Sunday, June 15, 2008

The oil picture

In the current oil market it doesn't make very much difference whether the price of oil is driven by speculation or by fundamentals, as this slightly geeky article points out. The quasi-circuit flow diagram about halfway down is especially useful. In any case,

The equilibrium expression is AI = DI, and when this situation prevails, s = h, and price is constant (i.e. Δp = 0)! Put another way, a stock equilibrium implies a flow equilibrium, while a flow equilibrium does not imply a stock equilibrium. In this type of model expectations are very important because of their influence on desired stocks, and in the real world expected prices are undoubtedly more difficult to describe than via the simple implicit expression shown in the figure – i.e. pe = f(p) – but right or wrong it is these expectations that are and have always been a key element in determining the oil price, however it was only when the oil price moved past $100/b that they were given their true weight in the scheme of things.
In other words, because of demand from China, India and the usual suspects, the current expectation is that the price of oil will be dramatically higher in the future than it is now. Therefore, the market adapts by trying to build inventory. The price of oil goes up, because whatever isn't consumed goes to the inventory stock. The increase in the price ought to cause inventory to build but it hasn't. So the bullish price pressure remains.

Among other things, selling off the Strategic Petroleum Reserve doesn't fix the problem, and in an odd way represents the opposite of the solution. The price of oil will go down when people see that there's lots of oil around that nobody knows what to do with.

No comments: