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Dallas Fed Analyzes Oil Prospects
Barry Ritholtz posted this analysis by the Dallas Fed of the oil market. It is sophisticated (as you would expect) and hits nearly all the relevant issues other than hoarding, which it fails to adequately consider. They also fail to appreciate the substantial problem of the decline of ageing major fields. Actually, if it were not for decline problems, oil prices might not rise much in the future, so the Fed’s lack of understanding of it may explain their problem.
Below I have reproduced their conclusions. I am at a loss to fully understand their final conclusion, in the last sentence, that oil prices are not likely to stay much above $100 in the future given what they write preceding it.
In the end, we seem to have a branch of the most sophisticated financial institution, perhaps in the world, failing to understand one of the central financial issues of our time, oil supply and demand. It’s rather astounding, and even more so considering that this is the Fed branch that is located in the heart of oil country.
Here is the Fed’s conclusion. You tell me:
Oil Price Prospects
What happens with oil prices will be determined by the same four factors that have shaped the market in recent years—global demand, expectations about future market tightness, the value of the dollar and fear of supply interruptions. If these factors stay on their present course, prices are likely to be pushed higher. If one or more factors change, markets could see some easing of price pressures.
At first blush, crude oil demand doesn’t offer much hope for lower prices. It is likely to grow with an expanding world economy. Higher oil prices will prompt some conservation and take some of the edge off prices—but not much.
The past response of U.S. oil consumption to rising prices suggests the quadrupling of oil prices since 2003 might reduce U.S. consumption by 10 to 20 percent over the next decade. Europe might see similar declines. However, these reductions won’t be sufficient to relieve pressures on prices, given the projected demand growth from China, the Middle East, India and other rapidly expanding economies. Only a dramatic, worldwide move toward energy conservation or a much stronger U.S. and European response to higher oil prices could substantially alter the outlook.
Geopolitical factors affecting supply disruptions aren’t likely to change much, either. The Middle East’s heavy concentration of conventional oil resources suggests the region will become an even more important source of world oil production. Given the region’s historical instability, episodic fears of supply disruptions could remain part of oil pricing well into the future.
The dollar might offer some relief. Forecasting exchange rate movements is fraught with difficulty, but the currency is likely to strengthen with the U.S. economy. An appreciating dollar would lower oil prices for U.S. consumers. Further dollar weakening, however, would lead to higher prices.
Geopolitics and exchange rates aside, long-term oil prices will largely be set by supply and demand, which will affect prices directly and influence the expectations that shape futures markets. The key lies in how much new oil reaches markets. Four scenarios for conventional oil resources show a range of outcomes and impacts for the trajectory of prices:
- Oil production reaches a plateau or peak—prices likely to rise further.
- Oil nationalism continues to slow the development of new resources—prices likely to remain relatively high.
- In a shift of strategy, OPEC increases its output sharply—prices likely to fall.
- Aggressive exploration activities pay off with the quick development of significant new resources—prices likely to fall.
Both the futures markets and EIA forecasts currently anticipate some softening of oil prices over the next few years, suggesting markets expect supplies to gain ground on demand. International Strategy and Investment, an energy consulting business, has documented a substantial number of projects under way that would boost world oil supplies. The development of these resources could undermine the expectations underlying the higher oil price scenarios—even those of oil nationalism.
Supplies could be bolstered by nonconventional oil sources—tar sands, oil shale, coal-to-liquids. Industry experts regard these resources as plentiful, with development and production costs well below current oil prices. Tar sands and oil shale are already in production. Biofuels are too limited in scale and currently too costly to make much difference to crude oil pricing.
The substantial development of these nonconventional oil resources could mean downward pressure on crude oil prices in future years. Actual and expected costs of nonconventional resources suggest it might be difficult to sustain oil prices above $70 a barrel. However, the relatively high costs of these nonconventional oil sources could inhibit development because producers fear losses during a price collapse. The production and use of nonconventional resources would also generate more pollution, which could mean conventional oil could command a premium.
What’s the bottom line? Absent supply disruptions, it will be difficult to sustain oil prices above $100 (in 2008 dollars) over the next 10 years.
Tags: peak oil energy investments
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11 responses so far ↓
1 Lou Grinzo // May 30, 2008 at 5:32 am
I notice the casual reliance by the Dallas Fed, on non-conventional oil reserves. I see this a lot in such discussions, and it strikes me as wishful thinking. Given the energy inputs needed to cook oil out of the ground (natural gas now, with talk about building nuclear plants for this sole purpose), and the environmental cost of the operation overall, I don’t see why anyone would assume that sands production will (or could) ever scale up to a significant portion of world consumption. (Unless you also predict much lower overall oil consumption.)
2 jkingsdale // May 30, 2008 at 8:06 am
Absolutely.
3 paultaut // May 30, 2008 at 10:40 am
PGH, a CanRoy is building a Pilot plant using steam instead of Nat. Gas to extract oil from oil sands, won’t be operational until 2009.
The problem with nuc’s remains unresolved. What happens to the waste from same?
Oil is not in short supply, refiners are. India has just announced they are not satisfied with an 8.8 rise in GDP. They want their economy to ramp up to 12% within the next few years and remain at that level thereafter for an undisclosed number of years.
4 Len Diamond // May 30, 2008 at 11:25 am
Conclusion of Dallas Fed remarks do not follow from prior discission.”Aggresive exploration” - plenty aggressive now,lead times mean no near term impact.No mention of the incredible growth in oil demand in Saudi Arabia.Currently 2.3 million/bd–4.8 by 2020.
