I previously examined the interface between peaking oil supplies and oil price volatility as a predator-prey system. With the rapid drop in oil prices, it’s time to add another wrinkle to that story: widespread acceptance (psychosis?) about the stability of high oil prices acted as a damper on oil price volatility. Now that a collapse in oil prices is more than a mere theory, oil markets are poised for a long-term increase in price volatility.

The fundamental problem facing oil markets at present it this: while present supplies are sufficient to meet present weak demand, these sources of production face rapid decline. The current low oil prices are not sufficient to support the long term investment in future supplies, conservation, and consumption efficiency that will be necessary to mitigate the impact of this decline. Because of the time-lag between a sufficient price signal and oil reaching the market (or demand being reduced), and because of the impact of the recent price collapse on producer psychology, volatility will rapidly incrase as the market's price signal must make increasingly exaggerated moves to bring supply and demand into equillibrium.

This is a guest post by Robert Smithson, a portfolio manager at a London based investment fund.

This is part one of a two part article on the economics of oil price demand. The second part looks at the economics of peak oil, and how the oil fits into an overall energy demand curve.

Introduction

“The world is consuming more oil than it is producing.” --The Economist, July 14-20 print edition.

Wow, that’s a shockingly foolish statement. Each day approximately 84 million barrels of oil are extracted from the earth, and approximately the same amount is consumed. It can be no other way: inventory space is limited, and could not be extended significantly by “excess production” or indeed drawn down for long by “excess demand”.

The problem is a basic lack of understanding of economics. And The Economist is hardly the only culprit.