As the world ‘drowns in oil’: Analysts, once again, are churning out new ‘theories’

Caroline Baum, Today Online 30 Oct 08;

THREE months ago, the world was running out of oil. Remember? Everywhere you turned, you heard whispers that the day of petroleum reckoning was at hand.

Now there’s too much oil, prodding the Organization of the Petroleum Exporting Countries (Opec) oil cartel to cut production targets for the first time in two years. Last week, Opec, confronted with the halving of oil prices since July, announced a 1.5 million barrel-a-day cut in output.

World markets greeted the news of reduced oil supply by pushing prices down further. Crude oil fell US$3.69 a barrel on Friday to US$64.15. Yesterday, oil dropped another 93 cents to US$63.22, a 17-month low.

How quickly things change. Or do they?

All speculative bubbles have a kernel of truth behind them to justify their existence. This time, it was China and India. These emerging Asian giants were gobbling up all the commodities the world could produce to fuel their rapid industrialisation.

It wasn’t that the story was untrue; it was old. Growing global demand probably was the reason for the gradual rise in oil prices from US$20 a barrel to US$40 earlier in the decade, and even to US$60 by mid-2005.

It was the moon shot to US$147 that took on a life of its own. Emerging nations didn’t start gobbling up crude, coal and copper all of a sudden in the middle of 2007.

Yet, analysts on TV and in print told us with straight faces that the doubling in oil prices from July 2007 to July 2008 was a result of fundamental demand, not speculative buying or investors, including pension funds, “diversifying” into “alternative investments” in search of “uncorrelated returns”. (It sounds a lot better than admitting you got suckered into buying what was going up and are now stuck with a pile of stuff that no one wants.)

By the early ’80s, following two oil shocks in the previous decade, the running crude commentary went something like this: Oil prices couldn’t go down because they were controlled by a cartel (Opec). Banks extended credit based on — you guessed it — a belief that the underlying asset couldn’t go down.

When prices plunged to about US$11 a barrel in 1986, that myth went down with them.

The spike in crude oil earlier this year had the support of the popular theory of “peak oil”. In a 2005 book Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy, investment banker Matthew Simmons argued that oil production by Saudi Arabia, the world’s largest producer, was likely to decline.

Just a few years before the peak-oil theory was hot, the world was “Drowning in Oil” according to the Economist magazine’s March 6, 1999, cover story. Oil was trading at US$13.50 a barrel at the time. “We may be heading for US$5,” the Economist predicted. “Consumers everywhere will rejoice at the prospect of cheap, plentiful oil for the foreseeable future.”

The silliness that accompanies speculative bubbles isn’t to be outdone by what passes for economic analysis. It’s just over three months since commodities began their sharp, swift descent, and already the nonsense is starting: Lower oil prices are going to boost consumer demand.

Whoa! The price of oil (and other raw materials) is falling because of a cutback in demand, both actual and expected.

To say that lower prices will stimulate demand confuses a movement along the demand curve (lower price, higher quantity) with a shift back in the curve (lower price, lower quantity).

Why this is such a hard concept to understand, I’m not sure. People imbue oil prices with all kinds of mystical powers. They see a falling price and treat it as a cause, not an effect.

That oil prices are falling in the face of Opec’s announced production cuts — a reduction in supply would tend to raise the price, not lower it — suggests that demand is falling even faster than Opec can reduce supply.

That won’t boost demand, but who knows? Maybe it will help recapitalise the banks!

The writer is a BloombergNews columnist. The opinions expressed are her own.