Fed Researchers: Difficult to Sustain Oil Over $100
Thursday, May 29th, 2008http://blogs.wsj.com/economics/2008/05/29/
fed-researchers-difficult-to-sustain-oil-over-100/?mod=mod
May 29, 3:49 pm
Fed Researchers: Difficult to Sustain Oil Over $100
Countering the conventional wisdom, researchers at the Federal Reserve Bank of Dallas are skeptical oil prices can remain at their current heights over the long run. “Absent supply disruptions, it will be difficult to sustain oil prices above $100 (a barrel, in 2008 dollars) over the next 10 years,” Dallas Fed researchers Stephen Brown, Raghav Virmani […]
May 29, 2008, 3:49 pm
Fed Researchers: Difficult to Sustain Oil Over $100
Countering the conventional wisdom, researchers at the Federal Reserve Bank of Dallas are skeptical oil prices can remain at their current heights over the long run.
“Absent supply disruptions, it will be difficult to sustain oil prices above $100 (a barrel, in 2008 dollars) over the next 10 years,” Dallas Fed researchers Stephen Brown, Raghav Virmani and Richard Alm write in the bank’s monthly Economic Letter.
The future of 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.” The paper argues “if these factors stay on their present course, prices are likely to be pushed higher.” But, “if one or more factors change, markets could see some easing of price pressures.”
For the researchers, the key factor appears to be the development of new supply, coupled with a recovery in the dollar as the broader economy begins to improve. They point to reports of a rush to develop nontraditional sources of oil as a signal market forces themselves will work to counteract some of the recent surge.
“The substantial development of these nonconventional oil resources could mean downward pressure on crude oil prices in future years,” the paper said. “Actual and expected costs of nonconventional resources suggest it might be difficult to sustain oil prices above $70 a barrel,” the paper explained, although the economists did note a drop in prices related to other factors could inhibit further non-traditional source development.
The Dallas Fed paper appears to run counter to the prevailing expectations of oil prices, which offer the prospect of a gloomy future, at least for Americans and their long romance with cheap fuel prices.
Some forecasts predict a move to as much as $200 a barrel in the next six to 24 months, and some predict a move to $145 by mid-summer. On Thursday, oil prices were lower and trading around $126 a barrel, as traders focused on a decline in gasoline demand. Some expect high prices at the pump to further depress demand.
The Dallas Fed report speculated that a quadrupling of oil prices since 2003 may reduce U.S. oil consumption by 10% to 20% over the next 10 years, and that Europe could see a similar decline. But, “these reductions won’t be sufficient to relieve pressures on prices” given the rise in demand from other nations.
Oil prices, and commodity prices more broadly, have been a touchy subject for Federal Reserve officials. Food and energy prices have been historically volatile, so when policy makers measure inflation, they tend to strip those factors out, believing that method gives them a better read on the economy’s underlying rate of inflation.
That approach has been getting policymakers a lot of grief lately, because energy and food related prices have done nothing but go up for several years now. Indeed, gains there suggest inflation is likely worse than what most policy makers reckon.
The matter grows more complex because some have argued the Fed itself has helped fuel the problem. The monetary policy run by the central bank in recent years have created several periods of very low interest rates. That’s created a world where investors have had a difficult time finding decent returns. Many believe that’s forced money into commodities, in turn fueling a boom in a sector that both creates inflation, and acts as a bleed on consumers’ spending ability.
Fed officials reject the thesis and argue that by and large surging commodities, including oil, look to be rising due to fundamental demand, tied to things like economic growth in China and India. In a recent speech, Fed Vice Chairman Donald Kohn said “lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.” –Michael S. Derby
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Very ironic that this comes out today! Coincidence? Don’t you believe it!
Comment by - May 29, 2008 at 4:12 pm
the fed is smoking something as usual
Comment by - May 29, 2008 at 4:23 pm
to elaborate on that… maybe $200 is not sustainable but $100 is … lack of supply will catch up to any outside market influence
Comment by - May 29, 2008 at 4:25 pm
This is pure Fed propaganda to indirectly deflect pressure to raise rates. The report states four factors in determining oil prices and then subtly gives reasons why they would give an upward push to oil prices.
