Saturday, June 28, 2008

Can we drill our way out?

There is a lot of talk among pundits (both political and business) that say we have to conserve to get prices down. Others say we have to drill. Others yet that we need to do both. I have heard a lot of people say "We can't drill our way out of this problem!". They say it emphatically and with complete certainty. Others, and these people show an even greater misunderstanding of commodity markets, say the whole problem is future's traders (speculators if you will) and the artificial bubble they have created. Others demand the bulk of the problem is the falling dollar. Oil is traded in dollars, ergo it has to go up. Ask them a question that actually has to do with the answer and they are stumped?

  • do we have a world surplus or shortage of oil supplies?
  • how much reserves do we have and how does that compare to the world supply?
  • how does the future's market work?
  • is the cost of a barrel of oil going up in Pounds Sterling? Yen?
  • is US demand rising or falling? quickly or slowly?
  • if we could make 100mpg cars today how long before we convert the US fleet?
  • if we could magically move there today would it change the pricing trend?
  • does ethanol production from corn increase or decrease our oil consumption?
The world oil market is incredibly complex but the basics are simple. Yes, there is an artificial bubble caused by futures trading. Yes, the dollar is falling. Yes, worldwide conservation would help and we are a major consumer so we could help more than most other countries.

But, let us have some fun with math, shall we?

I went and got some data on 2003-2007. I normalized the data for you for graphing purposes and trend analysis so the graphs are not absolute. Absolute numbers are important to detailed analysis but normalized numbers work better for spotting trends. The first graph is hard to make heads or tails of because it is too busy but here you go. Let's compare price, US demand, Chinese demand, World Supply, World Demand, and World Shortage.

Not very interesting, so let's clean it up a bit. If our consumption is the cause, then price should correlate with our consumption. This seems elementary. US demand multiplied by 4 to get the curves in the same data range.

Hmmm. No correlation there. US demand is pretty flat, rising slightly but nowhere near the price. At times our demand was falling while price was rising and vice versa. How about we look at world demand?

That is interesting. Still not an absolute correlation but closer than anything we have seen so far. Since supply is falling in the US and rising only slightly worldwide maybe the cause is purely world demand increase? WARNING: Remember kids, correlation does not necessarily imply causation, we are just looking for correlations here. Then we have to go back and see if there is a causation at work.

Next let's look at worldwide shortage (demand - supply) and compare that to cost. In a purely open market these two things should correlate perfectly. If there is a shortage prices go up and a surplus prices go down.

UGLY! There is a nice correlation in 2007 but not so much for 2003-2006. So, we know we don't have a pure market (those of us with a clue knew that before we saw the graph). What else might be interesting to look at? I know, let's compare price to China's demand.

Well, buckle my britches! How in the world does China's demand correlate so cleanly with price? Is there direct causation there? China consumes less than 10% of the world oil demand. We consume almost 3 times what they do (4th quarter 2007 actuals: China 7.87, US 20.68, total world demand 86.62, all in millions bbl/day).

Answer: China's demand is growing rapidly. So is India's (I would have given you that graph but I couldn't find good raw data). The rest of the world cannot possibly reduce our consumption fast enough to make up the difference so the prediction is that without significant increases in supply the shortage is going to get much worse.

To put a big exclamation point on it for you let's look at 2003 actuals (China 5.58, US 20.03, total 79.61). So in 4 years our demand has increased by a little over half a million bbl/day. In that same time China has increased by over 2 million bbl/day. In that time world demand has increased by 6 million bbl/day. And, by the way, in that same time production has increased by less than 5 million bbl/day. Demand rising faster than supply triggers futures traders to drive up futures prices to stimulate more production. That is how the system is SUPPOSED to work.

The speculators are driving up a bubble. This is true. That bubble is based on a prediction that these trend lines continue. There are a billion Chinese and a billion Indians who are industrializing. I don't think we are going to get their oil consumption to fall. We may not be able "to drill our way out of it" if by "out of it" you mean $1/gal gas ever again. But folks, if we don't start drilling it is going to get much, much, much worse.

As far as we know the US has the largest reserves in the world. Many, like ANWR, the Dakotas and the shale deposits in the Rockies are labeled as "unproven". That is because the government won't let the oil companies go prove them. Turn those three spigots on and the assumption on the futures market would be that the trend line won't continue and price relief will start. Once the oil comes available the price problems would abate.

And yes, the falling dollar is a problem, and yes, we should continue to look for things like hydrogen cars and nuclear power to lower our consumption. All I am saying is that we will not get out of this headlock by conservation in the US or the US and Europe alone. The numbers totally obliterate that assumption. We would be able to greatly ease the problem in short order by starting to Drill Here, Drill Now!


* sources DOE Price and DOE Oil Markets

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