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26 August 2008


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Mike Sheldrick


Michael Klare is the author of Blood and Oil, an outstanding exposition of the evolution of our military to an "oil production and transportation service." Here's a recent article of his from the London Review of Books.



While I would agree with the long term truth that “Peak Oil” is coming, and sooner than anyone wishes to face, basic supply and demand fundamentals can in no way explain the price rise in either oil, or its refined products, over the past few years.

As someone who has done financial analysis for now 2/3rds of my career, and still has to drive rather sophisticated financial planning models, my complaint is threefold. One, most people who claim to know “markets” are closer to being qualified to bag groceries than to comment about markets. Two, most people who comment about capital and operating costs can’t read an income statement or the Notes to the Financial Statements. Three, most people who comment about prices, know less about foreign exchange dynamics than they do about quantum mechanics and the unified field theory.

In regards to the first point, Col Lang’s recent commentary of the futures markets had much validity. I can assure you that a goodly portion of the price rice has been due to such speculation and manipulation. In regards to the former, it is difficult to run an analysis of buy / sells and money flows since there has been no transparency in the market. Blame Phil Gramm, his wife and the Enron loophole. Having met with and seen the operation of the old Enron folks, as well as the people from the Goldman Sachs trading desk, well, these folks would push their 80 year old grandmother in front of a bus for a quarter. As with the circa 2000 California electricity shenanigans, the recent partial closing of the loophole, along with increased visibility, prices have started to abate, notwithstanding all the talk that the price rise was almost wholly demand driven. The obvious caveat is correlation does not insure causality, but if these folks could manipulate the market they would and will manipulate the market. Regarding the concept of “market power”, I would point to two interesting metrics: (1) refining output as a percentage of capacity is actually down; (2) US exports of refined products are at their highest levels ever. Again, economics 101 calls that market power or the ability to generate higher profitability by deliberating generating less output. In other words, US refiners are operating their plants at reduced levels than in the past while simultaneously shipping more product out of the domestic market. Again basic economics, less domestic supply of refined product, results in higher price retail price since as well noted, demand is very inelastic in the short term.

Regarding, capital and operating costs, just once please just once, I wish someone would differentiate between the two. Regarding capital costs, remember first, at least for US taxpayers, that at the most basic level the capital expenditure generates a tax shield roughly equivalent to the effective tax rate. So, that 1 billion dollar oil platform in the Gulf of Mexico or the North Slope, really only costs 65% of that. Now take into account all the other bennies that are sprinkled throughout the IRS code for drillers and refiners – to which admittedly I am not an expert – and I’d wage that the USG is picking up more than ½ the cost. Roll that into a full blown net present value analysis, and I’m sure none of us need to shed a tear. In regards to operating costs, while it’s a nice buzz word – “operating costs” – it is essentially meaningless without additional information. Talk about gross profit, talk about gross margin, on a product by product basis, talk EBITDA margins. Talk about when margin in important and when absolute dollars are important (hint: while high margins are necessary with low volume and high overhead, low margins are perfectly acceptable with low ”unit overhead” and high volume.)

Finally, in regards to Foreign Exchange, I will readily admit that every time I have to wade into that pool it gives me a headache. I’ve come to realize that it is principally due to the fact that as a American, I’ve never had to learn it intuitively since the USD was always the worlds reserve currency. However, one could do what I did a couple of months ago with easily available statistics from the DOE and historical FX rates pulled from Yahoo. Run the correlation between the price of refined products over the past 6-7 years between the US and the EU. You’ll find that while the retail price in the US has gone up by approximately 150%, the price in Europe has only gone up approximately 50%. While admittedly this is simplistic and doesn’t account for all the inputs, it does strongly imply that the collapse of the value of the dollar vis-à-vis other currencies represents a huge component of the overall price increase of a barrel of oil since oil is priced in USD. After running these and other numbers I roughly estimated that 2/3rds of price rise was speculation and FX effects (with the FX effect being larger than speculation) and one third being supply and demand fundamentals. Your mileage may vary.

