Incite -- (v) 1: give an incentive; 2: provoke or stir up; "incite a riot"; 3: urge on; cause to act
Tuesday, June 22, 2004

Written by: Speculator

I tire of hearing about $50, $60, $100 oil.

First, some facts (all '03 figures):
1. In a given day, the world consumes 78.1 million barrels of crude oil (mbpd).
2. Iraq's current production is around 2 mbpd, and it is widely assumed that Iraq is currently producing near their capacity. (Here and henceforth on, by capacity I mean working capacity.)
3. Saudi Arabia currently produces 9.8 mbpd, and it is widely assumed that SA produces around 60% of their daily capacity. This is to say SA currently has existing infrastructure in place that would allow them to pump around 16 mbpd at full-bore. It is assumed that SA could achieve 80% of their capacity, or 3.3 additional mbpd, within 5 days. (The constraint on day 5 would be dock space at the ports, not wells or pipes.)
4. The US currently produces 7.5 mbpd, and it is widely assumed that the US produces within 5% of full capacity. Before I forget, this makes the US the world's third largest producer, behind Russia and SA. Russia only overtook the US in 2001.
Michael Ledeen of the National Review made his case for the potential for $60 oil today, essentially pontificating on the power of saboteurs to shock the global oil market. He also goes into potential motives, but that is for another post.

Let's take a look at this. First, let's establish that world markets of all types, equities, debt, but especially commodities, respond to price signals. They respond quite efficiently in fact. This is the primary reason that crude oil has such a difficult time maintaining prices above $40/bbl. The reason is simple: there are enough suppliers in the global crude markets who are compelled to introduce incremental supply when prices exceed certain thresholds. There are two reasons for this: 1) profit, and 2) the sustenance of historically elevated prices will induce additional monies to be earmarked for the development of new crude oil production, something a country like Saudi Arabia would like to avoid. (They rather like their powerful presence, and it is thought that countries like Russia have only begun to understand the tip of their oil-reserve iceberg.)

Second, we need to establish a brief idea of pricing behavior. Most commodities experience a "pricing-at-the-margin" phenomena. As supply is interrupted, prices generally respond to a level where the next marginal unit can be sourced. This process is not instantaneous and is subject to other conditions, such as speculative pressures and risk premia, but in general holds.

Ledeen suggests that the arresting of Iraq's 2 mbpd would cause prices to surge, and maintain, $22 above today's price. Restated, there are a host of merry-andrews out there who ejaculate that the sudden absence of 2.5% of the world's supply would cause prices to achieve 160% of their current levels. There are two reasons this will not, under any circumstances, at all, ever, happen: 1) response to price signals, and 2) pricing-at-the margin. Saudi Arabia alone, not to mention the spare capacity elsewhere, can and is interested in responding to an Iraqi supply outage.

Quite simply, saboteurs can spend the next decade field testing advances in ordinance and its delivery on the pipelines in Iraq, and it will be of little long-term consequence to the global crude market. It is high time someone with a greater dissemination machine than a third-tier blog refuted these asinine claims.

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