Oil at $1,000 per barrel?

Great Debates
1

Can someone explain how oil is valued, and if there are any differences with regular companies’ stock prices?

On the stock side: The price of, say, Apple stock can go to $1,000. Nothing is stopping it. As long as people think that that’s what other people think it should cost, they’ll pay that much for it. Also, if Apple stock goes to $1,000, it will have practically no effect on consumers: Apple’s products will not cost more.

On the oil side: As I understand it, oil is traded on the open market, so theoretically, it could go to $1,000 per barrel. If it does, gas prices will skyrocket and at that high level it will definitely reduce people’s demand for gas, which will mean reduced demand for oil, which means that those barrels of oil that you just bought for $1,000 on the open market will be hard to sell.

Given the above, how different are the dynamics of the market when you are trading some intangible thing (like stocks), versus trading something tangible and useful for consumers (like oil, corn, wheat, etc)?

The two main differences I see between trading tangible and intangible goods are
[list=a]
[li]You are left owning a physical asset that you have to store (and may spoil, depending on the asset you bought)[/li][li]It affects peoples’ lives (e.g. may cause famine if wheat becomes ten times more expensive)[/li][/list]

How do these differences manifest themselves in the markets for these goods?

e.g. if it is a good that spoils or costs too much to store, then there is pressure on buyers to sell soon, so you can’t just sit on it and “ride out the market fluctuation”, which I guess should reduce highly risky speculation.

Also, if a good is vital to peoples’ well-being (e.g. food), if the price gets too high, might governments want to step in? As I recall, the British pound was traded on the open market, and one day was losing so much value that the British government took it off the open market for a while, so it’s not unheard of for governments to step in and circumvent the open market if the situation is extreme.

My overall question/concern:
From what I know, I assume it is possible for speculators to drive oil and food prices to very high prices ($1,000 per barrel, wheat at ten times its current price, etc), and this will have a devastating effect on economies and on people around the world.

Is it indeed possible? If not, what is stopping it from happening?
If it is possible, should we reconsider how these goods are traded?

2

Good grief…where to start with this on.

First off, in your example between Apple and the price of oil you are, um, comparing apples to oranges so to speak. When you buy stock in Apple you are buying a piece of the company. Driving the price of the stock up doesn’t drive the price of Apple computers up because those are completely unrelated things…in fact, driving up the price of Apples stock gives Apple the company more value, more capital available. The company is WORTH more. This won’t have a direct effect on the price of the goods and services they sell…though it will have a couple of indirect ones.

When you buy oil you are buying a commodity…and in fact, you are speculating on the future price of said commodity. If a lot of people buy, say, oil, and it drives up the price then that has a direct effect on that cost…because in essence they are buying the future price of that commodity.

I have to head for a meeting atm but I’m sure someone will be along with a more coherent post explaining all this. Sorry to cut this off mid-post without editing for clarity…but the RW calls. :slight_smile:

-XT

3

A futures contract has an expiration date. When you hear oil prices quoted at $120 a barrel in the media, this is shorthand for crude oil for June delivery. Commodities are traded this way to allow people who need the commodity to lock in a price. You’ll notice that crude oil delievery for future months isn’t quite as high.

If you buy the shares of Apple, you’re being shares which you can hold them forever. There is no expiration on your shares, although there is always the risk of the company going bankrupt.

4

Yeah, it’s kinda like oil and water don’t mix. :slight_smile:

5

The other thing to consider is that commodities don’t exist in a vacuum. People buy commodities because they want to do something with them. So people buy oil because they want to turn that oil into gasoline and sell the gasoline, and people buy gasoline because they want to power their cars and trucks.

But if the price of oil (and therefore gasoline) gets really high, then there are cheaper ways to power your cars and trucks. If oil was $1000/barrel no one would use it to power their car, they’d switch to an electric car. But if everyone switches to electric cars, then the market for gasoline collapses, and the gasoline isn’t worth much anymore.

Of course, what happens in the real world is that as the price of gasoline increases, more and more people use less gas and start to switch to alternatives, which slows the increase in gas prices. There is constant feedback between the supply and the demand and prices track a constantly moving equilibrium value.

6

I should really be careful how I phrase the first sentence of my OP’s since most people don’t seem to read past the first sentence.

Besides some intermediate questions, the last question, which remains unanswered, was

My overall question/concern:
From what I know, I assume it is possible for speculators to drive oil and food prices to very high prices ($1,000 per barrel, wheat at ten times its current price, etc), and this will have a devastating effect on economies and on people around the world.

Is it indeed possible? If not, what is stopping it from happening?
If it is possible, should we reconsider how these goods are traded?

7

It is impossible for everyone to stop using gas within any reasonable amount of time.

I think that the price can reach $1,000 per barrel, due to speculation, much faster than we can move away from consuming gas.

