Supply Shocks

Oil prices rise further:

WSJ.com - Crude Futures Rise to Near $64 On Geopolitical, Supply Worries: Crude futures rose to a new high Monday, nearing $64 a barrel, as the U.S. government announced the closure of its embassy and consulates in Saudi Arabia due to security threats and on continued concerns that earlier shutdowns of U.S. oil refineries would reduce supply. Light, sweet crude for September delivery on the New York Mercantile Exchange rose as high as $63.95 a barrel, up $1.64 from its record close of $62.31 a barrel on Friday. Oil traders suggested $65 oil may be a foregone conclusion, as crude futures contracts for late 2005 and early 2006 shot past $65 and $66 a barrel Monday. "I guess we're going to $65 a barrel -- you can pick out almost any variable right now and it's all pointing to the upside," said Michael Guido, director of commodity strategy in New York for French bank Societe Generale. "Holding short in this market has been a losing proposition."

Comments

[knzn]

Can someone explain to me the link between refinery bottlenecks and crude prices? Over the past year I have repeatedly read things like (e.g. from this post) “Crude futures rose ... on ... concerns that ... shutdowns of U.S. oil refineries would reduce supply.” My intuition says that shutdowns of refineries should put downward pressure on crude prices. Why would people demand crude oil when they are unable to refine it? (By the same token, an auto strike reduces the demand for steel.) Obviously there is something strange about the oil business that I don’t understand.

[dcoates]

I think the NYTimes article on oil prices contains a bit of sarcasm... who knew senior commodities economists were so sassy?

"Other than the weather, and hurricanes, and refineries going down, and Saudi Arabia and Iran, and strong economic statistics, there really is no reason why crude oil prices should be so high," Ms. White said. "It must be speculation, don't you think?"

At least I'm hoping it's tongue in cheek.

[Darren]

Kuzn: I've wondered that too. Shouldn't refinery problems push crude prices *down*?

[kharris]

I hazard only the most timid of explanations regarding the link between crude oil and petroleum products. I think Darren and Kuzn are right, that a restriction in demand from refineries for crude oil should push crude prices down, at least in the spot market. However, there is such a strong link between crude and product prices that traders often ignore economic logic and play the correlation. If gasoline and oil prices have nearly always gone up and down together, then when gasoline prices rise due to refinery problems, the knee-jerk reaction is to buy oil. When that works out, it is reinforced, so that pretty soon everybody with any money left expects the pattern to be repeated.

It is easier to make an argument for buying crude futures in response to refinery interruptions. If product inventories are lower than they otherwise would be a month hence, then refineries will need more crude a month hence, so impediments to refining today mean increased crude oil demand in the future. I'm not sure I would put too much faith in this latter argument. I like the knee-jerk explanation better.

Little story. A fellow I know who was assigned to write about commodities in Chicago many years ago noted that bad weather had destroyed a big part of the Central American banana crop. He asked some of his contacts in markets for other commodities what would happen to banana prices. "To the moon, by god!" Never happened. Prices were pretty stable, so he called up somebody who actually bought bananas for a living to ask why banana prices didn't sky-rocket. His answer was there was no futures market in bananas (at the time), so not much opportunity for speculation. The writer put that into a story, but was told he couldn't publish it. In financial journalism at the time, you couldn't go around writing that commodity markets would be more orderly without speculators.

[anne]

KHarris

Interesting commodity price conjectures to consider. I have to ask a couple of traders.

[dilbert dogbert]

Could someone tell me how much storage capacity is out in the real world relative to flow. Storage would act as a capacitor in a circuit. It would seem to damp any price flucuations. Just a dumb old engineer wondering.
Must be very small realative to flow.
The Prof has been active of late. Thanks.

[Ottnott]

The U.S. energy bill was an announcement to the world that the U.S. government won't even pretend to attempt to reduce demand growth (much less actual demand) any time before 2009.

[wkwillis]

All oil is not equal. If a heavy crude refinery goes down, Bonny Light or Arab Light or Trent Light or whatever is the market quote for oil will go up.
Would you mix up the Dow Jones and the Nasdaq?

[James Wimberley]

Ultimately of course the ceiling on fossil fuel prices is set by renewables. But at what oil prices do different forms of renewable energy become competitive for different purposes? A simple question you would think, but I've not been able to find an answer by googling.

This page: http://www.solarbuzz.com/DistributedGeneration.htm
has current comparative costs of different renewables for distributed generation. (Omits solar thermal, an inherently centralised generation technology). There is a partial comparative table for elctricity generation on page 5 of tp://www.nrel.gov/analysis/seminar/pdfs/2004/ea_seminar_sept_20_2.pdf . This is based on data and estimates for 2000, but the only item seriously out is likely to be the gas price.

With a doubling of the oil price, I would guess that new oil-fired electricity generation is already uneconomic compared to wind unless you are very optimistic about future oil prices. There's a link between oil and natural gas prices, so combined-cycle gas power stations (the best conventional technology) may be a questionable investment in windy regions. There's no particular reason to think the switch will occur gradually, as most green scenarios posit; once a technology is cheaper, everyone goes for it, and economies of scale reinforce the advantage. There are few real environmental or safety obstacles to wind and solar energies, or production scarcities.

In the medium term, both gas and oil will disappear from electricity generation and space heating. This leaves two far less tractable problems for climate change: the availability of lots of coal for electricity (with very high local environmental and safety costs), and our dependence on hydrocarbons for transport.

[me]

I think you have to look at it as two problems. Problem one is refining capacity. There have been several fires and shutdowns recently and that causes the proice of refined products to rise.

The second problem is the US closing its Saudi embaassy for fear of a terra attack. That attack may not be on our embassy but could be on Saudi oil fields.

It is a lot of bad situations converging.

[glenn hefner]

...and demand for oil still hasn't beem impacted.

[Ian Whitchurch]

The link between refineries going down and crude prices going up is because 'Oils aint oils'.

Light sweet crude (ie the West Texas Intermediate you see quoted) is easy to refine. Heavier crudes (ie the new Saudi production) isnt.

So if there is less refining capability, there's more demand for the easy-to-refine light sweet crude, and as thats the 'headline' grade, people see prices going up.

Ian Whitchurch

[SW]

I think it is because the futures market is a matter of psychology. I'm only jumping in here because I don't see a satisfying answer on the board so far. Hopefully a trader will pipe up and give us an opinion. But I would think that the effect is indirect. When a refinery bottleneck develops that indicates that there will be a finished product supply problem (maybe) which will cause the price to go up. Since there is a relatively fixed relationship between the price of the finished product and the price of crude, crude goes up in lock step. That is any event that would cause the finished product to go up will also cause crude to get bidded up. we are talking about futures contracts here. So unless they are running out of storage capacity, any event that would tend to drive up the price of the finished product will also drive up the price of crude.