The following is an article that I wrote for FTAlphaville that was never run.
Quite a number of people think that financial market dynamics are substantially distorting the price of oil. FT Alphaville’s own Izabella Kaminska has laid out in a wonderful analogy as to why this might be. But she’s not the only one. As I’ve pointed out elsewhere there’s a whole motley crew of people who think this may be the case – including one Ben Bernanke before he was put in charge of the money-machine known as the Fed.
It might be interesting then to turn to the historical data to see what it might tell us. In this way we can put aside the mechanisms of how such distortions might be taking place and simply look at the fundamentals.
The best way to do this is to compare spare capacity to price. Presumably, if there is a substantial amount of spare capacity on hand and the market is being driven by fundamentals then the price should be either stable or falling. While if there is only a small amount of spare capacity available then the price should be rising.
A glance at that chart tells us that there appears to be no firm relationship between spare capacity and price and if we dig a little deeper we can confirm this. Between 1994 and 1998 the level of excess capacity was pretty stable and so was the price. Then something strange started happening. Between 1999 and 2002 the amount of excess capacity rose by nearly 40% in comparison to its 1994 to 1998 levels and yet at the same time prices rose by over 60%. This seems to indicate that something other than supply and demand fundamentals was at play in the price increases in these years.
Then between 2003 and 2008 excess capacity took a dive and prices soared. During this period the average level of excess capacity was about half that of the 1994 to 1998 period and about a third that of the 1999 to 2002 period. Meanwhile prices increased by over 100% in relation to their 1999 to 2002 levels. This makes a bit more sense, but the question as to what was going on in the 1999 to 2002 period still remains.
When we turn to the post-2008 world we also encounter something of a mystery. Between 2009 and 2012 the average amount of excess capacity was above that of the 1994 to 1998 period when prices were stable and yet prices continued to soar – rising over 55% by 2012 from their 2009 trough. Yet surely if there was ample excess capacity on hand these prices should have fallen rather than risen.
All in all, the only periods that make sense from a supply and demand perspective are the periods 1994 to 1998 and 2003 to 2008. The rest of the periods studied are characterised by stable or increasing excess capacity while prices nevertheless rise. From looking at this data we cannot answer why this is the case but as stated at the beginning of this piece there are plenty of people who think that they can explain this. We will leave it for now in their capable hands.