How anyone can predict oil prices for the next 10 years is beyond belief. These guys are worse than dumb Wall St analysts.
Comment by - May 29, 2008 at 4:27 pm
The US Fed now has a new roll and the FDIC has asked congress to mandate closer regulation on the Investment Banking System.
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#1 How in the hell can the Fed become a “CENTRAL CLEANER” system for the mentioned Investment Banks below… this will happen take my word for (IT) in order to keep them afloat… I just wonder what the Fed New “Cleaning” Window will be called… “JPM… Savings (Gut the US Tax Payer) and (Reward) Greed”?
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Efforts to tackle the risk surrounding privately negotiated credit derivatives will take a step forward on Thursday when 11 of the world’s biggest investment banks announce the creation of the first central clearer for the opaque contracts by September. The absence of a central “FED” clearer window of lower rates has made such contracts risky because there is no guarantee that parties will pay out. This systemic risk has fuelled the global credit crunch, prompting regulators to step up pressure on banks to show they are trying to make the system more dependable… yea right, how come the Fed got in bed with them in the 1st place… to save the country (Wall Street”) or “We the People”? Your 1st guess I think would be the best guess… You think?
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#2 When congress passes these new regulations (FDIC) for the Investment Banks will they in turn ask for overseas regulation through the IMF and WB for controlling authority… hum! Makes one stop… and think for a moment, just who in the hell is running the country… YOU THINK!
Comment by - May 29, 2008 at 4:29 pm
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http://dallasfed.org/research/eclett/2008/el0805.html
Economic Letter—Insights from the Federal Reserve Bank of Dallas
Vol. 3, No. 5
May 2008
Federal Reserve Bank of Dallas
Crude Awakening: Behind the Surge in Oil Prices
by Stephen P. A. Brown, Raghav Virmani and Richard Alm
The first few months of 2008 saw crude oil prices breach one barrier after another. They topped $100 a barrel for the first time on Feb. 19, then rose past $103.76 about two weeks later, surpassing the previous inflation-adjusted peak, established in 1980. In April and early May, oil prices pushed past $110 and then $120 a barrel and beyond.[1]
These milestones reflect a new era in oil markets. After the tumult of the early 1980s, prices remained relatively tame for two decades—in both real and nominal terms (Chart 1). This long stretch of stability ended in 2004, when oil topped $40 a barrel for the first time, then embarked on a steep climb that continued into this year.
Modern economies run on oil, so it’s important to understand how recent years—with their surging prices—differ from the preceding two decades. A good starting point is strong demand, which has pushed world oil markets close to capacity. New supplies haven’t kept up with this demand, fueling expectations that oil markets will remain tight for the foreseeable future. A weakening dollar has put upward pressure on the price of a commodity that trades in the U.S. currency. And because a large share of oil production takes place in politically unstable regions, fears of supply disruptions loom over markets.
These factors have fed the steady, sometimes swift rise of oil prices in recent years. Their persistence suggests the days of relatively cheap oil are over and the global economy faces a future of high energy prices. How they play out will shape oil markets—and determine prices—for years to come.
Supply and Demand
As incomes rise, economies use more energy for transport, heating and cooling and producing goods and services. A broad cross section of nearly 180 countries shows that doubling per capita income more than doubles per capita oil consumption (Chart 2). How much each country contributes to increases in global energy demand depends on its population and rate of income growth. Big nations moving quickly up the income ladder have huge implications for oil markets.
China and India, two giants with a combined population of nearly 2.4 billion, shook themselves out of a long economic slumber and began growing rapidly in the 1990s. Adjusted for inflation and purchasing power parity, China’s per capita GDP rose from $1,103 in 1990 to $4,088 in 2005; India’s went from $1,202 to $2,222. In this decade, new energy demand from China, India and other emerging countries has added to continued growth from the U.S., Europe and other parts of the world.
As economic activity in the U.S., the world’s largest oil consumer, began accelerating in 2003, markets began feeling the full force of the world’s increased appetite for oil. Global consumption rose from 82.6 million barrels a day in 2004 to 85.6 million in 2007. Since the beginning of the oil era, prices had ebbed and flowed around the U.S. economy’s ups and downs. Now, markets view demand increases as a fact of life that won’t be blunted much by a slowing U.S. economy.
