Blog : 1 Factor Really Controls Oil Prices (It's Not Supply or Demand)

 

Oil is the drama queen of all commodities.  Just look:

 

 

 

 

Meanwhile, supply decreased significantly. 

(86.6 mbd to 71.3 mbd).  

Shouldn't lower supplies increase prices?

Of course, there was a major risk premium in the original spike to $145, but not one which justified prices (Israel used the word "inevitable" when they spoke about a nuclear strike against Iran).  

Even so, why did oil prices fall so much further than supply or demand would suggest?  Why did they fall so strongly with demand holding steady?

Maybe this was a one-off scenario?  

Nope.  Oil traded way too high or low many times over the last few years.  The price-drivers all the "gurus" are talking about are NOT causing the wild swings, or moving the prices.  Forget OPEC, U.S. shale oil, global tensions, Libyan supply disruptions...

Consider just a few examples of these over-done price moves (but remember there are several dozen others I'm not bothering to mention here):

Oil spiked 150% in 6 months from $19.13 to $51.64 (Jan. '74).  

From January, '79 to April, '80, oil saw a 125% increase.

Meanwhile, in 5 months oil prices dropped 60%. 

(Nov. '85 to March '86, $67.28 to $27.61).

4 months in 1990 saw prices double.  

(June to Oct., $30.91 to  $64.05).

In none of these examples were supply or demand even close to explaining the wild price swings.  Not even close.

To further drive the point home, in many cases global demand or supply actually acted opposite to what prices implied.  Sometimes supply would increase and then prices skyrocketed.  In many cases, demand would collapse while barrels of oil just kept getting more expensive.

Over the long term, oil should always be increasing in price. The world runs out of oil in about 52 years, according to many sources, such as British Petroleum to name just one.  In other words, a child born today will live in a world without oil long before they retire.

So many ostriches pull their heads out of the sand for minute to say, "What about solar?  What about alternative energy?"

Maybe that extends our run-way, but I won't be flying in any airplane powered by solar or coal.  Also, plastic is made out of oil .  To quote the immortal Michael Ruppert, even electric cars need several gallons of oil for each tire, plus for anything plastic in the vehicle, and also for the machines to transport the parts to the assembly plant, and finally to put the vehicle together.  Solar, coal, or nuclear won't help create shower curtains, artificial turf, skis, insecticides, contact lenses, paint, or footballs.  Oil is needed for all of these items.

(Side note - my wife says I watch too much football.  Given that I just noticed my example had turf and football in it, of the thousands of examples I could have used, maybe she's right!  NFL on the brain!!)

So, what is really controlling oil prices?  I can tell you in one word, but I must first explain it with a quick analogy:

The majority of oil traders have never seen a barrel of oil.  

Pretend, instead, they buy and sell "photographs" of barrels of oil.  Polaroids, if you like.

Some of the Polaroids are photos of different types of oil, different grades, various refineries, and several end-uses (like gasoline, diesel, jet fuel...)

For every $10 invested in physical, real, stinky oil in a drum, there are hundreds of dollars trading hands among the Polaroid-holders in London and Manhattan.  While demand for real oil surges 5%, this might set off a run on pictures of barrels of oil among traders, and drive the prices up 25%, 60%, or more...  If there is a bottle-neck at a certain type of refinery, or a run on a specific type of fuel, prices can quickly multiply.

In the end, the actual price of oil has nothing to do with oil.  It is based on the "photographs."  

In other words, oil prices are driven by speculation.  That speculation is nearly completely detached from the3 underlying commodity.

You will hear the standard "confirmation bias" theories from the TV guests whenever oil makes a move.  For example, "OPEC didn't cut production, so their is more supply in the market, and that's why prices plummeted."  Good theory, but it is incorrect.

More accurately, they should have said, "OPEC didn't cut production, so that spooked a bunch of oil traders, who unloaded their positions all at once."  Since oil prices are based on these traders exchanging "pictures," oil prices fell.  

Supply and demand both moved only slightly, while speculation among traders pulled the price per barrel down sharply.

To play oil, think about what speculators will do.  Don't waste your time believing all those supply and demand dynamics - they have very little to do with prices.