While this is overly long, let’s take a quick look at Exxon Mobile, to see if we need to cry for them. From their 2007 10-K to the SEC, they had $390 billion in revenue, 70.5 billion in income before tax, paid $30 billion in income taxes resulting in 40 billion of net income. Now you might say that, well look at how much they paid in taxes and a 10% net income margin ain’t too hot. But they had only 12.2 billion of depreciation and depletion on that 390 revenue or only 3% - I just ran that number and still don’t believe it. Also don’t be fooled by the net income number, look to the cash flow statement: $52 billion in income from operations. Also from that cash flow statement, only $15 billion in capital expenditures or 4.8% of revenue. I could find you almost any rural US elec coop or telco that spends triple that as a percentage of revenue. Finally, while that Income tax number of $30 billion seems mighty impressive, - again looking at the notes to the financials you’ll find that only $5 billion was taxes paid to the US government – the rest was foreign income taxes. I do have more than a passing familiarity with Subpart F of the IRS code so I have full sympathy for all the foreign income taxes they pay, but one has to realize, that when we offer tax breaks and subsidies to – ostensibly US companies – who pay the vast majority of their taxes overseas, we are really subsidizing overseas governments and consumers.

William R. Cumming

Wow! What a great comment by dcgaffer. Very helpful. Maybe part of the explanation is that between the 2008 and 2028 election most of the top 10 US domestic oil companies will be long gone from the energy business. So no reinvestment required. As the world moves well above 80% of proven (and unproven)reserves held by NOCs (National Oil Companies) the liklihood of US major oil companies finding countries willing to allow the majors to exploit those countries oil and gas reserves will be de minimus. Question is what will US policy be when oil and gas reserves are held 95% by NOCs. Certainly Putin has already announced publicly long ago that he would view oil and gas production and distribution as an arrow in the quiver of Russian national security. Just playing out more and more each day now. Certainly more than likely by 2028. Remember the 1917 Mexican revolution was an "Oil" revolution ending up with PEMEX.


Col., I commend you for posting this link and analysis. More than the subject under discussion, it shows what sort of a person you are, how this blog is so different, and so superior to most others.

While agree with Fabius, I must say that his analysis is also rather thin on facts and references that he faults you for omitting. I believe that your commenters, myself among them, have raised points that Fabius identifies in his piece.

Fabius also errs in not referring to the comments. One of the great innovations of blogs is the ability to continue, refine and advance the argument and discussion through comments, where all sides of the topic may be aired and examined. Ideally, this can lead to an 'intelligence of crowds' where the 'hive mind' arrives at better answers than the average individual. Though this is not guaranteed.

The oil market is not a pure or perfect expression of Adam Smith's capitalism. Like all investing, there is an element of wagering, and the opportunity for gaming by various parties. However, this is the long-established method by which commodities are bought and sold, and investment in companies working in this area raise substantial amounts of capital. No one complains about the workings of commodity markets when prices are declining.

None of us like having to pay more for gasoline and fuel. But in the absence of a coherent and functioning national program to move towards energy independence, it is only rising prices that produce any tangible action and improvement.

As dcgaffer suggests above, we are to be blamed in not properly overseeing energy companies, and not properly accounting for their activities and taxing their profits and operations. As with Enron, we are socializing the costs while privatizing the profits. That is nothing to be happy about, and it is not in the public's or the country's best interests to continue in this way.

Patrick Lang

jon et al

My comments on the movements of the oil markets are made on the subject of the psychology of the financial markets.

I have never attempted an analysis of the economics of the underlying commodity market in oil.

Since thatis so, I do not think it is correct to say that my analysis lacks data. pl

Dave of Maryland

So far as long term & short term & medium term & trying to figure out when the top or bottom may arrive, or how the various cycles repeat,

I have books & books & books on my shelves that claim to do exactly that. Charts & graphs & analysis from experts of all stripes. Both self-appointed & self-deluded. The best analysis that I have seen are astral, but astral is not socially acceptable.