With consumption on the rise, oil markets grew tighter as suppliers neared productive capacity. The Organization of Petroleum Exporting Countries (OPEC), a 13-member group that produces more than a third of the world’s oil, has maintained excess capacity of only 1 million to 2 million barrels a day since 2004, down from 4 million in 2001 and 5.6 million in 2002 (Chart 3).
Although OPEC’s excess capacity has rebounded from its 2005 low, the gains are largely in heavy crude oils that can only be processed in specialized refineries. Those facilities are running full bore, so the added supplies aren’t relieving a tight market. The latest evidence also suggests OPEC is now restraining its output.
While some warn that oil production has peaked—or will soon—most industry experts contend that oil resources are plentiful; it just takes time and money to get them out of the ground and into the market.
Higher prices have done what economics would predict—stimulated efforts to increase supply. Companies have expanded their exploration budgets. Oil-producing nations have announced new projects. Drilling activity is at a high level, both offshore and on land. Wages and oilfield services costs are being bid up, while shortages persist for some key skills and equipment.
So far, new supplies haven’t materialized quickly enough to keep up with growth in world demand, largely because various hurdles have slowed their development. Oil resources, for example, are concentrated in countries with state-run oil companies or little economic freedom. Where market signals aren’t allowed to work, incentives to boost production may be muted.[2]
Oil demand is inelastic in the short run—that is, it doesn’t react quickly to changing prices. Consumers adjust their spending to maintain consumption as prices rise, even if they have to pay more for it.[3] Most likely, this reflects businesses’ commitment to keep up production and individuals’ need to drive to work, run errands and heat homes.
When demand is inelastic, even modest tightening in markets translates into strong price movements. In recent years, this inelasticity has magnified tight markets’ impact on prices.
The Role of Expectations
The fundamentals of supply and demand not only led to higher crude oil prices but also fed expectations that world demand will continue to grow faster than supply. The result is escalated price expectations, which show up in futures markets. The anticipated price for 2011 crude oil has moved steadily upward—from around $60 in January 2007 to more than $120 in the first week of May 2008 (Chart 4).
Futures prices reveal oil traders’ expectations, but they also feed back into current prices. As a market efficiency condition, spot prices have to increase with futures prices to keep investors equally willing to hold or sell the marginal barrel of oil. If current and futures prices get out of sync, traders taking advantage of arbitrage opportunities bring prices back in line.
Forecasters offer another window on expectations. Their outlooks can provide additional information about possible price scenarios because they incorporate data beyond traders’ sentiments. Each year, the Energy Information Administration (EIA) presents a mainstream forecast, which incorporates projections on the supply and demand forces expected to shape the marketplace.
As the realities of higher oil prices have sunk in, EIA forecasts have marched steadily upward (Chart 5). The 2004 projection, for example, saw prices relatively flat in the $30 range through 2025. The latest forecast, issued in 2007, anticipates a price decline in upcoming years, with oil settling above $60 for the long haul out to 2030.
While $60 oil looks good in today’s markets, it’s worth noting that the EIA’s best guess for long-term prices doubled in just four years. It did so because the EIA decided its earlier demand projections were too low and supply projections were too high.
Consider the projected market for 2025 (Chart 6). It can be inferred that the EIA’s projected demand curve moved significantly to the right between 2003 and 2007, signaling the expectation that consumers will want more oil at all prices. It can also be inferred that the projected supply curve moved significantly to the left, reflecting a more pessimistic view about future production. The market-clearing price ends up considerably higher.
Dollar’s Weakening
Oil has long traded in U.S. dollars. Having a single-currency system lowers transaction costs for a commodity that trades globally. In recent years—while oil prices were rising on supply and demand fundamentals—the dollar has weakened against the currencies of the nation’s trading partners, particularly the European Union’s. The dollar has fallen 46 percent from its mid-2001 peak against the euro and 21 percent since 2004.
A declining dollar makes oil cheaper for Europeans and other foreign consumers, propping up their demand. A weakening U.S. currency also reduces the dollar-denominated supply from foreign producers. Together, these two factors exert additional upward pressure on prices. Daniel Yergin, chairman of Cambridge Energy Research Associates, adds a third element in arguing that some investors have used oil as a hedge against the dollar’s decline.
