Sunday, August 01, 2004

Oil: Risk Premium or Supply Crunch?

It's not an easy question as it sounds. This is because the risk premium in the oil market straddles both the question of supply and demand. The risk premium occurs because people begin hoarding to guard against energy supply disruption. How much you need to hoard however depends on how much you expect others to bid on that oil. Some people bid because they want to speculate against others hoarding it. So as you can see, it's a far from straight foward question. The CSM explores this question.

But analysts say the fact that Yukos could jolt the global oil market underscores how several factors are making the market vulnerable to shocks, and are likely to conspire to keep prices high for the next 12 to 18 months.

They point to the doubling of the pace of global demand in the past year, little spare production capacity, continuing terrorist attacks in the Middle East, and a controversial presidential referendum on Aug. 15 in Venezuela, the world's No. 5 oil producer.

"You can write a checklist of factors that are contributing to this very overheated and feverish market," says Peter Kemp, editor of the Petroleum Intelligence Weekly in London. "The [oil supply] cushion ... that can be used in an emergency is very, very thin."

In part because of higher gasoline prices, the US government said Friday that economic growth slowed sharply in the spring.

Adjusted for inflation, however, the cost of oil remains about half has high as the peaks reached in the late 1970s and early 1980s.

While some estimate a $10 per barrel "terror premium," Mr. Kemp figures that at least half the current price surge is "going to be a permanent feature until we see increases in supply, which are not imminent."...

After several years of sluggish demand growth, the markets have been caught off guard by several factors: a very cold winter last year, nuclear power outages in Japan, surging natural gas prices in the US, and China's expanding economy "emerging as a driver of world demand," says David Fyfe, principal oil supply analyst at the International Energy Agency in Paris...

After several years of sluggish demand growth, the markets have been caught off guard by several factors: a very cold winter last year, nuclear power outages in Japan, surging natural gas prices in the US, and China's expanding economy "emerging as a driver of world demand," says David Fyfe, principal oil supply analyst at the International Energy Agency in Paris.

The global demand is growing at the fastest pace since the late 1970s, with one estimate putting the figure at 4.1 percent growth for the first half of this year.

To meet that demand, the supply side today is also pushed to the limit. The Organization of Petroleum Exporting Countries (OPEC) is already pumping at close to capacity. In late July, OPEC officials said they were producing 27.5 million b.p.d, two million b.p.d. above their quota. As of today, OPEC says it will boost production another 2 percent or 500,000 b.p.d.

While some of OPEC's 11 member nations are investing in new capacity, it will take 12 to 18 months for that investment to bear fruit.

My take is that the price increases are on trend, permanent. OPEC is investing in new capacity but in eighteen months demand will have increased by then, since we don't expect the energy needs of the world to decrease. If anything demand will increase, as well as instability in Iraq and Arabia.

If you look at their handy chart, the price of oil has increased on trend about ten dollars in six months. In another year, if the price increases continued the price of oil would be twenty dollars higher. This is speculation, but that would be in the sixty dollar per barrell area. If you look at the trend volatility however (the zig-zagging) that over this six month period the swings in the price of oil have only increased, more than doubling. Currently the last zig-zag seems to have been a shift of about seven dollars per barrell.

If that trend continues, then in one years time, the volatility of the price of oil will be about $28 per barrell, with a top range of about $60 and a bottom of about $30. Of course it's unlikely to happen in that way. I'm extrapolating those trends for a reason. Earlier someone asked me how long did I think Saudi Arabia would remain stable.

Of course this isn't a question purely of economics, it can be trumped any time by superior political or military maneuvering. However markets do have the ability to forecast certain things. The increased volatility and the increase in price will have a 50% price value convergence in about a year. When projected intersection of when a commodity's volatility reaches 50% of its top price range is a rule of thumb of the market predicting based upon extrapolation a point of destabilization.

Using this quick and ready rule of thumb, we can see from the increased volatility of price and its increase that as of this point time with the information now available that the market's projected intersection is on the time scale of about one year for destabilization. This is because whenever the variance of the price of something reaches about 50% that means that the market consensus on its value starts to break down. There are some extremely hopeful persons and extremely pessimistic persons. Beyond a fifty percent variance whatever market participants are reacting to so extremely usually begins resolving itself. That's because crudely about fifty percent variance is the largest variance a stable price line can sustain. So either the price takes off or it plummets.

This assumes nothing materially changes the underlying situation or trumps it of course. Of course I'm just visually reading off these numbers. A more careful application of the rule to more precise data points and measurements would be able to precisely pinpoint the anticipated market forecast destabilization point. However I'm emphasizing the rule of thumb in its crudest form in order to share a lesson about how one can quickly eyeball charts and read off convergence points in rough time frames.

If Arabia suddenly liberalizes and stabilizes its political situation, the price of oil will sink in about a year. If it fails to reform, then things should begin destabilizing significantly in about a year and the price of oil should rise up. Usually volatility increases to a significant fraction of a price line before resolution and a market consensus happens. So the moving volatility is a sort of finger on the pulse of the market participant's anxiety about the uncertainty of the situation.

If one of my readers wants to do a more formal mathematical treatment and share the results, I'm sure we would all be interested in testing this rule of thumb against external events.

5 Comments:

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5. Take some time out for yourself, relax and read a book, do something for yourself.

6. Meditate. Meditation is an excellent habit to develop. It will serve you in all that you do. If you are one who has a hard time sitting still, then try some special meditation CDs that coax your brain into the meditative state. Just search for "Meditation music" on Google or Yahoo and explore.

Our outside work is simply a reflection of our inside world. Remember there is no reality just your perception of it. Use this truth to your advantage. Whenever you are sad, realize that it is all in your mind and you do have the power to change your perception.

These tips will lift you up when you are down, but don't just use them when you are sad or generalized anxiety disorder symptom . Try and practice them everyday, make them a habit. You will be surprised at how these simple exercises will keep the rainy days away.

On a final note, if you are in a deep depression that you can't seem to shake, please go see a doctor. This is your life and don't take any chances. generalized anxiety disorder symptom

 
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