Misconceptions On Venezuela And Oil Markets

Okay, I’m breaking my self-imposed moratorium on Venezuela strike commentary to disabuse folks of some of the misconceptions that have been swirling around in the media commentary over the past few days, typified by Paul Krugman’s superficial assessment of US oil policy in his 27 December column. Krugman focuses only on a sideswipe comment about the extent to which “nobody seems to have thought about the state of oil markets if there is simultaneous turmoil in the Persian Gulf and Venezuela,” which I cannot refute as I have not been in attendance at administration meetings that may have addressed this issue. I can, however, illuminate some of the economics of world oil markets and the role of expectations in moving world prices.

1. Prices rose late and quickly because the strike has lasted longer than oil companies and traders expected. NYMEX light sweet crude prices only went above $30/barrel on 16 December, almost three weeks after the strike commenced, and only stayed above $32/barrel for four days (26-29 December). Why? Because when prices rise, buyers look for alternative suppliers, and alternative suppliers are happy to bring more oil to market (when they have capacity, which OPEC suppliers, Russia, Mexico, and West Africa all do right now) because they can get a pretty good price. So, not surprisingly, Venezuela’s export decline from 3.1 million barrels/day to 200,000 barrels/day did not have a large effect on world markets until it persisted beyond expectations. Now, OPEC members are planning to increase their production to reduce the price to their $22-28/barrel target range (see also this Financial Times article, this Reuters story, and today’s Oil Daily headlines for more on the same point).

2. Expectations of the duration and dislocation of the strike are also a function of the extent of crude supply inventories and of the dislocation of transportation. Although Venezuela’s production has halted, PDVSA claimed that they have enough inventory to meet existing contracts. Once tanker movements were blocked and tankers were not being loaded for export any more, it became clearer that those inventories would not necessarily get to customers, and prices began to rise. Today, Bloomberg Energy News reports that even though some production is coming back online, foreign tankers are unwilling to dock and fill up with oil for export. Furthermore, our existing crude inventories, held by refiners in the US and in the strategic petroleum reserve, tend to dampen price increases. And this Venezuela thing didn’t just come out of nowhere, so refiners and the US government have been amassing crude inventories. Throughout the fall US refiners built above-average inventories, according to a September report from the American Petroleum Institute, and Citgo is now requesting a release from the strategic petroleum reserve now that they have depleted their inventories and have not received their Venezuelan shipments. In a volatile and uncertain periods and markets, inventories serve as insurance.

3. It also matters how much trade occurs through long-term contracts versus the spot market. Long-term supply contracts are common in this industry, so the real economic impact of movements in spot market prices are actually quite small as long as the supplier can deliver on the contract. For example, about two weeks ago Citgo had to start buying crude on the spot market to meet their refining demand, because they had processed all of the crude in their inventory. That change in their market behavior itself contributed to the increase in spot market prices.

Note the similarity between this observation and the observed market behavior in the California electricity crisis — spot markets are inherently more volatile, so market participants have incentives to enter long-term contracts to manage and mitigate their risk. A complex web of intertemporal oil instruments and markets exist to enable that to happen, but were outlawed in California electricity.

4. Seasonality matters a lot. Right now is the seasonal lull in crude oil consumption, aided by the current slow economy, so the demand side of the crude oil market is not as strong as it will be in, say, March, when refiners want to make sure they have enough oil to produce gasoline for the spring and summer driving seasons. So if the strike looks like it will continue into February, then the interactive dynamics discussed in points 1-3 above will take into account those expectations.

So Krugman’s hyperbole seems unfounded; market participants are certainly paying attention (and I would bet that administration members are too) to the possible disruption of world oil markets. But instead of whining and carping, they are planning, to the best of their ability, to enable them to minimize the dislocation. That’s why markets are some of the most powerful and effective social institutions we have, because they enable people to plan, prepare and act on their preferences, over risk, over gasoline, and over freedom.

I could go on, but that’s enough for now. The core issues still remain — why do poor Venezuelans believe Chavez’s demagoguery? Where have all of the petrodollars flowing into the country gone? Certainly not into the pockets of the Venezuelan people, as would happen in a healthy, functioning democracy and economy. How do you get rid of a democratically elected “leader” who has abrogated his constitutional responsibilities?

Actually, in the 17th century Algernon Sidney wrote in Discourses Concerning Government that not only do citizens have a right to rebel against a repressive ruler (which was Locke’s argument), but that citizens have a responsibility to rebel. Sidney’s writings had a lot of influence on the American founders and their decision to rebel against their constitutional monarch. I’d be interested to know what the political theorists and constitutional scholars have to say about Sidney’s relevance and the responsibility to unseat a democratically elected leader who has abrogated his responsibilities. You can pretty much tell where I stand on this, but it is well beyond my professional expertise.