Fundamentals of Oil Pricing

Another research report released today, this time by JPMorgan, showing that oil market price movements are driven by fundamentals and not speculation.  I agree fully with the JPMorgan findings and it is interesting that almost everyone from academics to regulators such as the CFTC analyzing this issue reaches the same conclusion.

Is the Future of Transport in Niches?

Transport occurs in fairly stable patterns.  People commute to and from work, school and stores each day within a known range of miles and load. However, these stable patterns do not define the vehicles people buy. People tend to buy vehicles which cover a large array of contingencies.  Daily commuter vehicles are more often than not heavier than needed for a daily commute as they are purchased for events such as a once every month journey more than 200 miles with 6 people.  This contingency-link to vehicle purchasing creates a lot of fuel inefficiency.

(source: US Census Bureau)

As transport fuels become more diverse and expensive, powered transportation devices may also become more customized to fill niches.  These niche vehicles will be more efficient as they would just cover the vast majority of daily transport in the most efficienct manner.  Services such as car sharing Zip Car would meet the need for less frequent vehicle uses.

In cities, people tend to use taxis, subways and buses.  Taxis are expensive. Subways and buses, while most often the quickest way around, can be slow and infrequent at the edges of a city.

I was passing a motorcycle store the other day and saw this Ultra Motor A2B electric bicycle which can travel 20 miles at 20 miles per hour between charges.  It is an urban commuting vehicle.  One can pedal if the batteries have been drained.  The vehicle can be stored inside an apartment or an office which is an advantage over gasoline-powered scooters.  I am not endorsing this bike, it is simply interesting that products which would once have been considered gimmicks are now slowly at the edges of becoming more mainstream.

Leading Edge Oil Demand Data

Is 2009 OECD oil demand destruction like 1974, when efficiency didn't stick, or the early 1980s, when efficiency almost bankrupted the oil industry? I have a much more detailed theory as to which version it is - which I will post at a later date. For now, let's dig into some data.

OECD oil demand growth is being written off by most oil analysts for the next few years. OECD demand growth is probably the most significant known unknown in the oil market. Early data indicates that we may be seeing signs of permanent OECD oil consumption efficiency. Given the huge numbers involved in OECD oil demand, it is worth teasing any data out for signs of how this efficiency is progressing and if it is lasting.

Automobile sales in the US are recovering (chart 1). The October sales numbers were at an annualized rate of 10.45 million units, up from 9.2 in September and 14.09 in August. The August number was prematurely high due to the cash for clunkers program which took place mostly in that month.

(click image to enlarge)

Now that the data dust of the cash for clunkers program has settled it is becoming clear that the mix between cars and SUVs/light truck sales is changing (chart 2). A higher share of car sales rather than heavier vehicles would tend to indicate that sticky changes in efficiency are occurring. Oil analysts factor these shifts into long term vehicles on the road when modeling oil demand. I speculated last month that the August cash for clunkers program had the effect of being a giant advertising program for efficient vehicles and would kick off this efficiency move.

(click image to enlarge)

What is interesting as an economic sidenote, but not so much for oil demand, is that US domestically produced automobiles appear to be gaining some ground (chart 3). Perhaps this is due to the weakness of the US dollar which makes imported vehicles more expensive as well as the recent report in an influential consumer survey of some US auto makers' vehicle quality improving.

(click image to enlarge)

Oil Demand Destruction Destroyed

The IEA this morning raised its 2010 forecasted oil demand by 0.35 million barrels per day (Mb/d) to 86.1 Mb/d. This means 2010 oil demand will be 1.7% (1.5 Mb/d) above 2009. Almost all of the growth is coming from non-OECD countries with OECD oil demand growth expected to be flat.

What is it about 4.6 barrels per year?

Cats are curious
(a friend of mine behind the computer screen)

Since 1982 the number of people in the world has grown by almost 45% or 2 billion people (chart 1).

