Price Determines Demand (and Supply)

[William Edwards + 708]

I am new to Oilprice.com. But I am not new to the oil business. I personally experienced much of the industry history that most of you have learned by reading. Incidentally, most historical descriptions are filled with errors. In many cases the errors result from the author presenting the common wisdom and following that, he has tried to match that recitation with historical facts. The accuracy of history usually suffers.

A similar inaccuracy results from attempts to fit historical data to commonly-accepted pricing ideas. Usually the result is to ignore historical facts by beginning history five or ten years ago, rather than the appropriate 150+ years. This article is my attempt to set the record straight on one important element of industry assessments, namely the price setting sequence. The price comes first, followed by demand and its numeric equal, supply.Being the lazy person that I am, rather than re-writing my assessment, I have copied the description that I posted in OilPro a few years back, as we entered the demise of the previous price bubble. The additional four years of elapsed time with its additional confirming data have not altered the assessment, since if is soundly based and should have perpetual value. I hope that the readers find this analysis beneficial.

Understanding Oil Demand and Price

As we continue our quest to replace fiction with fact, we now turn to the subject of demand and price. Most of the participants in the oil business have succumbed to the simplistic explanation that “High prices are evidence of strong demand”. Therefore most efforts of price forecasting begin with a demand forecast. Although it is counterintuitive, this results in forecasts of, simultaneously, high prices and high demand. Such forecasts are common as evidenced by the EIA, the IEA and most major oil companies’ forecasts. But if anyone is asked “Will people buy more oil at a higher price or a lower price, reason always answers “You will buy more at the lower price, Silly!”. Oil industry forecasts say differently. Then which is it? The fact, as substantiated by history and reason, is that higher prices create lower demand.

What is the underlying factor that has allowed most people to adopt the wrong sense of the demand/price relationship? The answer is the lag time between demand’s occurrence and the knowledge of its quantitative measure. While we know prices instantly, knowledge of demand figures take a year or so for us to have the demand number. In the absence of data the knee-jerk assumption is that demand must have been high in order to create the high price. This idea will have been firmly adopted long before demand numbers are available and almost no one looks back at the data to confirm or deny that assumption. The following chart gives us that historical information.

In the time periods when prices were above $80/B, 1979-1985 and 2008-2013, we had growth rates of less than 1% and in some years we had negative growth rates. Hardly a period of strong demand. Looking at the other side of the coin, that is, the period when growth rates were high, in other words, times of high demand; between 1947 and 1970 we had growth rates of 6-12% with prices of $10/B in today’s dollars. These facts prove that high demand is not the cause of high prices.

This then leaves us with the question ”If demand does not set the price, what does?” The uncomfortable, but accurate answer is “Price is an independent variable which is set by the marginal producer.” Whether that marginal producer sets the price overtly or by acquiescence, that is still the price setting mechanism.

In today’s world, the marginal producer is Saudi Arabia. The floor price of crude is the price that the Saudis  are willing to accept for their  sales. If they accept the futures price, then that will be the price of oil. If they, instead, select a number — any number — and abide by it, then that will be the price of oil. The real takeaway from this situation is that if producers around the world want a good price for their production, they will do whatever is necessary to convince Saudi Arabia to set a good price and stick with it. Non-Saudi producers should beg, plead, negotiate, educate, cooperate or anything else that convinces Saudi Arabia to set a desirable price. Incidentally, production level is not a meaningful tool as it is determined by demand and needs no management. Production level will take care of itself.

The following chart adds perspective to the demand picture. Here is global demand, by year, since 1920. This time span encompasses cold wars, hot wars, droughts, depressions, booms, famine, pestilence, Democrats, Republicans, Peak Oil, running out of oil, China, Russia, etc.  

 Of particular note are two facts:

1. There are no demand spikes.

2. The only significant deviations from a steadily growing curve are two demand drops — both following price spikes.

If anything in the oil business is predictable it is demand growth. Since 1985 demand growth is like the Energizer bunny — it just keeps going and going and going, at its 1.5% growth rate. In spite of the popular sentiment expressed in the past ten years, there have been no demand surprises on the high side.

