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147 comments on DrumBeat: February 8, 2007

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new account on February 8, 2007 - 2:31pm Permalink | Subthread | Parent | Comments top

Excess capacity does not put a ceiling on oil prices



Ron, I disagree on this point.


If we believe that all producers are producing at maximum capacity and that maximum rate of production remains unable to meet market demand then we can make the case that this excess of demand over supply will result in an increased future price for the commodity. Since future prices are anticipated to be greater then current prices it makes sense to buy now, i.e. to hoard.


On the other hand, if we observe that market demand is being met by existing rate of production and we also observe that there exists a surplus prodcution capacity that may be brought on stream to meet future demand, then we cannot justify the case for future price rises or for future shortages and it is therefore much harder to make the case for hoarding. In fact, under this scenario, there would be a strong argument to liquidate inventory to reduce the costs of carry.


Your views?

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Darwinian on February 8, 2007 - 3:44pm Permalink | Subthread | Parent | Comments top

New Account, two things, you edited my post in mid sentence. That is what is called changing the context. Or "quoting out of context". In debating circles that is a real no-no. What I said was:

Excess capacity does not put a ceiling on oil prices or decrease volatility unless that excess capacity is used to do so.

First, oil traders must believe that the holders of such spare capacity will indeed use that spare capacity if the price reaches a certain trigger point. But even that belief will not affect supply and demand today, or more correctly the price swings that over demand or under supply causes.

The farther out futures contracts follow the front month contracts. True, they reflect the expectations of what prices will be down the road and excess capacity can influence the distant futures contracts and therefore trade either at a premium or discount to the near term contract. But spot prices and the front month prices and most certainly volatility are affected by what can be delivered this month, not three to six months down the road. Observe the price volatility caused by a sudden cold spell if you doubt this.

Simply the knowledge, or more correctly the belief that spare capacity exist and can be brought to the market in a few months, does not affect the spot price of oil or the close in contract or the volatility of the price of oil to any large extent. Think about it, if it did, then there would be no need for OPEC nations to hold oil off the market. That is any increase in price due to tight supply would be driven right back down due to the increase in spare capacity. Spare capacity in the Middle East does not increase the inventory level of gasoline in the US.

Ron Patterson

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Pitt the Elder on February 8, 2007 - 4:16pm Permalink | Subthread | Parent | Comments top

That is what is called changing the context. Or "quoting out of context". In debating circles that is a real no-no. What I said was:

It was quite clear what you said, and that he was responding to your full statement. While he may not have quoted the full context, he addressed it and did not appear to misrepresent your position in his argument. So it's no big deal.

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Darwinian on February 8, 2007 - 4:47pm Permalink | Subthread | Parent | Comments top

It was quite clear what you said, and that he was responding to your full statement. While he may not have quoted the full context, he addressed it and did not appear to misrepresent your position in his argument. So it's no big deal.

Pitt, I thought my reply was courteous and resonable. I did not make a big deal of it. But when two parts of a sentence are connected by the conjunction unless, and when one quotes you they leave out that unless along with the entire second half of the sentence, then that is most definitely changing the context. The unless was not dealt with in his reply at all.

And that was the entire point. If a country says that they will, if the price reaches a certain point, dump mass quanities of oil on the market, then that will definitely affect the price of oil and even the volatility. But they have given absolutely no indication that this will happen. And unless they do........well, you get the idea.

Ron Patterson

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ggg71 on February 8, 2007 - 4:50pm Permalink | Subthread | Parent | Comments top

Ron,

While I totally agree with you in principal, traders make assumptions. They have too. If OPEC reduces exports by 2 million barrels per day to support the price, the thought on the Nymex floor is most likely that if there's a big supply disruption (Hurricane, terrorist) the Saudi's (or whomever) will jump in with additional supplies.

Just because they don't say they will doesn't mean they won't. Just like if they say they are going to increase production by X million barrels per day doesn't mean they really can.

At the end of the day there is a lot of subtlety, nuance, and even bald face lying that goes on in the Oil markets.

Garth

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Darwinian on February 8, 2007 - 7:12pm Permalink | Subthread | Parent | Comments top

Egg, with all due respect I don't think we are talking about hurricanes here. At any rate there will still be tremendous volatility if a hurricane hits the gulf. It takes about six weeks to transit from Saudi to the US you know. At any rate we are really talking about what effect any excess capacity that exist right now is having on the price of oil and price volatility.