8

Oil futures on the major exchanges (eg NYMEX crude) are backed by a physical delivery. For The NYMEX trades you could indeed have speculators who have no intention of taking delivery of one drop, pushing the price up on the market. However when the contract expires someone has to go and pick up 1,000 bbls of West Texas Intermediate, from Midland in Texas, I believe Cushing Oklahoma is also another delivery point.
Now if due to market fun and games you have pushed the price up to $1,000/bbl, and the general demand for teh physical product has tanked because of it, you are going to be left with having to take delivery of the oil, and can’t do anything with it, except sell if off at a huge discount to the 990 bucks you paid for it to anyone who will take it.

So the speculation and fun and games on the exchanges is kept somewhat connected to the reality of supply and demand through the eventual physical delivery.
It should be noted that there are quite a few benchmark crudes and contracts backed by a physical delivery, in addition oil is sold through all manner of other contracts and deals, the prices of which are pegged to the rates on the exchanges
and modified by the quality of the oil, so not all oil is traded through the NYMEX etc

9

Define “reasonable”. Sure, most people can’t change their gasoline consumption patterns on a day to day or week to week basis. But they can over months and years. If you figure out a way to carpool to work you cut your gas consumption in half. If you work from home one day a week you cut your gas consumption by 20%. If you switch from an SUV that gets 20 mpg to a Prius that gets 40 mpg you cut your gas consumption by 50%. If you move from a house that’s 60 miles from work to a house that’s 30 miles from work, you cut your gas consumption by 50%. And so on.

People really can do these things. The reason people haven’t done these things until lately is that the price of gas has been really really cheap until lately. And all these changes are multiplicative. If you change from no carpooling, going to the office 5 days a week in an SUV from a house 60 miles away to carpooling 4 days a week in a Prius from a house 30 miles away, your gas consumption from commuting would be .5*.8*.5*.5–you’re using ONE TENTH the amount of gas you used to use. Reducing your gas consumption this way would require some dramatic changes, but not impossible changes.

10

The main thing affecting price speculation is the perception of how valuable something is going to be in the future. In the Dot-Com bubble, stock values inflated dramatically because large numbers of people were convinced that they were getting in on the ground floor of the next Microsoft, and that $1000 a share was a bargain when that company might someday be worth $10,000 a share. By contrast, although the price of crude oil might spike due to flucuations of supply and demand, no one thinks that crude oil is going to have some use or value dramtically different in the future. Oil will pretty much be used for what it’s used for now- energy production. If a wild hoax started that someone had developed a way to make an elixir of immortality out of petroleum, then you’d see $1000 a barrel speculation. In short, people will pay what they think it will be worth to have something in the future.

11

It’s not really possible to drive the price up to $1000.00/barrel, no. To illustrate, think about it in terms of another commodity, like, say, oranges. One COULD push the price of next years crop of oranges on the commodities market up to, say, $50/orange. However, when you take delivery of your crop of $50/orange oranges…well, how are you going to sell them? Do you really think people will PAY the market price you’ve set? Would they be willing to buy oranges for $50+ a piece (for you’d have to tack on the price to get the oranges to market, processing, etc)? Or would they buy apples instead?

To answer the question they would change their habits and mostly do without oranges…so, you’d end up with a crop of oranges you mostly couldn’t sell at the price you bought them at. You’d have to drop your prices below what you paid for oranges to the level the market would actually bear…and you’d end up losing tons of money.

Same goes for oil. If you COULD corner the market on oil ( :dubious: ) to the point where you could make oil scarce enough that you could actually drive the price up to such a ridiculous level then a host of alternatives would hit the market place and undercut you. You’d be left with a commodity that no one wants to buy at the price you set. Refiners couldn’t afford to buy the oil to refine because they wouldn’t be able to sell the refined product to make a profit…no one would buy it.

No, it’s not possible. Long before the price got that high alternative products would be coming into the market, and the demand for oil would drop…which would stabilize the price.

What is stopping it? You and I and everyone else, collectively a.k.a. The Market is stopping it. You couldn’t buy gas at $20-30/gallon…at least you wouldn’t buy it in the volume you currently are. You’d find alternatives or alternative ways to get around it (you’d take the bus or the metro, for instance, instead of drive your car…or you’d pool your gas with a bunch of other people and defray the cost. Or some smart person would come up with an alternative fuel to run in your car at significantly savings).

Certainly not. Why do people always think it’s a good idea for the government to stick their thumbs into things as an alternative to all our problems? Look…think it through. Can you give me an example where the government setting price controls on a commodity has ever been a GOOD thing?

-XT

12

It’s not unheard of for government to (temporarily) interfere when the “free market” goes a bit bezerk.

As I mentioned above, one example is when the British pound, which was traded on the open market, was losing so much value in one day that the British government took it off the open market for a while.

Another example are “circuit breaker” rules for the stock exchanges, which stop all trading when prices drop too much, to prevent panic selling. Of course, these are not government rules, but they do still represent an example of an external entity disrupting the free trading of assets.

The free market is a dynamic system, and, because it has the vulnerability of being a positive-feedback system, it is unstable, so during periods of instability (bubbles and crashes) it makes sense for an external entity to restore stability.

13

The Nymex WTI futures contracts also have monthly limits to prevent the sort of explosions or melt downs similar to the suspension of the Stirling (see below). There has been some mutterings in the markets about lack of liquidity in some of the benchmark crudes along with a lot of investment going into buying what appears to be a sure fire bet in rising prices. This has led to some decoupling from past strong links of immediate crude supply, refining capacity and demand

. From the NYMEX rule book.