If thoughtful consideration is given to the data presented herewith, one must reject the common notion that demand sets prices.

 

[Promear + 2]

I am new too, Mr. Edwards. As a matter of fact. I own no oil. I came on board to learn how to buy into the business. I want to say, welcome on board because I am new with you.

[Promear + 2]

I understand that you re not new to the oil business. WOW! I am here to learn and learn how to start an invessstment.

[William Edwards + 708]

5 minutes ago, Promear said:

I am new too, Mr. Edwards. As a matter of fact. I own no oil. I came on board to learn how to buy into the business. I want to say, welcome on board because I am new with you.

Thanks, Ronald.

[Guillaume Albasini + 851]

44 minutes ago, William Edwards said:

If anything in the oil business is predictable it is demand growth. Since 1985 demand growth is like the Energizer bunny — it just keeps going and going and going, at its 1.5% growth rate. In spite of the popular sentiment expressed in the past ten years, there have been no demand surprises on the high side.

Do you think the demand growth is still so predictable today ?

Oil is mainly used to fuel vehicles and for a century there was no other energy for transportation. Today with the advent of electric cars (and busses and trucks..) the monopoly of oil on transportation is coming to an end and it will have an effect on the oil demand.

Now the EV market share is less than 2% but its going to increase in the coming years and the real unknown factor is the rate of this increase. Forecast about the EV market share by 2040 are between 10 and 90% and that makes a huge difference for the oil demand.

[William Edwards + 708]

7 minutes ago, Guillaume Albasini said:

Do you think the demand growth is still so predictable today ?

Oil is mainly used to fuel vehicles and for a century there was no other energy for transportation. Today with the advent of electric cars (and busses and trucks..) the monopoly of oil on transportation is coming to an end and it will have an effect on the oil demand.

Now the EV market share is less than 2% but its going to increase in the coming years and the real unknown factor is the rate of this increase. Forecast about the EV market share by 2040 are between 10 and 90% and that makes a huge difference for the oil demand.

I look at it this way, Guillaume. If all the occurrences of society over the past 100 years have not changed the demand growth rate, I do not possess the arrogance necessary to forecast a significant change going forward. And if I did, I might drop the growth rate projection by an insignificant 0.1 to 0.2%.

The only factor of significance that concerns me is the potential of a severe disruption of the world economy. That might give us one of those rare drops in growth rate.

Edited May 16, 2018 by William Edwards

[Bhimsen Pachawry + 72]

11 hours ago, William Edwards said:

I am new to Oilprice.com. But I am not new to the oil business. I personally experienced much of the industry history that most of you have learned by reading. Incidentally, most historical descriptions are filled with errors. In many cases the errors result from the author presenting the common wisdom and following that, he has tried to match that recitation with historical facts. The accuracy of history usually suffers.

A similar inaccuracy results from attempts to fit historical data to commonly-accepted pricing ideas. Usually the result is to ignore historical facts by beginning history five or ten years ago, rather than the appropriate 150+ years. This article is my attempt to set the record straight on one important element of industry assessments, namely the price setting sequence. The price comes first, followed by demand and its numeric equal, supply.Being the lazy person that I am, rather than re-writing my assessment, I have copied the description that I posted in OilPro a few years back, as we entered the demise of the previous price bubble. The additional four years of elapsed time with its additional confirming data have not altered the assessment, since if is soundly based and should have perpetual value. I hope that the readers find this analysis beneficial.

Understanding Oil Demand and Price

As we continue our quest to replace fiction with fact, we now turn to the subject of demand and price. Most of the participants in the oil business have succumbed to the simplistic explanation that “High prices are evidence of strong demand”. Therefore most efforts of price forecasting begin with a demand forecast. Although it is counterintuitive, this results in forecasts of, simultaneously, high prices and high demand. Such forecasts are common as evidenced by the EIA, the IEA and most major oil companies’ forecasts. But if anyone is asked “Will people buy more oil at a higher price or a lower price, reason always answers “You will buy more at the lower price, Silly!”. Oil industry forecasts say differently. Then which is it? The fact, as substantiated by history and reason, is that higher prices create lower demand.

