Price Theory 101 - p(OIL)=mc(OIL)

The roll-a-coaster of oil prices continues today as oil looks set to drop below $90. This has me wishing I'd take my own advice a few months ago when I said that $120 a barrel oil was unsustainable and I should throw all my meager assets towards shorting oil.

Per usual, the laws of economics have reared their reasonable head. As everyone remembers from Econ 101, price should approximate marginal cost, e.g. the cost of producing the last barrel of oil. Currently, about 90% of the proven oil reserves in the world can be produced for about $55/barrel (This includes the HUGE reserves of shale sands in Canada.) And this belies the fact that a vast majority of all the oil currently PRODUCED has a MC of about 5$/barrel.

Granted, the oil market is a bit more complicated (e.g. not perfectly competitive) since it includes a cartel, OPEC and oil is a necessity good with many significant geo-security implications. However, even if we allow for a %50 premium for these considerations this puts oil in the $75-80 range. Why then, did oil surge to nearly $150 a barrel? Because, as Ms. Clifford notes, oil was being valued for reasons that have nothing to do with its uses as a commodity, namely as a financial instrument to hedge against the turmoil in more sophisticated financial instrument, mainly the CDOs. This happends because investors, foolishly, believe that since commodities are "scarce", they tend to be a better store of value. (e.g. once the oil is gone, it is gone - whereas there is a virtually "infinite" supply of potential credit derivatives). This is why silver, gold, platinum, etc all shot up in response to the financial crisis. Obviously, this is not the case, the value they "store" (e.g. as a baseline) is their marginal cost of production.

So why is oil falling? The initial fall (say from $150 to $120) was precipitated less by decreases in demand forecasts (Although demand is falling in the developed world, global demand growth forecast still largely project increased demand, namely due to increased demand from the 2 billion Indo-Chinese that will soon be driving Tatas ). No, the Saudi's have it right - global supply and demand are pretty much in balance. Oil fell, because at least some speculators (e.g. those who use oil as a financial instrument) realized that the pricing of oil was way out of wack. As oil began to fall, more and more investors who had hedged with oil realized that oil was NOT a store of value, and jumped off the ship. Increasing signs of a global economic downturn COMBINED with the fact that oil was already falling perpetuated the fall, but did not cause it. Again, global supply and demand are largely balanced. Price, in this market, like all markets, is based on marginal cost (and in this case some risk, good-specific and cartel premium). If you can add these up, you'll have a good idea of the true "value" of oil - and you can make a killing next time oil jumps to $150, by shorting shorting shorting...