Oil at the “Break Point”

I just read the report about the current oil crisis that Daniel Yergin gave to US Congress in June. It summarises all the issues very well, and I think it’s a much more informed and less-biased analysis than many I have seen. He says the current high prices are caused by a confluence of factors including “traditional fundamentals” such as supply problems, and “new fundamentals” such as increased investment costs due to shortages of skilled labour and materials, slowing down supply expansion.

He then gives his views on the issue that everyone seems to be talking about – the role of financial markets or “speculators”. I don’t think he agrees with the view that speculators are to blame for distorting the market but he does talk about a “shortage mentality” that is probably responsible for driving up oil prices higher than they need to be. Here’s an excerpt.

the general expectation of very tight supplies is based upon the assumption that the global market cannot generate the responses that are warranted—in terms of demand and efficiency; in terms of new supplies and timely investment; and in terms of renewables, new technologies, and alternatives. Delays and postponements are read as predictions of shortages. Meanwhile, developments of great importance—such as the very large discoveries in offshore Brazil—get relatively little attention. Downward shifts in future demand from what would have been anticipated two years ago are discounted.

This sounds more plausible to me than all that talk about speculators deliberately manipulating the market for personal gains, or indulging in irresponsible gambling. It’s more of a herd-mentality argument where market information and expectations are self re-enforcing and begin to ignore contrary evidence. Demand in the US is dropping fast and OPEC and non-OPEC supply is slowly coming online now. What happens if prices do drop sharply? Will the speculators be left with worthless futures contracts that they can’t sell?

Tags: oil price, speculation