But let me put it a bit different. If there is excess capacity because the market is already flooded with oil, then prices will be low along with volatility. Then if the supply gets tight and any excess capacity disappears then both price and volatility goes up. Then prices get so high that demand destruction sets in and prices begin to fall. Now at this point OPEC decides to take oil off the market, creating some excess capacity, this will neither decrease the price of oil or the volatility. Imagine if it did. Then what would be the purpose of taking the oil off the market if it only resulted in the decrease of the price of oil. Then it would only be counterproductive.

Ron Patterson

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ggg71 on February 8, 2007 - 9:43pm Permalink | Subthread | Parent | Comments top

I disagree.

When OPEC takes oil off the market due to falling prices, it does not decrease the price (in fact it supports it), but it certainly does have the effect of decreasing volatility. Instead of excess supply causing the price to crash, the decreased supply puts pressures on inventories causing the price to stabilize. How can you not see this as decreased volatility?

That excess capacity can then be used to reduce volatility when prices are surging higher.

Garth

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Darwinian on February 8, 2007 - 11:35pm Permalink | Subthread | Parent | Comments top

Garth, as Simmons says, data trumps all theories. Check the the volitity since OPEC says they started the cuts on November 1st. There has been no decrease in volatility. The price swings have been just as great the last two months as they were the previous months. As this chart shows, the weekly price swings have been just as great as any time in the last two years. In fact they have been very volatile in the last five weeks. But of course this does not tell the whole story as it only shows weekly swings. The daily swings and interday swings have been just as great.

http://futures.tradingcharts.com/chart/CO/W

The daily price swings have been just as volatile. However I don't claim that this excess capacity, if they really have any, actually reduces volatility. I don't think it has any effect whatsoever. But other factors have certanily increased the volatility in the last two months.

Volatility is the severe swings in the price of the near term contract on the NYMEX. Traders on the floor, as well as hedge fund traders, do not consider how much excess capacity OPEC may or may not have when they trade. The life of a NYMEX crude oil contract is currently less than one day. Last summer it was almost two days. That tells me that volatility is definitely increasing. (The volume of trades on the near term contract is greater than the open interest. This means that there are more trades in one day than contracts open. today open interest was 277,556 while there were 335,594 trades made today on the near term contract.)

Check the volume on the weekly contract above. Weekly charts are composite charts reflecting the near term price of every month and do not reflect only the near term contract as the daily chart does. (Simply put, the volume shown on the weekly and monthly charts reflect all contracts while the daily charts reflect only the volume of the contract being plotted, usually the near term contract.) Therefore the volume you see is the total volume for that day. You will see that volume has dramatically increased since Christmas. It was down Christmas week and New Years week for obvious reasons. And there were only three trading days during New Years week. But you will notice the volume last summer was about half what it is now. Volume is increasing, contract life is shorter and price swings are greater. Volatility is also increasing, in my opinion anyway but any excess capacity in OPEC nations, does not in my opinion even enter the picture.

http://futures.tradingcharts.com/marketquotes/quickquote.php3?sel=Crude+Oil

Ron Patterson

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Freddy Hutter on February 9, 2007 - 1:45am Permalink | Subthread | Parent | Comments top

Of course Garth is correct. Normally your reasoning would be right ron looking at the data as u have; but u have neglected to factor in the large Demand Call that i have been warning about for many weeks. Q1 is a record 86.2-mbd Call. The stabilization in volatilty that should have happened could not cuz surplus inventory was exhausted in January.

Q2 was scheduled to be a very light qtr. of 84-mbd Call. But there are reports that the lower prices in january created lotsa orders. We'll know better shortly.

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Calorie on February 8, 2007 - 5:44pm Permalink | Subthread | Parent | Comments top

Ron,

I assume you are aware that Deffeyes predicts increased price volatility as excess capacity is squeezed out of the production system? I believe I first read this in Beyond Oil, although I don't have my copy handy. Here's what he said about it in an interview I found that's about two years old:

http://www.energybulletin.net/4483.html

Michael Duffy: Ken, can I just change the subject slightly here—if you’re right and oil does run out this year or next year, whenever—what are the biggest problems that you predict will happen?