On the other hand, I have seen many books on how to invest in the markets. Few of these books were intellectually stimulating, and for a reason. The average market trader is not a Great Thinker. He simply wants money. Lots of it. Simple, clean, pure ideas are the only ideas he understands, wants or needs. He is emotionally volatile, he is easily swept up in the herd mentality.

Which, by the way, is why astral analysis will always be better than intellectual. One analyst, an astral-libertarian, declares flatly that by 2016 we will have abandoned markets altogether, which I think horrifies him, but I digress.

It is sometimes true that amateurs, standing outside the pack, may actually get things right. Sometimes a cigar is just a cigar. Sometimes greed is just greed. Just as Microsoft Windows has been repeatedly gamed by a handful of intensely-focused virus writers, the markets are, from time to time, gamed by a handful of intensely focused speculators. They enter the market when they are ready, and if they have judged correctly they will make their money and then move on.

When they are wrong - which I suppose is most of the time - you will never know they were there.


Excellent comment by DCgaffer.

My only question:

What are we to make of Paulson when he goes to the UAE, as he did in early June, and tells the Arabs that "speculation" and the "weak dollar" are only "minor factors" in the high price of oil?

PS: this is a leading question that relates back to some of your well-taken points.


Fabius Maximus

Three quick comments:

1. I did not read the comments to these posts. Thanks for the good idea; I will do so in the future.

2. re: "his analysis is also rather thin on facts and references "

At 2300 words, my post was far too long (far longer than any of Col. Lang's on this topic). There were some links in the posts to supporting material; links at the end wemt to extended discussion of these complex issues.

3. I do not understand dcgaffer's point. I repeatedly said that there was debate among experts about these points, which IMO Col Land did not represent.

Fabius Maximus

Trivia note: While Klare has an impressive background, is he an expert in the market-related dynamics discussed here? From Wikipedia:

"Michael T. Klare is a Five Colleges professor of Peace and World Security Studies, defense correspondent of The Nation magazine, and author of Resource Wars and Blood and Oil: The Dangers and Consequences of America's Growing Petroleum Dependency. ... Klare also serves on the boards of directors of Human Rights Watch, and the Arms Control Association. He is a regular contributor to many publications including The Nation, TomDispatch, Mother Jones, and is a frequent columnist for Foreign Policy In Focus."


Kudos Colonel for posting and hosting this discussion including Fabius's posting. I find myself in agreement with both yourself and Fabius, too. Here's why:

IMO, there are several issues at play here, the first being long-term and related to peak oil, a second, also long-term being the collapse of the dollar and the rise of all commodities and prices of imported goods (even official statistics on inflation levels suggest are bouncing between 5 and double digit values and there is good reason to think are understated), and the third being short term variability such as the recent run up (and run down).

An excellent analogue to understand what is likely to happen in a market system when near its peak is to look at whale oil. Here I summarize from the story of whale oil:


Whale oil increased from tens of dollars in the 1810s to over $1000/gallon at its peak in the 1860s. What is very interesting is that the price is quite stable and follows a reasonably smooth, increasing curve during the initial phase - where production can relatively easily increase to match increased demand but once peak whale oil was neared, began to fluctuate wildly - factor of two in a few years time up and down!. These short-term fluctuations results from speculation and a captive (inelastic) market - i.e., there are many consumers who have no alternative but to buy at the price offered or declare bankruptcy (or sell the exurb house). Once alternatives became widespread, the price returned to low levels and stability (1870s).

Petroleum is far more important to the functioning of the world economy and more likely to trigger resource wars, etc. In this regards, making speculation less profitable (more risky) could smooth these fluctuations, which is one of the functions of cartels. Using the SPR in this function is IMHO an appropriate strategic use.


