Yesterday I wrote a response to an opinion article in the Wall Street Journal regarding $100 oil. Later in the day, one of our readers, AaronH, made some good points in a comment. Here is an excerpt of what Aaron pointed out:
“I have to disagree with the above strongly. Price here is not due to speculation. In commodities markets, supply and demand exist in relative terms instead of linear. In other words, consider rates of change, not absolute quantities in linear terms. ”
 Clearly Aaron is referring to the fact that commodities markets take into account the rate of production compared to the rate of consumption. This is true and is often the leading cause of speculation. As different events conspire in the market for oil the price will fluctuate as investors speculate about whether production can keep up with demand – as a side note, this is in line with basic micro-economic concepts of supply and demand.Â
However, as the post from yesterday explains, on a long-term basis the price of oil is unlikely to remain high (though it may rise yet further in the short-term due to speculation and supply issues) since we will likely never run out. Eventually the demand for oil will decrease leading to a decrease in price. I suspect this decrease in demand will come before the tipping point referred to as “Peak Oil” arrives. As a result, it seems that the truly long term investor should not be advised to go after the oil market due to the high amount of speculation involved and the likelihood of the price dropping in the future.
Saying I disagree strongly was a little too strong, but it does spark lively debate which is always fun. We may have already reached peak oil production. Does this create a speculative rush in oil and gas?
Consider the fact that most oil companies have moved to a development rather than exploration focus. However outsized oil prices could also be a result of the fact that nationalized oil companies can afford to pay inflated pries for oil leases. It could also be that developing nations like China subsidize gas purchases. It could be that the world is flush with so many US dollars their ensuing decline in value has required more to purchase an equivalent barrel of oil. In that case, the true value of a barrel of oil should be a wash. The bottom line is that it does not matter, and we do not have enough data to be sure.
Whilst I do not believe that the recent price of oil is due to a speculation boom, the recent price spikes could produce a speculation boom. Further, current prices are relatively accurate considering recent bursts in economic expansion.
In my opinion though, the speculative boom has been in China, which has been fueled by government subsidies of commodities and exchange rate fixes with the US dollar to encourage foreign purchases at artificial and subsidized prices. The speculation already took place years ago in a country that has never guaranteed property rights (the necessary ingredient for long term capitalist growth). So the issue here: Was it smart to pour billions of dollars in investment capital into a country that has historically not guaranteed property rights because “billions†or people guarantee future markets? Let’s not forget it’s these same billions in China and India that guaranteed a lack of investment the last 100 years. History has shown that political winds due to market shocks can change the political landscape that makes these economic booms occur rather quickly. The insteance are numerous to mention here. Since political risk is difficult to measure, I don’t believe there is much intrinsic value in investing in these nations yet.
On the demand side like you suggest, it is almost certain that creative destruction will lead to new technologies that will reduce demand for oil and gas. So will economies of scale. Whether this happens before or after peak oil is of no consequence.
Cheers,
AaronH