Kenneth Deffeyes: Well, it’s not oil running out, it’s just that the growth in oil production stops, and as we go over the top of the curve we don’t have any growth for a while and then it starts to go down. But the kinds of things that I am predicting are increased volatility in price because when the demand on the system approaches the capacity of the system little things mean a lot; a SARS scare that cuts back on air transport, an unusually warm winter in the American northeast will cut back on the demand for oil and the price falls much more than just that change in demand. On the other hand, an abnormally cold winter and suddenly the price shoots up. So two years ago, three years ago, over one week the price of natural gas here in the northeast of the United States doubled over one weekend, the price doubled. So we’re going to see very large volatility. My sarcastic line about that is that OPEC can no longer control the price of oil. So the good news is OPEC is not in charge of oil…the bad news is nobody’s in charge of the price of oil.

If diminishing excess capacity results in increased price volatility, then it seems reasonable to assume that increasing excess capacity results in reduced volatility.

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Darwinian on February 8, 2007 - 6:35pm Permalink | Subthread | Parent | Comments top

Calorie, thanks for the post.

When OPEC first decided to cut production last fall, some of the talking heads on CNBC said this would cause the price of oil to drop because this would increase excess capacity. Is that logical? Not in my book but it appears a lot of people are buying into that argument.

But let me put it another way. When there was plenty of oil on the market excess capacity meant little because a surplus of capacity kept prices low. The term "excess capacity" is just another way of saying "the market is fully supplied". Or countries have more oil than they can sell and are holding some of it back. This depresses prices and keeps volatility low.

On the other hand when production drops below demand, prices rise. Very high prices causes demand destruction and therefore prices drop slightly until demand and supply are in balance. So far so good.

But then OPEC cuts back on production. This supposedly increases spare capacity. Yet prices rise and volatility remains about the same and in some cases actually increases. The price of oil jumped $2.00 today because of a fire in California. Does anyone actually believe that the perceived OPEC spare capacity actually diminished that price rise today or the volatility of prices today?

Now IF OPEC had said something like; “Not to worry, we will dump an extra 120,000 barrels per day on the market to compensate for the oil taken off the market by the California fire” then that might have reduced the price rise and volatility. But that’s absurd. We know OPEC will just sit on any spare capacity they might have.

My argument is, the OPEC spare capacity, if it really exists, is not presently reducing the price or the volatility of the market.

Ron Patterson

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new account on February 8, 2007 - 5:35pm Permalink | Subthread | Parent | Comments top

Pitt: I only agreed with half of the statement and only quoted the half to which I was objecting. Me thinks Ron is having a Hothgor moment.


Cheers!

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Darwinian on February 8, 2007 - 6:13pm Permalink | Subthread | Parent | Comments top

Me thinks Ron is having a Hothgor moment.

New Account, I deeply resent that remark. My reply to you was very courtous, without any smart alec remarks whatsoever. I simply pointed out that you changed the context of my statement entirely. You could have stated, in your reply, that you disagreed only with the first half of my sentence. But your reply did not give that indication at all.

At any rate, I think that pointing out a change in context is entirely proper and should be done in all occasions when that happens. On the other hand, calling that a "Hothgor moment" was snide and sarcastic. That is how I would expect Hothgor to behave!

Ron Patterson

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new account on February 8, 2007 - 5:33pm Permalink | Subthread | Parent | Comments top

or decrease volatility unless that excess capacity is used to do so.



Didn't add this to the quoted extract as I agree with it. Excess capacity will not impact short term market volatility as the Elk Hills fire of today demonstrates.


Still disagree with you on the point quoted in the initial comment. Part of the reason for the under-investment in the oil industry in the decade of the 1990s was the fear of surplus capacity under the control of OPEC. OPEC does not have to utilize that surplus capacity, they simply have to convince other producers that they do in fact have such surplus capacity. This is the primary reason they have for not making full disclosure of their actual reserves. Everyone else is left guessing and this works to KSA advantage; nobody wants to bet against them.


The issue is one of market perception. That perception will eventually generate its own reality.

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dabble_doomer on February 8, 2007 - 11:30pm Permalink | Subthread | Parent | Comments top

So, after reading this whole thread, Im mostly left in a fog with a nasty little headache. The sparkly gem Ill take away is: '..having a Hothgar moment'

Gonna make tshits ;-)

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147 comments on DrumBeat: February 8, 2007

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