How much has the weakening dollar added to oil prices? If the U.S. currency had held its 2001 value against the euro, oil would have traded at about $80 a barrel in early 2008, about $21 below its actual price (Chart 7). Put another way, exchange rate movements accounted for roughly a third of the $60 increase in oil prices from 2003 to 2007.
Most of the dollar’s price impact occurred toward the end of the period. When it comes to adjustments in oil consumption and production, a declining dollar takes time to reshape crude oil prices because expectations don’t shift quickly. Factors that push up expectations of future prices, however, also put upward pressure on spot prices because markets will adjust until investors are indifferent between holding and selling the marginal barrel of crude oil on the spot market.
Would it matter if oil were priced in euros or a basket of consuming countries’ currencies? The headlines might be somewhat less alarming, but little would change in real terms. As the dollar’s value declined, U.S. consumers would still be paying more for oil. It would take more dollars to acquire the euros needed to buy oil. In a world where the dollar is weakening, the burden of higher oil prices would still fall more heavily on the U.S. than Europe.
Geopolitical Risks
The geopolitics of oil is a brew for sleepless nights. The Middle East sits atop two-thirds of the world’s reserves. The region pumps oil amid a war in Iraq, potential conflicts elsewhere and terrorists prowling for targets. Russia, a major non-OPEC producer, has expanded state control over the oil sector, pulling more of it into the realm of dicey internal politics tinged with nationalism. In recent years, violence has cut production by a quarter in Nigeria, Africa’s top oil producer. Venezuela, South America’s largest producer, is under the sway of the quixotic Hugo Chavez, who has threatened to cut off sales to the U.S.
Tight oil markets don’t have the luxury of spare capacity to offset supply interruptions resulting from trouble in important oil-producing countries or regions. Because oil demand is inelastic, even the temporary or partial loss of significant production capacity can strongly impact prices. Wars, political intervention or unexpected breakdowns send shock waves through oil markets. Just the fear of a supply disruption is itself enough to prompt price spikes.
Fears of disruptions are reflected more in short-term price movements than in longer-term ones. The increases can prove temporary, particularly when rumored troubles fail to materialize. However, the persistent threat from some disputes—for example, Iran’s long-simmering conflict with the U.S.—are likely to keep upward pressure on oil prices for longer periods.
Fear is hard to measure, but the futures market offers some help. We usually expect futures prices to slope upward from the spot price, a pattern the financial markets call “contango.” However, prices for future delivery sometimes dip below the spot prices, creating a phenomenon called “backwardation.” This can occur because of sudden shortages or a jolt of uncertainty.
It’s in this phenomenon that we find indirect evidence of fears of oil supply disruptions. When fear spreads, refiners bid aggressively for short-term oil supplies because they face extremely high costs for shutting down operations. Not enough oil can be brought to market quickly, and spot prices rise above futures prices, putting the market into backwardation.
Oil markets have been in the grip of backwardation lately, with futures prices declining. As spot prices climbed toward $120 a barrel in early 2008, for example, futures prices stood at $102 a year out and $100 two years out—a clear backwardation (Chart 8).
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.
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by Stephen P. A. Brown and Daniel Wolk, Federal Reserve Bank of Dallas Economic and Financial Review, First Quarter 2000.
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Economic Letter is published monthly by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System. Articles may be reprinted on the condition that the source is credited and a copy is provided to the Research Department of the Federal Reserve Bank of Dallas. Economic Letter is available free of charge by writing the Public Affairs Department, Federal Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX 75265-5906; by fax at 214-922-5268; or by telephone at 214-922-5254. This publication is available on the Dallas Fed website, www.dallasfed.org. |
It’s hard to believe: the credit crunch is getting close to a year old. When it first hit, the result was stunning as pending deals came under much pressure, such as with price renegotiations, litigation and abandonments. There was also an evaporation of mega deals.
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Lehman says a pair of Marubeni employees, as well as executives at two smaller companies, presented bogus documents, fake corporate seals and an impostor to convince Lehman officials that a partnership it was joining was a legitimate business. The purported partnership was supposed to provide short-term financing–at annualized rates as high as 25%–to hospitals buying sophisticated medical equipment through a one-time Marubeni subagent.
