Oil: Less Speculation, $200/bbl, Risk Premium, and Sources.

In my previous entry "Drill Here. Drill Now. Pay Less." More Conservative Bullshit., I discussed some of the basic memes that are out there about our current relationship with petrochemicals, including the idea that speculation was at the root of the current price shock, whether the price shock is directly related to "liberal politicians" (as Newt Gingrich has suggested), oil and food, oil supply and demand, and alternatives.

Because I have a family history in the 'awl bidness' and a couple of groups I'm involved with, and because any rational person wants to understand why the world is the way it is, I try to keep up with current ideas and trends in the petrochemical world and how they effect the rest of the world.

Here are a few of the sources I read. If you are interested in what's happening, you should read them too:

Dedicated Oil Sources
The Oil Drum: Discussions about Energy and Our Future
Royal Dutch Shell plc.com
Vancouver Peak Oil Executive

Generalized Economics Sources
Paul Krugman
Brad Delong
Marginal Revolution
Paul Kedrosky

What's Changed Recently?
One thing that has changed is that the generalized economics blogosphere appears to be coming down even harder against the idea that oil is a bubble or that speculation is responsible for much of the price shock. Part of that is because "a bubble" is very poorly defined (and usually after the fact) and that "speculation" is so incredibly vague as to be almost meaningless. Technically, anyone who buys a stock or currency or any commodity in order to make money selling it later is a speculator.

Another thing that has changed is that the meme of $200/bbl oil seems to be gaining traction. A quick Google turns up more than 12 million hits. Goldman Sachs suggested the idea in March, but there were other* mentions before that. Now the conversations are happening everywhere. Deutsche Bank is warning that $200 oil would "break the back of the global economy". Call options on oil at $200 (December) are up almost 40% since the end of April.

Risk Premium
And a third thing is the risk premium. Risk premium is the amount of the price of oil attributable to various risks around the world. For our purposes, the risk premium is the rise in oil price attributable to the possibility of disruption in oil supply.

We know from previous experience that world events can have significant impacts upon oil prices. The first Gulf War was associated with nearly a doubling of oil prices. The Iranian revolution and accompanying OPEC price increase raised oil prices 20%. The 1973 embargo raised prices 187%, according to the EIA.

Several major possibilities are in the front of people's minds: Nigeria, Iran, Russia.

In Nigeria, MEND has successfully attacked (for the first time) one of the distant offshore platforms. They've also cut pipelines onshore, cutting off 120K bpd. Nigeria supplies about 2400K bpd, so that is only .5%, but the capability begins to worry one.

Iran supplies about 4100K bpd. If the US military becomes more active there, everyone expects at least part of that supply to be cut off (as a significant amount of Iraq's oil extraction capacity has been off the market since the US invasion).

Russia is the second largest extracter of oil after Saudi Arabia at almost 9700K bpd. Their extraction is declining and they are showing signs of resource nationalism, especially in natural gas.

The way risk premiums work is that each oil buyer (consciously or unconsciously) calculates an expected value (EV) for oil in the future. They incorporate their beliefs about the likelihood of a disruption event and the resulting price into that EV, and that informs the price they are willing to pay for an oil futures contract. Various sources suggest that the risk premium right now is between $20 and $50 per barrel, or between 14% and 35% of the price.

Of these, I consider the Iran scenario to be the most worrisome because of volume, but the Nigeria scenario most likely and overall, scariest. In fact, I fear that MEND is showing others how to make significant strikes against the developed nations by disrupting oil supplies. The map at the top of the post links to a dynamic map at NewScientist. Click around. Look at the "Oil pinch points" portion and the Straits of Hormuz and Malacca. It's easy to see Iran disrupting travel through Hormuz, which is only 21 miles wide. Malacca is perhaps of more concern. At 500 miles long, Malacca narrows to only 1.5 nautical miles wide and portions are only 82 feet deep -- shallow enough that some supertankers must use other passages. Despite that, roughly 1/4 of world oil travels through Malacca. In 2003, 1/3 of global piracy attacks were in the strait of Malacca (I note that Wikipedia is not the greatest source).

I can easily see effective disruption of oil transport happening in either Hormuz or Malacca. If 1/4 of world extraction were to be destroyed, embargoed, or even just threatened for a few days, there could be a price spike the likes of which the world has never seen. Sam Bodman, US energy secretary, has indicated that every 1% rise in oil demand means a 20% rise in price. Taking 25% of supply out of the equation would (by his numbers) raise the price of a barrel of oil 500%, or to about $700. I don't see it being quite that bad, but I can easily see a doubling to $280 or even $300. And I have no doubt that re-routing would happen quickly to drop prices back, and that the US Navy would be patrolling the Strait as soon as possible.

But for a few days, we'd find out what Peak Oil really means.

So that's the news. Nothing** suggests that prices are going to drop anytime soon. Conventional wisdom is against it, which may be the only argument for lower prices :-). If political worries smooth over (which seems unlikely while Bush is in office or if McCain is elected), we could see the risk premium drop. That might get us back to $100 oil, but I doubt any better than that. IMO, the most effective weapon we have against high oil prices right now is diplomacy, and I mean that in the archaic sense of talking, not the neocon sense of preparing to attack.


* Yes, I consider that link a joke.

** Actually, I just read one thing. Gasoline usage is dropping in the US, and as a result, oil stocks are rising (that is, the amount of oil stored). We had a bit of a dip in prices last week as a result before they shot back up again. We've seen the basic scenario before: oil price shock lowers economic output, which lowers oil demand, which reduces oil price. But with multiple growing economies in the world demanding oil, it's going to be harder to make this scenario work this time.

Disclosure: I am passively invested in the extraction side of petrochemicals. I do not own stock in or have any active (decision-making) relationship with any company mentioned in the post.

[Updated: 2008.07.01 14:03 PDT to add final ** paragraph about reduced demand in the US possibly lowering prices.]