Arnold Kling  

My Model of the Oil Market

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Oil, Inventories, and Bubbles... The Under-Principled Life...

My model of the oil market does not predict a relationship between speculation and inventories. Paul Krugman must have a different model in mind. My guess is that it is a reasonable model, and that he will explain it at some point, perhaps on his blog.

Meanwhile, here is my model.

Think of there being two prices for oil; the forward price, say, for delivery one year from now; and the spot price, for delivery today.

The forward price reflects the market's view of long-term fundamentals in oil production and oil demand. Relative to that, and to other factors such as the interest rate, there is a normal inventory of oil along with a normal spread of the forward price over the spot price. The spot price is bid up to the point where refineries are just willing to hold the normal inventory. If the spot price is unusually low relative the forward price, then they hold above-normal inventories until spot prices rise. If the spot price is unusually high relative to the forward price, then refineries try to unload their inventories while they can get a good price.

In that model, I don't see how the level of inventories relates to the level of prices at all. I only see how it relates to the discrepancy between the spot price and its normal relationship to the forward price.

I assume Krugman has a different model. As to his larger question of whether the price of oil represents a bubble, my behavior shows that I agree with him that it is not. I would not dream of buying put options on oil futures, which says that I do not think that oil is clearly overpriced. However, I do not look at inventory levels as an indicator of whether or not forward prices are a good predictor of spot prices.

Suppose that the forward price of oil were ridiculously high relative to long-term fundamentals. In that case, I would expect refiners to bid the spot price up to ridiculously high levels also, while holding a normal level of inventories.

UPDATE: The first comment leads me to dredge up this old post on how oil companies should be using futures prices.


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COMMENTS (10 to date)
kebko writes:

Here's an article that suggests Exxon's investment decisions imply that they are pricing oil in the long term at $30-$50. Sorry, the point is not linked to references in the article.

http://articles.moneycentral.msn.com/Investing/JubaksJournal/IsExxonMobilsFutureRunningDry.aspx?page=2

Arnold Kling writes:

Kebko,
I saw something like that years ago, and I was livid. It makes me angry that Exxon would not put its money where its mouth is and short the oil futures market. They should drill for oil based on the market price and place their bets in the futures market, not the other way around. I wrote this on my blog when I first saw an article like that.

kebko writes:

Are there rules, regulations, or natural limits to the size of positions they can take in the futures market that would make that approach hard for them?

Lord writes:

I wonder if the way things work isn't that low inventories and price volatility go together and would signal the need for increased storage to moderate fluctuations. 'Speculation' would be an uncertainty of supply premium. Increased storage would allow a reduction in this uncertainty but only for an end user. A distributor on the other hand wants to pass through all costs and maximize profits by reducing inventory. It does seem they would be missing the profits of selling their inventory capacity to others that could use it though.

manuelg writes:

> It makes me angry that Exxon would not put its money where its mouth is and short the oil futures market.

Exxon plays "the oil futures market" by leaving oil in the ground in owns, or not. It can do so without a added transaction fee.

Since we are not oil companies, this option is available to us. We must use the public oil futures market, and pay the applicable transaction fee.

I fail to see what is dishonorable or unethical by Exxon's behavior, assuming "pricing oil in the long term at $30-$50" is an accurate characterization.

Les writes:

Writers seem to lack knowledge of the oil market. It is far from competitive. Two important facts are:

a) OPEC owns 80% of proven reserves of oil, but supplies only about 20% of world supply. Clearly they restrict supply to keep prices high.

b) 90% of world oil supplies are owned by governments, and only 10% by private sector corporations. So corporations are a minor factor in oil pricing. They tend to be high cost producers, and gladly shelter under the high price OPEC umbrella.

JR writes:

How much oil is traded under long term commitments-to-supply and long term fixed-price contracts?

Why are refiners like Valero getting squeezed while producer/refiners like Exxon are still making great profits?

reason writes:

Arnold,
your model makes no sense to me. How do you think the spot market works again? If production is high and refiners don't won't to increase their inventories, where does the (already extracted) oil go to exactly? You seem to be assuming that the demand side controls the market and the supply side is totally passive. If refineries don't want to hold stocks, then surely the suppliers have to.

Khaleed writes:

Writers seem to lack knowledge of the oil market. It is far from competitive. Two important facts are:

a) OPEC owns 80% of proven reserves of oil, but supplies only about 20% of world supply. Clearly they restrict supply to keep prices high.

b) 90% of world oil supplies are owned by governments, and only 10% by private sector corporations. So corporations are a minor factor in oil pricing. They tend to be high cost producers, and gladly shelter under the high price OPEC umbrella.

****STATISTICS IS LIKE A BIKINI WHAT IT REVEALS IS SUGGESTIVE BUT WHAT IT CONCEALS IS VITAL******

aaron writes:

Beyond storing oil, what about storing fuel?

Kevin Drum recently posted that driving and fuel production are down with gas prices being up.

I responded that driving is down several time more and fuel production (and noted that economic growth is down along with production and driving).

His reply was not satisfactory to me. He claimed that fuel consumption may be less than production (inventories increasing) and that people may be cutting long efficient trips more than others. While both of these are plausible, they are far from adequate. First, I found it hard to believe that several percent of fuel production is going into reserves. Second, I find it even harder to believe that most of the driving we cut is long, efficient trips and that the difference in efficiency between these and normal driving is great enough to make such a big difference.

[Even if consumption were down 3% (production is down .7% according to Kevin), that would mean that all the trips we cut would have to be 60% more efficient than our compulsory driving to achieve the 5% decline in driving that Kevin notes.]

Is it possible people are hording large quantities of fuel, not oil?

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