Oil prices jumped in September and early October of this year (2018), but have dropped $20 a barrel in the last few weeks. The sharp turnaround is attributed to OPEC’s inability to cut supply, but this is old-fashioned thinking. OPEC’s power is a small fraction of what it was in the 1970’s. What’s happening now is wild swings in thinking about the future.
Oil prices have to balance supply and demand, of course, but not necessarily today’s supply and today’s demand. Commodities traders can hold inventories in storage tanks if they think that prices will be higher in a few months, and producers can run wells at lower pumping volumes. (There are limits to flexibility in pumping volumes, though, based on the technical characteristics of each well.)
When traders and producers expect falling prices, they can sell quickly from storage tanks and push their wells to maximum flow to capture today’s prices.
Expectations of future supply and demand play a large role in current prices. And demand, in particular, is a bigger mover.
Future supply from wells (as opposed to supply from inventory) is fairly stable. That is, knowing the reserves currently being tapped explains most of production. Fracking activity can be dialed up or down, causing a short-term increase or decrease in supply, but within narrow limits.
Higher oil prices will induce greater exploration and development of new oil fields, but that takes about a decade. (Time frames are variable, of course, but ten years is a good rule of thumb for bringing new production online.)
Future demand, though, is highly variable. Routine variation in the world economy can cause demand over the next decade to rise or fall three percentage. Throw in the possibility of a global recession and potential drop in demand is even greater.
Today’s buyers and sellers of oil are looking out over the next decade, estimating future demand and supply. A small change in expectations about the future can translate into a major change in future supply-demand balance, which in turn translates into large price changes.