With regards to the peak oil angle in this thread, I encourage you to to read the latest update to the http://www.theoildrum.com/node/4419>Oil Megaprojects initiative via The Oil Drum Note their projected decline in production beginning in 2012. But this is not equivalent to supply. Supply will equal production minus the oil removed from the market by nationalist policies and by the increased demand for oil by exporting nations. Oil will be in very short supply as we come out of this economic slump.


Fabius gets half-credit for his work here, because he got half of his assertions right, namely this one:

His observations about military and geopolitical affairs are IMO consistently interesting.

On the other stuff, Colonel Lang is not writing about long-term price behavior, as he has made abundantly clear here. So when Fabius points out in his posts (yes, I've read them) that he's discussing long-term price behavior, one can only suspect that he's in violent agreement with Colonel Lang.

And anyone who believes that Peak Oil (the aggregate reservoir production physical response, not the mass hysteria induced by the term) is the reason for the recent wild swings in crude oil prices ought to "show their work", because the math just doesn't add up.

Here's the summary version of mine...

Peak Oil is a term that captures the aggregate production-vs-time response of world oil production. If oil is a finite resource (and all the serious science tends to indicate that it is, some Russian "experts" to the contrary), then eventually any form of extraction technology will induce peaking (in every reservoir, and thus in aggregate for world supplies), so the production-vs-time curve for individual wells, or for the planet itself, tends to be modeled by bell-shaped curves much like those found in statistics (or made fun of in Taleb's book).

In reality, the production curves are not of the shape postulated -- they tend to decline faster than they increase, which means that we are likely overestimating the ease by which we can extract oil from individual, or collective, reservoirs.

Which is part of why Hirsch's report suggests doing something early on, because we're already on the unsafe side of our fundamental assumptions.

There's more to Peak Oil than that, e.g., the price per barrel makes the resulting math nonlinear because extraction margins depend on crude oil prices, so we improve technology for extraction as oil gets more expensive, etc, etc.,... but none of these other issues changes the fundamental truth, that we need to be dealing with the peaking of our available oil supplies. We really do...

But this is what we call a "secular" or "slow-time" phenomenon, because said peaking is something that takes place over decades. Its effect on the oil-price-vs-time curve is to induce a slight positive slope, so that even after one corrects for inflation, value of the dollar, foot-pounds per man-hour, or whatever, the price-vs-time curve still rises slowly with time.

But that's not what the posts at SST are about! We are discussing fast-time fluctuations in price of crude oil, and those simply CANNOT be created by the physical phenomenon known as Peak Oil. Reservoirs and extraction infrastructure don't operate in fast time -- and hence these cannot produce such changes by themselves.

Peak Oil can influence the market in fast time (i.e., recent events), by psychological means that every student learns about in ECON 101A. If all of us believe that oil is suddenly more dear, then we'll pay more, and if demand is inelastic, folks at various places in the supply chain can make a killing.

Including speculators.

Daring to point out the key role of mass market psychology in setting prices (or how markets can be manipulated when supplies are tight and demand is inelastic) is not a denial of the problem of Peak Oil.

It is simply assigning blame for the short-term behaviors of the market.

The secular behaviors are due to many things, including Peak Oil reservoir extraction problems. But that's not what Colonel Lang has been writing about, so there really is no problem here, beyond what I find to be an inaccurate characterization of the Colonel's intent.

Sorry for the length of this, but at least I didn't start trying to expand partial derivatives of price via comment text! Thank your lucky stars for that...


Great discussion above. For more info that is easily accessible, check out the following links.

Former Oilman/Shell exploration geologist Dr. Jeremy Leggett explains the market, the 'debate,' fudging of official numbers a BP, etc. (highly recommended)

The Independent: "Fade to black: Is this the end of oil?"

Michael Klare on "The End of the Petroleum Age":

"Michael Klare, The Pentagon as Global Gas-Guzzler"

"The Pentagon as Energy Insecurity Inc."

