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Sun 2 Nov 2008 04:00 AM

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World is drowning in oil (again) after drought

Markets greeted the news of reduced oil supply by pushing prices down further. How quickly things change.

Three months ago, the world was running out of oil. Seriously. I kid you not. Everywhere you turned, you heard whispers that the day of petroleum reckoning was at hand.

Now there's too much oil, prodding the Organisation of Petroleum Exporting Countries to cut production targets for the first time in two years. Last week OPEC, confronted with the halving of oil prices since July, announced a 1.5 million barrel-a-day cut in output.

World markets greeted the news of reduced oil supply by pushing prices down further. How quickly things change. Or do they?

All speculative bubbles have a kernel of truth behind them to justify their existence. This time around it was China and India. These two emerging Asian giants were gobbling up all the commodities the world could produce to fuel their rapid industrialisation.

It wasn't that the story was untrue; it was old. Growing global demand probably was the reason for the gradual rise in oil prices from $20 a barrel to $40 earlier in the decade, and even to $60 by mid-2005.

It was the moon shot to $147 that took on a life, and a litany, of its own. Emerging nations didn't start gobbling up crude, coal and copper all of a sudden in the middle of 2007.

Yet analysts on TV and in print told us with a straight face that the doubling in oil prices from July 2007 to July 2008 was a result of fundamental demand, not speculative buying or investors, including pension funds, "diversifying'' into "alternative investments'' in search of "uncorrelated returns.'' (It sounds a lot better than admitting you got suckered into buying what was going up and are now stuck with a pile of stuff that no one wants.)

"It happens in every market,'' says Michael Aronstein, president of Marketfield Asset Management in New York. "Once it goes up an enormous amount, creating unfathomable wealth for the fortunate participants, someone makes an ex-post case as to why we are only at a beginning and it's not too late to get in.''

This advice is "generally formulated by someone who has a vested interest in selling the stuff,'' he says.

By the early 1980s, following two oil shocks in the previous decade, the running crude commentary went something like this: Oil prices couldn't go down because they were controlled by a cartel (OPEC). Banks extended credit to the Oil Patch based on - you guessed it - a belief that the underlying asset couldn't go down.

When prices plunged to about $11 a barrel in 1986, that myth went down with them. The spike in crude oil earlier this year had the support of the popular theory of "peak oil.''

In a 2005 book, Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy investment banker Matthew Simmons argued that oil production by Saudi Arabia, the world's largest producer, is "at or near peak sustainable volume'' and likely to decline in the foreseeable future.

Just a few years before the peak-oil theory was hot, the world was "Drowning in Oil,'' according to the Economist magazine's March 6, 1999, cover story.

Oil was trading at $13.50 a barrel at the time. "We may be heading for $5,'' the Economist predicted. "Consumers everywhere will rejoice at the prospect of cheap, plentiful oil for the foreseeable future.'

Oil prices took off and never looked back. Like the world of fashion, trends in markets come and go.

Oil is a limited, albeit vast, resource. At some point in the future, we probably will run out of petroleum, at least as we know it.

Man's ingenuity is equally vast. When the time comes, given all the tax incentives that will be thrown in the direction of alternative energy, I have full confidence the world will not return to travel by horse and buggy.

The silliness that accompanies speculative bubbles isn't to be outdone by what passes for economic analysis. It's just over three months since commodities began their sharp, swift descent, and already the nonsense is starting: Lower oil prices are going to boost consumer demand.

Whoa! The price of oil (and other raw materials) is falling because of a cutback in demand, both actual and expected.

Expressed as a graph, the demand curve for oil has shifted back, to the left. Consumers demand less energy (gasoline, heating oil) at any given price than they did before.

People imbue oil prices with all kinds of mystical powers. They see a falling price and treat it as a cause, not an effect.

That oil prices are falling in the face of OPEC's announced production cuts - a reduction in supply would tend to raise the price, not lower it - suggests that demand is falling even faster than OPEC can reduce supply.

That won't boost demand, but who knows? Maybe it will help recapitalise the banks!

Caroline Baum, author of ‘Just What I Said', is a Bloomberg News columnist. The opinions expressed are her own.

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Frank Zapola 11 years ago

Surely, President Obama can just wave his magic wand and keep prices from rising too much in the future. Seriously now, with all of the "fixes" the government is looking into (for this economic mess) why is no one talking about what to do to prevent (yet) another speculation-based run-up in the price of oil? THAT was just as responsible as anything for this economic tailspin (which of course was precipitated by the greed behind the zero-down home loans, which of course really took off after 9/11 as the government in its infinite stupidity, looked for a way to stimulate the economy by lowering interest rates).