Tag Archives: commodities

Oil Prices Up

This has been the most interesting year for oil for as long as I can remember. Talking with my parents, they say it’s hard to believe the incredible supple of oil available at this moment. When they were growing up, there was a quota on how much gas someone could get in a week. Now, the supple is so high prices are down to levels not seen in decades. Oil prices are now at a one month high after prices shot up 7% on Tuesday. Oil futures continue to rise, with Tuesday marking the fourth straight day of prices increases. This marks the longest winning streak for oil in six months. According to the article, “Tuesday’s rally came in response to a U.S. refinery strike, which pushed up prices for petroleum products on concerns that the refineries could shut down fuel production.” http://www.wsj.com/articles/oil-extends-rally-but-markets-cautious-over-rebound-1422944186. If fuel productions fell, this would lessen the supply of oil, leading to a surge in prices. While oil prices have been showing signs of recovering, I do not think we have seen the end to low prices. If one oil refinery decides to cut production, they could be undercut by one of their competitors. There needs to be some sort of assurance that all oil producers agree to cut production. I believe this may happen, but it will not lead to prices going back up to $100 dollars a barrel. I believe prices will increase, but gradually find a steady state well below this summers levels. While US oil producers want to cut production, there is still an over supply on the global level. This will not get solved easily it is nearly impossible to get all oil producing companies around the world to cut production and spending in 2015. Many oil producing companies are losing money and will cut spending in 2015. This will lead to layoffs and lessened production. It will be interesting to see how companies that have oil and a main factor of production react. Oil futures continue to rise, indicating companies are playing it safe. by buying at prices they believe will continue to rise. According to marketwatch, “Crude-oil futures rallied well above $50 a barrel to settle at their highest levels of 2015 Tuesday, as prices jumped on speculation that a sharp decline in U.S. drilling activity will result in supply declines.” http://www.marketwatch.com/story/oil-prices-continue-to-rise-as-investors-worry-about-supply-cuts-2015-02-03. This article also notes that they do not believe this decline in drilling will be enough to offset the global oversupply. On a worldwide scale, there is a surplus of 1.5 million barrels per day. This is remarkable and explains why prices are so low. It will be interesting to see if companies on a global scale follow the US’s lead and cut down on drilling and production in order to raise prices. With many economics struggling worldwide, I find it doubtful this will happen anytime soon. It will be interesting to see how it all plays out!


Why the OPEC Put Matters

As of the time of writing, current month Brent is trading at about $47.86. This is a 60% fall on the year. Prices this low have not been observed since 2005, and back then prices were on the rise. What gives?

Demand side factors are certainly playing a role. James Hamilton from Econbrowser estimates that dollar strength, global macro weakness as proxied for by copper prices, and the decline in 10 year rates explains around 44% of the fall in crude prices since July.

That leaves around half of the decline unexplained. By definition, if it’s not coming from the demand side it must be from demand. Many analysts have talked about fracking and the growth in tight oil in the United States as a major factor. But there’s two reasons to be skeptical.

First, increasing tight oil production has been a long time coming. That should have easily been priced in.

Second, more sober analyses of the expansion in US oil production that suggest that much of the hype surrounding US oil production substantially changing global prices is overrated. There’s just not enough oil of the right blends to be making such a huge impact on global markets.

In my view, any plausible story for the recent decline in oil prices has to explain why recent small shocks about the future state of the world can translate into such dramatic price moves today.

One possibility comes from a story about the OPEC put. OPEC’s announcement in November wasn’t just about not cutting production, but rather it represented a regime change about how OPEC would respond to lower prices. One way to think about it is that OPEC’s previous policy of cutting production at low prices functioned as a put option on oil. No matter what, there would be a price floor.

But now that put option is out of the window. Without it, the left tail in oil prices exerts an effect on the current price. This can happen in at least two ways. As a first order effect, people with oil stocks sell at expected value, and when the low price events become possibilities, you sell at a lower price. But there’s also an effect on storage. By removing the put option, OPEC raises the specter of highly volatile and potentially very low oil prices in all future periods. This makes oil much less worthwhile to store, and as such producers will flood the current market with their stocks.

The formalism resembles a Hotelling model in which speculators store oil only if the expected return is competitive with other market interest rates + a risk premium. Given that rates are so low, variance in the risk premium matters more. If we think that the states of the world with extremely low oil prices are “expensive risk” states of the world (because macro conditions are bad), then these risks should now play a powerful role in inducing drawdowns in oil stocks.

Crosslisted from medium