This is a 15 minute news segment from The Australian Broadcasting Corporation http://video.google.com/videoplay?docid=-2125452324977038599

This is a the longer, three-part documentary on the story of oil, from its creation, to its implementation, to the future along with implications of climate change. http://www.abc.net.au/science/crude/

Then there is this RTE documentary from Ireland that is good as well http://www.rte.ie/tv/futureshock/av_20070618.html

David Habakkuk


Leaving aside for a moment the question of how far speculation affects short-term price movements:

If the long-term expectation is for prices to rise (both for oil and for gas), and if moreover an exporting country knows that its own reserves are liable to be exhausted quite rapidly -- may it not then be a rational strategy for such a country to pursue 'nationalist policies' and limit the amount of its dwindling resources it makes available to the market?

If moreover the importing countries (such as, for example, gas importers in Europe) appear to be either themselves deeply concerned to constrain the power of a major exporting country (such as Russia), or to be allied with a power so concerned:

Might not such an exporting country have particularly strong incentives to limit supply, drive the prices up, and look for alternative export markets that will become far more promising in the context of such higher prices?

Fabius Maximus,

I had always thought you were William Lind draped in a toga. Doubtless I am wrong. Anyhow, it is good to have you appearing on this blog.

I would also second jon's recommendation that you read further among the comments.

Sometimes, I think it is fair to say, we really do get to an 'intelligence of crowds' where 'the "hive mind" arrives at better answers than the average individual.'

Perhaps because of the Colonel's somewhat awe-inspiring presence, one finds people from all over the world, with a wide range of experience and beliefs, finding elements of common ground.

(Ironically, this may be a demonstration that sometimes -- even if rarely -- 'benevolent dictatorship' works.)


This is a graph of gasoline prices in Ohio over time:

Ohio gas prices

All that I would add to the discussion is that this graph can probably be superimposed on Obama's chances of winning the Presidency, and that things don't look good.

In other words, putting peak oil to one side, the price of gasonline is about to elect the next President of the United States. None of the electrons expended in this post or the comments are wasted.


"In the short run, the market is a voting machine but in the long run it is a weighing machine." - Benjamin Graham

This is the essence of what Pat's posts were on the short term prices of oil, in my opinion.


Two points need to be made:
1) Speculation and peak oil are not mutually exclusive. In fact, a rising market is an ideal time for speculation. Heck, even I made 40% on the oil stocks and funds I invested in in 2004.

2) The coronel attributes the speculation to market psychology. However, the only difference between "market psychology" and manipulation is the intent of the participants. As the number of trader consolidates (which it has), the propensity to engage in "oligopolistic pricing" increases.

"CFTC Chairman Reuben Jeffrey recently stated: 'The Commission’s Large Trader information system is one of the cornerstones of our surveillance program and enables detection of concentrated and coordinated positions that might be used by one or more traders to attempt manipulation.'

In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight."

In conclusion, it is mere speculation to attribute the recent rise in prices to either manipulation or "market psychology."


I imagine one component of speculation has been the roulette game of Peak Oil--when will the supply crunch come and how big will it be? If you bet the right time the profits will be huge.

With regards to NOC and Russia using oil as a weapon, in response we will revert to coal, being a short-sighted and dis-functional country and continue poisoning ourselves.


DH, Yes. I think we agree. I have been in consistent disagreement with PL about the significance of speculation in the oil markets. Whatever place speculation has in driving the price of oil, real supply and demand concerns will continue to play a significant part in the pricing of oil. IMO it will take a severe recession to keep oil below $100 for any significant time. Your points are in part what I am saying.

Fabius Maximus

A follow-up to Habakkuk's commment -- I agree, the advantage in many fields of collective judgement over expert opinion cannot be too often mentioned. The classic text here is "The Wisdom of Crowds" by James Surowiecki.

Wikipdedia: http://en.wikipedia.org/wiki/Wisdom_of_crowds

Fabius Maximus

Cieran -- you raise many good points. Responding here is probably not appropriate, but if you email me at fabmaximus at hotmail dot com I will send some thoughts about your comment.