What is the underlying factor that has allowed most people to adopt the wrong sense of the demand/price relationship? The answer is the lag time between demand’s occurrence and the knowledge of its quantitative measure. While we know prices instantly, knowledge of demand figures take a year or so for us to have the demand number. In the absence of data the knee-jerk assumption is that demand must have been high in order to create the high price. This idea will have been firmly adopted long before demand numbers are available and almost no one looks back at the data to confirm or deny that assumption. The following chart gives us that historical information.

In the time periods when prices were above $80/B, 1979-1985 and 2008-2013, we had growth rates of less than 1% and in some years we had negative growth rates. Hardly a period of strong demand. Looking at the other side of the coin, that is, the period when growth rates were high, in other words, times of high demand; between 1947 and 1970 we had growth rates of 6-12% with prices of $10/B in today’s dollars. These facts prove that high demand is not the cause of high prices.

This then leaves us with the question ”If demand does not set the price, what does?” The uncomfortable, but accurate answer is “Price is an independent variable which is set by the marginal producer.” Whether that marginal producer sets the price overtly or by acquiescence, that is still the price setting mechanism.

In today’s world, the marginal producer is Saudi Arabia. The floor price of crude is the price that the Saudis  are willing to accept for their  sales. If they accept the futures price, then that will be the price of oil. If they, instead, select a number — any number — and abide by it, then that will be the price of oil. The real takeaway from this situation is that if producers around the world want a good price for their production, they will do whatever is necessary to convince Saudi Arabia to set a good price and stick with it. Non-Saudi producers should beg, plead, negotiate, educate, cooperate or anything else that convinces Saudi Arabia to set a desirable price. Incidentally, production level is not a meaningful tool as it is determined by demand and needs no management. Production level will take care of itself.

The following chart adds perspective to the demand picture. Here is global demand, by year, since 1920. This time span encompasses cold wars, hot wars, droughts, depressions, booms, famine, pestilence, Democrats, Republicans, Peak Oil, running out of oil, China, Russia, etc.  

 Of particular note are two facts:

1. There are no demand spikes.

2. The only significant deviations from a steadily growing curve are two demand drops — both following price spikes.

If anything in the oil business is predictable it is demand growth. Since 1985 demand growth is like the Energizer bunny — it just keeps going and going and going, at its 1.5% growth rate. In spite of the popular sentiment expressed in the past ten years, there have been no demand surprises on the high side.

If thoughtful consideration is given to the data presented herewith, one must reject the common notion that demand sets prices.

 

Finally you agree with me that the price comes first in oil markets. I have been telling that the "actual price" of oil at which it can be substituted is much higher that what it has been traditionally sold at. The price of oil is based on political convenience rather than the actual demand or the value of oil. Due to many countries having differing political agenda, and many countries capable of producing oil, the price is a combination of the political agendas of various countries combined

[Dennis Coyne + 82]

William,

Interesting, I tend to think in terms of increased real income (real GDP at the World level) as driving demand, although over time the relationship has changed subtly as less oil has been used per unit of real GDP since the mid seventies.  In any case demand growth has been fairly predictable and correlates quite well with real GDP.

Note that your assumption that supply is always equal to demand certainly makes the analysis easier as we just look at oil output and assume this is the same as oil demand.

It seems this implies that stock levels would be fixed if that assumption was always correct.

Perhaps the assumption is a good one, but we don't really have decent data on World Stock levels.

OECD stocks seem to change over time which suggests that supply may not always be equal to demand, at least in the short term.

In any case your claim seems to be that both supply is always equal to demand and that demand does not determine the oil price.  As supply is always equal to demand, oil supply must not determine the oil price either and it couldn't be inventory, because supply=demand implies a constant inventory level.

This leaves me wondering.  What determines the oil price? KSA sets output level, presumably so that supply is equal to demand, so one would expect the oil price to be constant, but as far as I can tell this is not the case.