Oil supply has been unable to outpace population growth since the 1970s and has from 1982 until recently just been able to keep pace with demand (chart 2). What can one person do with 4.6 barrels (193 US gallons) per year? With a vehicle getting 30 miles per gallon one can drive an average of around 16 miles per day.

Why has per capita consumption been so stable since 1982 having grown at an increasing pace for the prior 120 years (chart 2 again)? The answer is that a new method of rationing demand emerged in 1983: benchmark pricing linked to transparent free liquid markets (see chapter 1 of Oil 101). Free markets and necessarily volatile oil price became the adjusting factor matching available supply to demand.

To put the global average of 4.6 barrels of oil consumption per year in perspective, the number of barrels consumed per person in 2008 in India was 0.9, China 2.2, Brazil 4.6, Germany 11.1 and the US 23.3.

Build your own chart of consumption patterns over time by clicking here (click the 'Play' button to start and the individual country to track over time - set X axis to 'Time' and Y axis to 'Oil Barrels Consumed per Person').

Floating Storage Holds Oil Price Key

(chart 1: model based on tanker data. click to enlarge)

Floating inventories should typically decline as demand picks up seasonally moving through the third and fourth quarter. Yet floating storage is increasing (see chart 1 above) to a new record high. Anecdotal evidence lends support to the above analysis.

(chart 2 above: AG to USGC VLCC in US$ per barrel. click to enlarge)

Low freight rates (see chart 2 above) result from OPEC not using tankers they had been using last year when they were producing flat out. This provides the first and most important of a few key incentives to increase floating storage. Another incentive is the shape of the forward curve which needs to be in sufficiently upward sloping contango (see chart 3 below). Future prices have to be above today's price plus the cost of the tanker. There are also financing costs which need to be covered.

(chart 3 above: NYMEX WTI Crude forward price curve. click to enlarge)

As OPEC increasing production will be the supply factor which ends the current oil price rally, changes in the above three charts may provide leading indicators to determine when oil prices have topped out and will begin to move sideways or fall.

Bear in mind that the above analysis is of the supply side of the oil market. As mentioned previously, above US$80 per barrel (oil spending equivalent to 4% of GDP) demand is likely to fall. OPEC may be able to created supply-driven price spikes above US$80 per barrel, but these are unlikely to last.

The 4% Rule: Oil above US$80 Equals Recession

(WTI Crude at the time of writing is US$64/barrel)
Oil above US$80 per barrel puts the world into an economic death zone.  As was evidenced in 2008, brief spikes above US$80 per barrel are possible but not for more than 6 months.  Historically, the longer oil prices stayed above the economic death zone level the more severe the following recession.

Oil consumption grows predictably when oil spending is below 4% of GDP. For developing nations, oil demand grows as a function of income (measured by GDP) and population. For developed nations oil per capita consumption tends to be relatively stable and oil demand grows with population.

An observation made in Oil 101 (pages 15-16) is that when spending on crude oil has risen above 4% of GDP, global oil demand has fallen. Such global oil demand destruction occurred in 1973-1974, the early 1980s, the early 1990s and in 2008.

(source: page 17, Fig. 1-10, Morgan Downey, 2009, Oil 101)

(source: page 17, Fig. 1-10, Morgan Downey, 2009, Oil 101)

The crude oil price equating to spending 4% of GDP is shown on the following chart along with historical realized prices. As you can see, in 2009 the oil price which equates to 4% of GDP is US$80 per barrel. Anything above US$80 per barrel may reduce global oil demand and prolong the current recession.

Looking to the future, what if supply declines? How much could oil prices increase? If we hold income (GDP) constant and oil consumption efficiency constant (roughly 4.6 barrels per person globally at the moment) then we get the following chart:

The bottom of the recession zone is the oil price equivalent to 4% of GDP and the top of the recession zone is the price equivalent to 8% of GDP (top of demand destroying price spikes historically). 

[Note that if the purchasing power of the US dollar declines in general against all hard assets and not just oil, then, all other things being equal, oil prices equating to 4% of GDP may increase above the levels shown.]