These Oil points are all well taken.

My Summary:

Peak oil has come and gone in America. Peak oil has hit Saudi Arabia. OPEC is unable to pump the world economy out of the current demand destruction recession.

There is a statistical correlation between fall of the US dollar and the rise in the price of oil. The fall of the dollar is due to deficit federal war spending and the US trade deficit.

The Iraq Invasion increased the war risk price of Persian Gulf oil. The second largest reserve of oil is sitting in the ground due to Iraqi resistance to the American occupation.

Speculation on commodities without any regulation inherently results in wide swings in prices. Corn ethanol increases food prices.

The lack of a national transportation or energy independence programs insures that America will be increasing be dependent on volatile foreign energy sources. Long distance trips will soon only be afforded by the wealthy and the few who have skills in demand by global corporations. More and more US dollars will be spent only on energy and food.

Fabius Maximus

As I said in my post, there are a host of alternative explanations for high oil prices. This was the point of the quote from the International Energy Agency.

For example, here is an analysis by the noted oil expert Philip K. Verleger, Jr — as explained in ”Explaining the 2008 Crude Oil Price Rise“, June 2008.

Note, by "market" he is not refering to specualtion, but supply.


"Start from a very simple fact. The price of crude oil in the summer of 2008 should be $70 per barrel, not $140. The rise from $70 to $140 has not been caused by a shortage. Instead it has resulted from bad policies, bad luck, and incredible inattention to market details by certain officials.

"… In these circumstances, policymakers have very limited alternatives.
* First, they can relax environmental standards. There are supplies of higher sulfur diesel that would address Europe’s current needs.
*Second, governments can release strategic stocks. The U.S. and other IEA members hold significant sweet crude inventories. Release of these crudes (perhaps in a swap) would relieve pressure on prices while preserving environmental restrictions.
* Third, the U.S. can suspend the renewable fuel mandate. This action would allow refiners to boost runs and produce more diesel fuel. Suspension of the renewable fuel act would also take pressure off food prices.

"Regretfully, none of these actions will likely be taken. The failure of policymakers to diagnose the causes of the crude price increase properly makes the adoption of rational policy improbable. Prices will continue to rise."


Very interesting discussion. I am not qualified to weigh in heavily, but as far as I understand the opposing views, it is something like this: Either the prices of oil reflects a coming structural crisis in supply, and are indications of a coming longterm crisis or B) The pricefluctuations are caused by speculants and indicates a crisis in the market mechanism. Is that about it?

If so, I would suggest that its a combination: The underlying awareness of the "impending crisis", wether real or not, as well as the instability in the international political scene has given rise to a psychological climate that lends itself perfectly to speculators. When the herd is already scared, a "boo" sound creates a much bigger panic, and panic is the bread and butter of speculators. That there is a crisis in the hyper-liberalistic voodoo market is a fact I think nobody can escape, however. A market that absobs billions and billions of illegal money every year yet doesnt reflect it seems to me to by necessity be built on several flaws. Enron is/was another example on how the paper-money machine has gone out of wack.

"Ironically, this may be a demonstration that sometimes -- even if rarely -- 'benevolent dictatorship' works.)"

As any industrial worker or military person will tell you, benevolent dictatorship is the only thing that works.;-)


This thread contains hints, faints, and occasional hits, at two subjects that are basically verboten in the MSM...and in many parlors in America. i.e. Conspiracy and class. As to dcgaffer's point that '... correlation does not insure causality", I would respond 'ensure', which I assume he meant, is a far too extracting standard for me. Preponderance of evidence works well for my tastes. In a nation dominated by oil interests, and financial speculators, and in a govt dominated by said same, the rise in price of oil et al comes as no surprise to me. Whether I can completely and competently describe manner of the swindle is one thing....whether I can see and sense the fix is in is another. And Fabius, just out of curiosity, what credential/s makes one an "... expert in the market-related dynamics"?

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