Wild Oscilations in oil prices

«OPEC is now reacting to one of these oscillations by reducing production; but the productive system has a much longer reaction time than the financial system, hence the effect will be limited. In any case, what we are seeing are short term trends superimposed to a medium/long term trend, that of a decline in production. Next year we’ll see chaotic price oscillations which, at present, cannot be predicted.»

An interview with Ugo Bardi, Italian physical chemist at the Universita di Firenze

PROFILE

Ugo Bardi, born 1952, is professor of Chemistry at the Department of Chemistry of the University of Firenze, Italy. He have been postdoc in Berkeley (California, US), Aix-Marseille (France) and New York at Stony Brook (US). He has a Ph.D. in Chemistry. He is the president and founder of ASPO Italy.

INTERVIEW

Q: After almost four years of climbing to the $145 pick, everybody was surprised with the sudden brutal downfall of the oil price to $30-40 (lowest prices so far — Brent spot last 24 Dec. at $34.04 and the WTI at $31.41 last 22 Dec.). How we can explain this huge reversal, larger than the volatility we observed in the past?

UB:”Everybody” is a little too much…

Q: I would say almost every analyst, most of them «peakists».

UB: It is true that many so called “experts” had predicted that oil would rise to $200 by the end of this year; but for those who understand the peak oil theory, it was obvious that the rise could not last for long. I said that already at the beginning of 2008 in several articles that I had published in Italian, and also in English. I stated that the climbing phase of the oil prices is the result of the economy trying to adjust to increasing costs of extraction. High prices tell to the industrial system that it is necessary to invest more and more resources into oil prospection and extraction for maintaining production at the same level. At some point, however, the system reacts by contracting its demand for oil. At this point, prices collapse, too. That causes also production to contract and is the mechanism that generates the Hubbert peak. The exact moment for the turning point couldn’t be predicted, but it was expected. We can imagine how, in the collapsing phase, everyone will start screaming that the “oil crisis” of the first decades of 21st century was just a hoax, just as it was said for the crisis of the 1970s.” See, for instance, where I said that we were heading towards a price collapse.

Q: Do you think the oil barrel price can go down further, consistently below the $40, during this recession, that most analysts consider to be severe and longer than the ‘normal’? Or the OPEC cuts will affect the global supply pressing the price for a new jump in 2009?

UB: We are entering a period of high price volatility. My models give an “equilibrium” price of the barrel around 70 dollars. It can oscillate around this value: much higher and much lower.

Q: Many OPEC countries say that $75 is the ‘fair price’ for a barrel of oil and the most recent World Bank Report expects an average annual oil price of $75-$76 in 2009 and 2010. The price for the OPEC basket of thirteen crudes stood recently (23 December 2008) at $34.49 a barrel, according to OPEC Secretariat calculations. So you have today a basket 54 per cent below the so called fair price.

UB: My point is the coming phase will be chaotic and unpredictable [regarding prices].

Q: How we can evaluate the impact of OPEC recent cuts that amount to 4.2 million barrels a day (Mbd) from September production levels? They announced at Vienna, Austria, in October, a cut of 1.5 Mbd for November and December 2008 and now (December) at Oran, Algeria, a 2.4 Mbd cut for January and February 2009. It seems also that the Russians (second largest exporter, after Saudi Arabia) and the Azeris can announce export cuts of more than 600,000 barrels a day in an eventual political coordinated movement…

UB: The present situation is expected as a medium and long term trend, although the short term trends are very difficult to predict. Despite the vagaries of prices, the cost of oil extraction has been gradually increasing over the past years. The world’s economic system is gradually adapting to the increasing cost; but it does so by “bumps” caused by the complex network of positive and negative feedbacks that link the world’s financial, political, and industrial systems. So, we see wild oscillations: price rises and collapses, financial crises, recession, etcetera. OPEC is now reacting to one of these oscillations by reducing production; but the productive system has a much longer reaction time than the financial system, hence the effect will be limited. In any case, what we are seeing are short term trends superimposed to a medium/long term trend, that of a decline in production. Next year we’ll see chaotic price oscillations which, at present, cannot be predicted.

Q: If history is a guide, what lessons we can learn from the final whale oil market in the 19thCentury, that you studied?

UB: The past is the only model we have for the future and the history of the whale oil market tells us that very strong price oscillations are to be expected after the production peak. It seems to be what we are seeing now. But we need also to consider that whale oil was not such a crucial commodity for the world’s economy as oil is today. So, we need to be cautious in interpreting the present situation on the basis of the whale oil case. But there is another element of similarity that can be missed: the reaction to the peak. Well after the peak of whale oil, whalers still couldn’t see that the reduced oil production was due to the depletion of their resource: whales. Rather, they preferred to attribute their problems to the “shyness” of whales and seek for government help. It seems that sometimes history does repeat itself.

Q: How CEOs of companies must deal with this volatility in the oil prices? How to plan in a situation so chaotic?

UB: A few years ago, a high level manager of a major oil company contacted me and he told me something like this: “I am paying a whole department of economists for predicting oil prices, and they always get it wrong; what can I do?”. It was not a fault of those poor people. The fact is that prices are very hard to predict. In general, the future cannot be predicted, but you can be prepared for it. There is an interesting story on how the oil crisis of the 1970s was predicted by Pierre Wack of Shell who used a method called “scenario planning”. With this method you are not trying to predict anything: you just build plausible scenarios and prepare for the worse one. You are never caught with your pants down. Unfortunately, people fall easily for the illusion of “predictions” that some economic models purport to do.

Q: Why you, a chemist, decided to study the whale oil history and why you follow the oil market, being the president and founder of ASPO Italy?

UB: Everyone of us has a complicated intellectual history: it is a little like surfing the internet. You start working on something that you find interesting, then from that you move to something else and soon you don’t even know how you get to a specific subject. I started working on oil because I am a physical chemist and I thought that the Hubbert model had something to do with the models describing reaction kinetics. It does. While working on the Hubbert model of oil depletion, I started looking for models of resources that went through a complete depletion cycle, worldwide. There are only a few examples for which we have good data – most are about fisheries: whales in the 19th century, but also caviar in the 20 century. And so it goes, from fisheries to where…..?

One Response to “Wild Oscilations in oil prices”

  1. December 2008 will be remembered for two significant “wild oscilations” amid intraweek and sometimes daily huge volatility. A daily record of 23,7 percent high Dec 29 and 14,3 percent high Dec 31

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