5 jkingsdale // May 30, 2008 at 11:40 am
Paul, you raise a point that has puzzled me: is it crude or is it refining capacity that is the supply issue? Logically, it seems that if refining is insufficient, the demand from refiners for crude would diminish and therefore a refining bottleneck would be bearish for the oil price. But when there is news of a refinery going off line, the price of crude generally spikes. That does not mean the market is being reasonable, but it is puzzling.
On the other hand, and more to the point you raise of foreign refinery construction, it will be interesting to see what impact new refineries in India, China, and Saudi Arabia will have. They could increase the demand for crude or they could utilize heavy sour crude now in abundant supply and thereby deminish demand for sweet WTI on which we base the price of crude in the U.S. futures markets.
6 ccrawford // May 30, 2008 at 11:45 am
Jim, I’ve been puzzled by the same thing. Although refiners are really the only customers for crude, a refiner going offline seems to cause oil prices to rise. One would expect prices to decline when demand from refiners falls. Could it be dumb speculators?
7 NewReader // May 30, 2008 at 6:03 pm
Regarding the refinery offlining puzzle: going offline obviously constricts the supply of cracked product which pressures up prices of cracked product.
The point is that this allows remaining refiners to pay more for crude without shrinking their holy crack spread.
Of course this does not exclude the possible role of dumb speculators, because you still need the crude suppliers to restrain supply to the amount the refiners can refine.
8 cwd // May 30, 2008 at 9:24 pm
They also fail to appreciate the substantial problem of the decline of ageing major fields.
This is an amazing statement.
As a boy raised in Texas in the 40s and early 50s, I remember gas being flared and oil being litterly thrown away.
When I questioned this obvious waste, the oldtimers said we would never run out.
There is much ado about the deepwater Brazilian find of 5 billion barrels, but remember this is less than two months of world consumption. The world consumsed over 31 billions barrels last year.
As far as I know consumption is exceeding new reserves. This does not bode well for lower prices.
Oil is a depletable resourse. That the Dallas Fed missed that makes you wonder what these PHDs studied in all those years they spent at school.
Maybe they ought to go East for about 150 miles and look at the East Texas field which at one time was the largest in the world and see what it produces after 75 years.
Remember the great Saudi fields have been producing since the early 50s.
Depletion is a fact of life, even the IRS recognizes this.
9 rbblum // May 31, 2008 at 11:13 am
Only three statements coming out of left field like a magician performing slight of hand antics.
(1) Both the futures markets and EIA forecasts currently anticipate some softening of oil prices over the next few years, suggesting markets expect supplies to gain ground on demand.
(2) Actual and expected costs of nonconventional resources suggest it might be difficult to sustain oil prices above $70 a barrel.
(3) Absent supply disruptions, it will be difficult to sustain oil prices above $100 (in 2008 dollars) over the next 10 years.
Sure would like to ask the author to substantiate these positions . . . until the questions are responded to.
10 GH // Jun 1, 2008 at 6:34 am
PaulTaut,
How is the steam produced? Surely it is not piped from geysers. Natural gas is the cheapest, cleanest way to make water into steam at most oil sand sites. Of course electricity can also be used, but statistically that means you’re burning coal to heat the water.
Jim,
To give an idea of how out of whack the oil market is, I once saw an investment bank’s oil analyst explain that crude price rises in response to refinery outages in expectation of a demand spike when the refinery comes back online. (Yes, of course that forgets the fact that it’s a zero-sum game and thus price should drop first and then spike). I think NewReader has a better take on it.
If someone wants to investigate this counter-intuitive price behavior further, it’s probably worth looking into what kind of refinery it is, ie. whether it can process sour crude.
RBBlum,
I came up with the exact same list. To me the Dallas Fed’s article read like a rehash of the dis-information that has been flowing out of Big Oil for decades: state lots of facts, mix them with dubious extrapolations, and then state conclusions not derivable from the presented basis.
In my humble opinion what Jim calls the “Rapid Transition” has opened a window wherein control of oil equates to control of the world economy. What we are seeing is a battle for membership in a small group with enormous power. Given that perspective, none of what we’re seeing is surprising, particularly resource nationalism.
11 Gary Wyatt // Jun 1, 2008 at 11:28 pm
As to why crude prices rise with refined product prices when there is an unexpected loss of refining capacity. I think there are basically two factors at play:
1. Obviously it is necessary to establish a new demand / supply balance. However, demand is a function of the outright refined product price, whereas supply is dependent on the refining margin (the difference between the refined product price and the crude oil price). Consider the following example: currently, Nymex gasoline is trading around 141 USD/Bl and WTI Crude at 127. This gives a crack spread of 14 USD/Bl. Say a refinery outage occurs and outright gasoline prices and the crack spread both need to rise 10 % for demand and supply to rebalance. This means that the gasoline price will rise 14.10 USD/Bl to 155.10 and the crack will increase 1.40 to 15.10. This implies that the crude price will move up 12.70 to 139.70.
2. Also at play is the fact that higher refining margins encourage greater production. Often refiners can only achieve this by running better grades of crude (e.g. light sweet crudes such as WTI or Brent). The demand for these crudes may thus actually increase even as total crude demand falls. It is the price increases for these high quality grade crudes that grab the headlines, even if prices of lower grade crudes are falling.
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