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James Hamilton

James Hamilton

James is the Editor of Econbrowser – a popular economics blog that Analyses current economic conditions and policy.

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Oil Price Collapse Down To Broader Demand Factors

The price of oil passed another milestone last week, falling below $50 a barrel, a level that I had not expected to see again in my lifetime.

CrudeOilPricesCushingOklahmoa

Price of crude oil (West Texas Intermediate, dollars per barrel). Source: FRED.

It’s interesting that we crossed another milestone last week, with the yield on 10-year Treasury bonds falling below 2%. That, too, is something I had not expected to see.

NominalInterestRate10YearBonds

Nominal interest rate on 10-year Treasury bonds. Source: FRED.

And these two striking developments are surely related. I attribute sinking yields to ongoing weakening of the global economy, particularly Europe. And slower growth of world GDP means slower growth in the demand for oil. Other indicators of an economic slowdown outside the United States are falling prices of other commodities and a strengthening dollar.

Related: What Will 2015 Do For Peak Oil?

A month ago, I provided some simple analysis of the connection between these developments in the form of a regression of the weekly change in the natural logarithm of the price of WTI on the weekly log changes in dollar price of copper and trade-weighted value of the dollar along with the weekly change in the yield on 10-year Treasuries. Here again are the results of that regression when estimated from April 2007 to June 2014 with heteroskedasticity- and autocorrelation-consistent t-statistics in parentheses:

Regression

Last month I used that regression to ask how much of the decline in oil prices between July 1 and December 12 of last year could be predicted statistically by the changes in copper prices, bond yields and value of the dollar. I found that the regression would predict a $20 decline in the price of oil over that period. Since it seems reasonable to assume that changes in copper prices, bond yields, and the exchange rate reflect primarily global demand factors rather than anything going on specific to the oil market, I concluded that about $20 of the $47 drop in the price of oil between July 4 and December 12 could be attributed to demand factors.

Related: Current Oil Crisis More Dangerous Than You Think

The price of oil has fallen another $8/barrel since then, prompting me to update those calculations. Since December 12, copper has slid an additional 6.15%, the dollar gained an additional 2.67%, and the 10-year yield fell another 13 basis points. On the basis of the above regression, that would have led to us predict an additional oil price decline since December 12 of almost another $4/barrel.

That is, of the $55 drop in the price of oil since the start of July, about $24, or 44%, seems attributable to broader demand factors rather than anything specific happening to the oil market. That’s almost the same percentage as when I performed the calculation using data that we had available a month ago.

So what’s been happening on the supply side of oil markets is important. But so is what’s been happening on the demand side.

I had a conversation about these and other topics with Jeremy Martin of UCSD’s Institute of the Americas that you can listen in on if you’d like.

By James Hamilton

Source - http://econbrowser.com/ 

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  • Roy on January 15 2015 said:
    I'm surprised you'd write that you never expected to see oil below $50 in your lifetime. I'm gathering you've been around since at least 2008. Oil prices have been all over the board with price shocks, my entire lifetime which began in 1966. But on a long-term chart it's ever upward....why? Inflation and extraction challenges, along with temporary supply-demand imbalances.

    In any event, the US has quickly become the swing producer, as evidenced by several of my operators putting on hold all their exploration (or manufacturing) operations (in North Dakota at least, the Permian is still taking care of current drills but most haven't announced abandonment of new drilling in 2015 quite yet).

    So, back to your demand analysis - demand has increased by 20% in the past decade. The increase will slow in 2015 but ever increasing and growing by 1.1 m barrels daily this year. That almost sops up the whole excess current supply (which is 1.5 m barrels daily). With CLR and American Energy and others shutting down in North Dakota, US oversupply begins to invert by end of the year. Global supply isn't as robust as it might seem, if you add up the whole picture. This downturn will be short-lived.

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