplus ever materialized. 

Of course, the supply disruptions in Iraq, Nigeria, Norway, and even the hurricane impacted Gulf of Mexico caused much of the miscalculation. 

Another error was in the assumptions of world demand for oil.  China alone raised its oil consumption by a million barrels a day.  U.S. economic growth at nearly 4.4 percent required another half million barrels.  When other Asian needs, South American growth, and even the mild increases in Europe are included, oil consumption jumped nearly 3 million barrels a day while supply disruptions removed 3 million barrels per day from availability. 

What has not been fully understood, however, is the shift in inventories needed to supply the world with petroleum.  The tanker runs are several days longer to Asia than the rest of the world, Indonesia’s excess petroleum supply notwithstanding. 

Nevertheless, through much of the year, the experts continued wondering why so much oil was being consumed.  China’s industrial mix is petroleum intensive, but that is not true of much of the world.  Computer programming, electronic games, and other electronics really do not consume the same amount of energy per dollar of value as China needs for its development. 

The latest oil inventory report suggests another reason for the miscalculation.  Consumers have been building their own inventory of oil. 

They do not have storage tanks in their backyard.  Instead, they have been filling their tank whenever they see “good” gasoline prices.  In the Northeast, they apparently also were buying heating fuel early. 

Just imagine if all the 220 million registered vehicles in the United States filled up at half empty rather than nearly empty.  The result would be every vehicle, on average, carrying another 4 gallons in their car. 

Assume further that the vehicle fleet has shifted to SUVs, with tanks holding 4 more gallons on average than the passenger car.  Of course, homeowners who rush to fill their heating fuel tanks at the first blush of cold air could have the same impact upon heating fuel. 

Of course, you should ask why people would want more inventory of gasoline and heating fuel when prices are rising.  Doesn’t this violate the most basic assumption in price theory: rising prices curtail quantities demanded in almost all conceivable market conditions?

I once pondered this question for sometime before coming to the appropriate answer.  If rising prices increase price expectations faster than prevailing prices are changing, then the current price is actually falling relative to the unkown, but expected, future price.  Compared to all other goods, people would want less oil.  However, compared to oil tomorrow (the fastest rising price), they would want more oil today. 

By the way, this behavior can be observed for much more than oil.  We could talk about beach houses or mountain retreats and come to similar results.  Indeed, stock prices and prices of other assets also behave in this manner. 

What this means is that markets with inventories tend to overshoot their equilibrium values.  Indeed, if many markets are overshooting at the same time, conditions for curtailing production leading to recession develop. 

However, the oil market has a special wrinkle.  Producers will store their inventory in the ground (not produce at capacity) if they believe future prices are rising faster than current prices. 

I had a student who demonstrated that these production choices depended upon what producers could earn on investments relative to what they could gain by not producing today.  In most cases, producers will be slow to raise production if rising prices lead to higher expected prices.  In short, they restrict supply just as consumers, using the same feelings, are expanding purchases for storage.

After a month of mild weather and declining visible inventories, the heating tanks are all full.  Therefore, continued mild weather is pushing up inventories.  Not only are prices plunging but so are the expectations of future prices.  The oil surpluses that never materialized in 2004 are now increasingly likely in 2005.  (OK!  I think oil prices will average $35 per barrel next year.)



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