What am I missing?

Edited May 18, 2018 by Dennis Coyne

[William Edwards + 708]

1 minute ago, Dennis Coyne said:

William,

Interesting, I tend to think in terms of increased real income (real GDP at the World level) as driving demand, although over time the relationship has changed subtly as less oil has been used per unit of real GDP since the mid seventies.  In any case demand growth has been fairly predictable and correlates quite well with real GDP.

Note that your assumption that supply is always equal to demand certainly makes the analysis easier as we just look at oil output and assume this is the same as oil demand.

It seems this implies that stock levels would be fixed if that assumption was always correct.

Perhaps the assumption is a good one, but we don't really have decent data on World Stock levels.

In many cases OECD stocks seem to change over time which suggests that supply may not always be equal to demand, at least in the short term.

In any case your claim seems to be that both supply is always equal to demand and that demand does not determine the oil price.  As supply is always equal to demand, that must not determine the oil price either and it couldn't be inventory, because supply=demand implies constant inventory level.

This leaves me wondering.  What determines the oil price? KSA sets output level, presumably so that supply is equal to demand, so one would expect the oil price to be constant, but as far as I can tell this seems not to be the case.

What am I missing?

Pricing was addressed in the 10-year-old article that you referenced earlier. It’s whatever number happens to occur based on what the Saudis, or whomever becomes the swing producer, allows to happen. It can literally be anything. Demand, and hence supply, will match accordingly.

[Dennis Coyne + 82]

On ‎5‎/‎17‎/‎2018 at 6:14 AM, Bhimsen Pachawry said:

Finally you agree with me that the price comes first in oil markets. I have been telling that the "actual price" of oil at which it can be substituted is much higher that what it has been traditionally sold at. The price of oil is based on political convenience rather than the actual demand or the value of oil. Due to many countries having differing political agenda, and many countries capable of producing oil, the price is a combination of the political agendas of various countries combined

Bhimsen,

At the end of the day there are multiple factors which influence both the supply and demand for oil, the oil price attempts to match oil supply and oil demand, too much supply relative to demand and the oil price falls and too little supply relative to demand and the oil price rises.

In the long run supply will tend to equal demand and the oil price will be determined by the marginal cost of production (these are the most expensive barrels, not the least expensive barrels).

[Dennis Coyne + 82]

11 minutes ago, William Edwards said:

Pricing was addressed in the 10-year-old article that you referenced earlier. It’s whatever number happens to occur based on what the Saudis, or whomever becomes the swing producer, allows to happen. It can literally be anything. Demand, and hence supply, will match accordingly.

Hmm,

The swing producer sets output, not price.  The level of output that satisfies demand (in the long run) will include both the cheaper barrels from OPEC and more expensive barrels by other producers, the price level in the long run will be the marginal cost of production for the most costly barrels to produce.

The oil price can't be "literally anything", it is unlikely to be $10/b in 2016$ and it is also not likely to be $1000/b in 2016$, at least in the next 10 years (and probably not ever).  A better range  (for annual average price) is probably $40 to $150/b over the next 5 years, my guess is that the Brent oil price will gradually rise from $70 to $120/b (2017$) over the next 8 years and may continue to rise to $200/b over the next 5 years.  Though I expect volatility along the way (swings above and below this trend of 20 to 30 per barrel.

Edited May 18, 2018 by Dennis Coyne

[William Edwards + 708]

7 minutes ago, Dennis Coyne said:

Hmm,

The swing producer sets output, not price.  The level of output that satisfies demand (in the long run) will include both the cheaper barrels from OPEC and more expensive barrels by other producers, the price level in the long run will be the marginal cost of production for the most costly barrels to produce.

No. This swing producer supplies the output required by demand. Demand calls the signals. The price level will be up whatever number the swing producer uses each day of his production.The price level will be up whatever number the swing producer uses each day of his production.

[Dennis Coyne + 82]

William,

The swing producer may produce what they think is the appropriate level to match supply and demand.  Nobody can see what the level of demand will be in advance.

Quote

The price level will be up whatever number the swing producer uses each day of his production.