14

But things like price controls do not restore stability. They undermine it. Look at what happens with rent-control housing: the person who lives there does not have their rent raised for 20 years, then when they move or die, the price of the housing skyrockets to reflect the market value. If they did that with oil they would have to control that price indefinitely or hope beyond hope that the price declines, because when they lift the price controls the price will go through the roof to represent the market value of oil. If government leaves it alone the price adjustment is more gradual to the consumer and can be absorbed more readily than a 200% increase overnight.

Price controls are a big mistake. They might provide short-term relief, but they never do in the long-term.

15

I hate to break this to you, but oil is not an orange.

If oranges tomorrow became $100 each, yes, you can stop eating oranges that same day.

But, if oil becomes $40 a gallon tomorrow, no, you cannot stop using gas.

Yes, you can curb its use, but it will take you a long time to do that.

You’d have to buy a new car, move to a new house, etc, to make a significant dent in your consumption, and these things take time.

On the other hand the price of oil could theoretically hit $1,000 tomorrow. In a purely free market there is nothing that prevents it from reaching those prices in a speculative bubble.

And so that we don’t focus exclusively on oil, the same holds with food (wheat, corn, etc). If these things are traded in a purely free market, there is nothing that prevents them from increasing ten-fold in price in a speculative bubble.

Yes, the suckers at the end of the run-up to the peak of the bubble will lose a lot of money, but this has always been the case with bubbles, but that has not prevented them because people think “Even though this is a bubble, people are still buying stocks/homes/etc and so the price will continue to go up, at least for a while. As long as I sell before the bubble bursts, I will make money”.

Why can this not happen in oil/wheat/etc markets?

But this happens all the time with stocks. You buy Amazon at $400, and then, when the bubble bursts “you have to drop your prices below what you paid for Amazon stock to the level the market will actually bear…and you end up losing tons of money”

So, the risk of losing loads of money if the good you just bought cannot be sold for the price you bought it as does not seem to prevent bubbles in the stock market, or in the housing market, for that matter (which deals with tangible assets). So, I don’t see why this risk should prevent bubbles in oil prices.

16

Perhaps, but the point is that the price isn’t going to shoot up to $1000/barrel because the market itself wouldn’t allow it. So, there is no reason for attempting to step in to fix the market with the ham hands of mighty gubberment.

How did that work out for them? Why did they put the pound back on the currency (which btw is a bit diffent than the commodities market) market? If taking it off was a good thing why put it back? Why have it on the market at all if bad things can and will happen?

Serious question…why have a market then? I mean, if bad things happen (like your examples of bubbles and crashes…btw, I see the current price rise in oil as a bubble, FWIW), wouldn’t it be better to simply let the government control prices all the time? That way you would avoid bubbles and crashes, as well as rising and falling markets…no?

-XT

17

I did not mean to imply that price controls are the way to go.

Stopping trading (like in the case of the British pound, or the case of NYSE “circuit breakers”) might be the way to go.

There may be better ways. It seems that price controls are not the way to go.
As an aside, I wish someone very smart would come up with a trading market mechanism that has built-in resistance to the problem of positive feedback that current markets have.

In today’s markets, if people believe an asset’s price will go up, a lot of them buy it, thus causing the asset’s price to go up. Same with the other direction (price going down). It becomes a self-fulfilling prophecy.

I wonder whether it is possible to set up an alternate stock exchange, that, without outside interference, avoids the positive feedback or self-fulfilling prophecy problem.

18

If they did who would use it? The price needs to change or there’s no reason to trade. People will naturally tend to buy stuff that they will profit from and sell that which costs them money. It’s this artificiality that makes it a lousy bet in the short-term but great for asset appreciation over 20-30 years. Market forces are an amazing thing, and there will always be winners and losers. If oil appreciates too much the market will collapse of its own accord. It will be Tulipmania redux. And it’s all because the market is generally self-regulating.

19

It’s like riding a bicycle. It is inherently an unstable device, but you ride it because it has benefits: it gets you to your destination faster than on foot.

But, sometimes, you fall.

Just because your bike it useful, does not mean that, at the moment that you see that you are headed for a fall, you will “stick with it” until you hit the road. You will jump off.

But, just because you jumped off on those few occasions when the bike became unstable and was headed for a fall, does not mean that you should abandon it and start going to work on foot.

As long as you don’t crash too often, it has an overall net benefit, so you keep using it.

Now if someone came out with a better bike, or even a totally different mode of transportation, that didn’t crash as often but provided the same or better benefits, of course you would switch to that.

20

Of course the price should change. But, what if the price changed only in response to a change in a company’s profits, and not in response to what other people “feel” the company should be priced at?

So, you would still bet on a company, as we do today, but you would be betting that the company’s profits will rise, and not betting on the more fuzzy concept of what other people think the price should be.

Think of roullette: No matter how many people bet on red, the return is still the same. If the casino were run like the stock market, the return on “26” would depend on how many people bet on it.