october's price (wti monthly) was down by a factor of 1.75 from july's peak.

kevin,

There was a lot of debate back when prices peaked as to the effect of speculators in the futures market. In particular was the supposed effect of the credit crunch forcing many of those players to liquidate their positions in a rather rushed manner and thus crushed the price support. The price swings we've seen seem to support that theory IMO. Following that the thought, the futures market should swing back to a more reality based flow. Add the potential OPEC production cuts and we could see a significant rise in prices in 2 or 3 months. I've seen it speculated eslewhere that such an expectatioin is being seen in longer term future contracts.

As I've been saying since the summer, there doesn't have to be a good reason for a price decline if it follows a run-up that also wasn't supportable on simple supply/demand changes.

The current price is below what I think it "should" be at this level of supply/demand (which doesn't mean that it can't/won't go lower - it very possibly will), but it isn't unusual to overshoot to the downside if prices previously overshot to the upside.

It's important to remember that oil is traded on the world market. What happens in the U.S. does not determine the world price since it's relatively easy to ship oil from one market to another. Given that the U.S. has been a wealthy nation lately, we have been able to pay the higher prices to purchase the oil we want. Other nations are not so fortunate, so one must consider the change in total world demand. Also, the production of oil can not be rapidly decreased (or increased), as the wells are drilled and the borrowing to do so must be repaid. The producers continue to pump and the last barrels pumped can't be sold when supply exceeds demand, so the price drops. The reverse happens when demand exceeds supply, as may have happened during last summer's price spike.

E. Swanson

There are as many theories as there are analysts. I am not convinced that anyone really knows and have given up worrying about it. There was an article in energy bulletin the other day that made a pretty convincing case that no one really understands what is going on. If someone really does understand and I were convinced they did, I would pay close attention to them and make a ton of money in the process. In the mean time, I am sticking to the theory that prices will rebound; I just don't know when. Buy and hold.

It's not just a 4% reduction in demand. The decline in oil prices represents an "unknown" future decline in demand in addition to the 4%.

6 months ago, it was assumed the demand would be higher in 2009. Now we know it is not going to be as high. No matter what happens, that is a certainty. Much industrial capacity is already scheduled to be taken offline, so we know for sure that we wont need as much oil. The degree of certainty that there will be oversupply is what drives the price down.

Go back in time 10 years and look at oil supply and demand. It was a similar situation, except now the potential demand destruction is greater. $5 a barrel isnt out of the question. That probably wont happen until after the next round of destructive "economic stimulus", Obama style. (Note it was the last stimulus that drove oil to $147.)

Kevin,
The theory is the amount of excess supply determines the price. If there is not enough oil to go around, suddenly the price takes huge leaps upwards, but with just a small decrease in demand (i.e. enough for everyone again) the price drops precipitously.

I am not an economist but supposedly this is well known. Can anyone out there explain it better?

1)we are looking at Feb 09 contract right now - I suspect that when Feb numbers are released there will be a much greater drop YoY than 4%.

2)The concept of price elasticity only works to a point on a non-storable commodity like oil (i.e. storable but with small limits). If storage is full, and even for a few weeks/months time demand is lower than supply, then price has to drop beyond where it would be in a 'normally' functioning economy. Lots of people think oil is cheap, but lots of people also think its going to $10. Watch distillate demand and the shipping indexes (which have really crashed). If those perk up, then oil prices will too- if not then it could be a long wait for demand drop to outpace decline rates, though the recent cuts may start to bite in a month or two.

3)While all commodities have plunged since July (not Gold but the rest), I suspect grains and NG will bounce before oil. Reduction in capital investments in oil and it's substitutes take years to be felt, whereas drops in rig rates will have impact in same year for Nat Gas (though rig plunge is still ahead of us - we are as yet only down about 350 rigs from 1600+ peak). For grains, drops in purchases of seeds or fertilizer will be felt within 6 months, as the entire crop comes to market each year. All of these commodities (except for gold, which is a perceived inflationary/crisis hedge), have built in negative feedback loops - its just a question of how fast the negative feedback occurs. With oil, it will likely be on the slow side - e.g. we might have a 10% YoY drop in crude supply and still have low prices.