I don't understand your quote above, can you rephrase?

Are you saying the price is determined by the output level of the swing producer?

I agree that the output level of the swing producer will influence the price, but there is a feedback whereby the price will affect the profitability of the non-swing producers and will affect their level of output, but I see what you are getting at.  The output level chosen by the swing producer is based on what they think will achieve some target oil price at some given level of demand such that total oil supply will meet that demand.

My point is as follows, whatever target price the swing producer chooses will also be the marginal cost of production of the most costly producer in the long run, otherwise those barrels would not be produced because it would not be profitable to produce them, I am assuming rational profit maximizing business behavior for the non-swing oil producers.

If I am correct, the oil price cannot be "literally anything", in the long run it must be the oil price that makes the most expensive marginal barrel produced along with every other less expensive barrel produced in any given day equal to the demand for oil at that oil price.

Edited May 18, 2018 by Dennis Coyne

[William Edwards + 708]

On 5/18/2018 at 12:46 PM, Dennis Coyne said:

William,

The swing producer may produce what they think is the appropriate level to match supply and demand.  Nobody can see what the level of demand will be in advance.

I don't understand your quote above, can you rephrase?

Are you saying the price is determined by the output level of the swing producer?

I agree that the output level of the swing producer will influence the price, but there is a feedback whereby the price will affect the profitability of the non-swing producers and will affect their level of output, but I see what you are getting at.  The output level chosen by the swing producer is based on what they think will achieve some target oil price at some given level of demand such that total oil supply will meet that demand.

My point is as follows, whatever target price the swing producer chooses will also be the marginal cost of production of the most costly producer in the long run, otherwise those barrels would not be produced because it would not be profitable to produce them, I am assuming rational profit maximizing business behavior for the non-swing oil producers.

If I am correct, the oil price cannot be "literally anything", in the long run it must be the oil price that makes the most expensive marginal barrel produced along with every other less expensive barrel produced in any given day equal to the demand for oil at that oil price.

Sorry for the typo. I should proof-read my typing. The statement should have read 
"The price level will be whatever number the swing producer uses each day of his production."

No, I am not saying that the price is determined by the output of the swing producer. I am saying that the price is determined by the price assigned by the swing producer. It matters not how he chooses that price. Once he assigns it, the is the price.

Your built in, erroneous thinking that the price is the result of some imagined demand, cost or other number is the source of your consternation. If you are seriously interested in understanding the pricing mechanism, may I suggest that you begin by thinking though, with no leaps of logical sequence, how the price of a cargo of Saudi Crude becomes the price on the invoice given to the tanker master upon loading. Where does the invoicer get his number. And if you answer "His boss gives it to him, please trace it back to the person who actually gives the number. Where does the actual number for the price on the cargo originate?

[William Edwards + 708]

On 5/18/2018 at 12:11 PM, Dennis Coyne said:

Hmm,

The swing producer sets output, not price.  The level of output that satisfies demand (in the long run) will include both the cheaper barrels from OPEC and more expensive barrels by other producers, the price level in the long run will be the marginal cost of production for the most costly barrels to produce.

The oil price can't be "literally anything", it is unlikely to be $10/b in 2016$ and it is also not likely to be $1000/b in 2016$, at least in the next 10 years (and probably not ever).  A better range  (for annual average price) is probably $40 to $150/b over the next 5 years, my guess is that the Brent oil price will gradually rise from $70 to $120/b (2017$) over the next 8 years and may continue to rise to $200/b over the next 5 years.  Though I expect volatility along the way (swings above and below this trend of 20 to 30 per barrel.

The key difference between my understanding of the global pricing mechanism and yours is embodied in your statement "The swing producer sets output, not price." My considered assessment is exactly the opposite. The swing producer sets price. The customer dictates the quantity that he is allowed to produce. If he tries to produce more than is needed to fill the tankers at his loading port, does he stubbornly pump crude into the Persian Gulf? No way! The actual, little recognized fact is that the customer, not the producer, sets production levels and the swing producer applies the price tag.