Why the Precipitous Decline in Oil Prices? Adapting to Changing Expectations

Lynne Kiesling

Oil prices have declined since their July high, but the decrease has been particularly precipitous in the past week. As of 8:23 EDT this morning, the NYMEX future price is $91.73/bbl. Less than $100!

Why? Here are my off-the-cuff thoughts:

1. Financial market instability Oil prices are a leading indicator of expectations of future economic activity. If the roilings in global financial markets are going to lead to reduced economic activity, either because of lower wealth, lower growth, or just battening down the hatches until things calm down, then we can expect lower future demand for oil.

This is not new. But what’s interesting about what’s happening now is the speed of the transmission of the information through expectations and into prices. The Merrill Lynch-Lehman combo of weekend events has propagated quickly through stock markets, futures and options markets, and commodity markets. I am struck by the magnitude of the oil price decline just in the past few days.

2. Lower-than-expected hurricane damage Because market prices are driven by expectations of supply and demand, and the expectation of Ike’s effects were large (not surprising, given the satellite photos of the size of the storm!), oil prices were reflecting expectations of a reduction in supply that would be due to Gulf oil platform damage. Although they sustained more damage than Gustav produced, they did sustain less damage than expected. Those platforms had shut down operations in advance of Ike, but will be restarting promptly.

Interestingly, crude oil prices and gasoline prices are moving in opposite directions, which reflects the differential effects of the hurricane damage on refinery capacity on the Texas coast.

So my answer to my question is that this is how a liquid global market adapts to changing expectations in a very fluid environment. This article from today’s New York Times provides a good overview of these factors:

That oil prices are falling despite the hurricane reflects a deep shift in the market’s sentiment in recent weeks. Oil prices peaked at $145.29 a barrel in July but have since been falling as oil consumption has slowed markedly in Western countries. Some analysts expect oil prices to continue the slide in coming weeks, given the crisis on Wall Street and the darkening economic outlook.

“Wall Street now has everybody worried about the global economy,” said Adam E. Sieminski, chief energy economist at Deutsche Bank.

Early this year, some analysts predicted that surging demand and the limited growth in new supplies would push oil prices to $200 a barrel by the end of the year. Many are now scaling back their forecasts. Paolo Scaroni, the chief executive of Eni, Italy’s largest oil company, predicted on Saturday that the slowdown may push prices to $70 a barrel, a level that could bring average gasoline prices below $3.50 a gallon nationwide.

UPDATE: see also this post from Tim Haab on almost the same topic, in near-real-time.