All this volatility is like a sonic shock wave with differing amplitude each iteration- low prices inhibit production meaning less product next time around. As events progress, the timing intervals between lows and high prices are going to get shorter and shorter. There is a (meaningful) chance that the July 2008 all time peak in production may also prove to be the all time high in price. I would roughly guess that there is a 30% chance of NO new higher high/energy investment cycles and this is start of permanent great depression - e.g. when fundamentals again support $148 oil, no economic social democracy in the world will be able to afford it and nationalization, stoppage of futures trading, etc. will have occurred along the way. I think a 60% chance that there is one more 'energy bull market' run, where the economy partially reloads, and oil demand outstrips supply and we have significantly higher world prices, for a time. Finally, I put at 10% chance there are TWO more of these cycles left, albeit shorter in length both within and between. In any case, as the amplitude gets narrower each time, there will be fewer (public and national) energy companies making money, as receding horizons on energy costs loom closer.

What to do? Depends if you are an individual or a government.

If you think about it, ALL of us spend our lives trying to get enough abstract wealth to turn it into real wealth when we retire (land, vacation home, books, time with friends, nature hikes, garden, etc.) This energy crisis will just accelerate the timing of this mass 'investment re-allocation' from financial to real capital. My 30/60/10 distribution is just suggestive that though there are still a great deal of variables in play, there is a non-zero chance you may not have years ahead to capitalize on energy investments and transfer dollars into real capital.

From policy perspective, big, bold, and painful decisions need to be made now, to emphasize energy and basic goods over throwing good money (and resources) after dead-end endeavors.

The oil producers are not just selling the oil that they produced today but are also selling the oil they pumped yesterday and didn't sell.

And once their storage is full they have to shut down wells and lay off people, which means they sell less oil etc........

So the price goes lower, and lower

Ed

I have several written articles on the subject of the big oil-price drop relative to the drop in demand. The current financial issues (including collapse of credit) seem to be playing a significant role in the situation. Those making comments to my articles also have some interesting insights.

See:

Why are Gasoline (and Oil) Prices So Low, and Where Are They Headed Dec. 8, 2008

Impact of the Credit Crisis on the Energy Industry - Where Are We Now? Dec. 1, 2008

Oil Prices, a Little More of the Story Oct. 27, 2008

Why Are Oil and Gasoline Prices So Low Oct. 22, 2008

US is 'only' 1/4 of world market, so 4% US decline is 1% world decline. However, china also sharply cut oil imports just as the olympics began having previously stocked a substantial amount to assure no shortages during their coming out party. Perhaps world demand declined 2%, mostly on account of high prices.

However, opec has been producing all they could since 2004, resulting in a production increase this year of around 1.5%, boosting world production to a record this summer. So the combination of new supplies plus declining demand was around 3-4%.

This is a very large and relatively sudden change in direction of the supply/demand tug of war, reversing the 2003-2008 environment. Western stocks rebounded, refiners had to curtail deliveries. Then a one-time event occurred - hedge funds, facing redemptions, had to cut their commodity holdings. However, this effect is either over or nearly so.

IMO we are now moving into a new era, one where opec is once again in control, surprising many at tod, including me. I thought opec was a spent force, unable to pump enough to maintain prices under three figures... however, their announced cuts are nearly 5% of all liquids, an amount that is more than sufficient to raise prices back to 100, except that cheating has, so far, prevented about half the cuts from being implemented. However, the various countries seem to be becoming more serious, more are announcing compliance daily. Meanwhile, low prices are stoking demand, suv's are once again selling well as of this month and overall driving is rising. IMO opec will cut enough to bring prices at least to saudi desired 75/b level by mid-year, maybe sooner.

Those who think that oil usage must be curtailed will naturally cheer opec cuts and the higher prices they bring. Better, of course, to tax ourselves, but we don't have the political will or popular support for such a policy. OPEC is also useful for investors, note that oil is the only commodity with a relatively effective cartel. Oil price has occasionally dipped during this century's runup in price, and each time was an extremely good entry point for investors. And we are coming closer to the permanent decline, indeed we might never really recover from the opec cuts.

Kevin, I've had the same thoughts, but think of it this way. When there is no extra capacity in the system, people bid up the price and there really is no limit to the upside. But as soon as there's extra capacity, and quite a bit of it, the price will drop to soak that extra capacity up. We have tons of extra capacity now, and that's the reason the price is low.
Philip Arnason