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Does queueing theory explain oil's wild price swings?

Kurt Cobb
August 11, 2008

To paraphrase Mark Twain, rumors of the oil bull market's demise have been greatly exaggerated. With crude oil down a mere $30 from its recent peak, many economists and financial analysts are proclaiming the end of the oil bull market. They seem to have forgotten that not too long ago the entire distance from zero to the oil price was only $30. While no one can predict the future of oil prices with certainty, there are explanations for the recent price decline consistent with an ongoing bull market.

First, let's summarize the arguments for the bears. The proximate causes of oil's pullback are said to be a slowing world economy, demand destruction and new supply. Certainly, there is some evidence of a slowing economy, and this very well might reduce demand for oil. Then, there is demand destruction. High prices force some users to cut back on consumption, and this also may have happened. Finally, there is new supply. Large finds now going into production are believed to be putting downward pressure on the price.

Trouble is, all of these explanations are as speculative as the oil market itself these days. Not until many months have passed will it be possible to ascertain whether and how much any of these factors are acting on the price today.

For those who are inclined to the view that the world is approaching peak oil production and therefore restricted supply is the key factor in soaring oil prices, Princeton geologist Kenneth Deffeyes offers a compelling explanation for wild price swings.

An acquaintance from years ago, Suzy Sachs, pointed out an additional consequence. As a systems engineer, she knew that queueing theory predicts that queues behave in a noisy and chaotic manner when demands approach the system capacity. In the grocery store, in the bank, or at the airport, queues tend to be unpredictably very long or very short. Instead of energy prices rising to a new stable level, wild price oscillations will result from short-term changes in demand. There will be a tendency, the first time that prices go down, to announce that the crisis is over and oil and gas are now cheap and abundant again.

The above explanation comes from 2003, so it is not an after-the-fact appraisal. Instead, queueing theory predicts this kind of price behavior in systems that are near 100 percent capacity. In the same way that lines for bank tellers can unexpectedly move from very short to very long, prices in markets can move quickly higher and then lower in very short intervals when the capacity in those markets is near the maximum.

It is largely accepted that there has been a very slim margin of spare oil production capacity worldwide for perhaps the last three years. In other words, the world's petroleum system is running close to 100 percent. This along with robust oil demand has almost certainly contributed to rising prices. But if queueing theory as applied to oil demand is correct, this same lack of spare capacity may also be responsible for sudden, jaw-dropping declines in the oil price as well. As users and speculators crowd together on the "buy" side of the market waiting to be serviced by the producers on the "sell" side of the market, they create a bottleneck. The surest way to get to the head of the line is to offer a higher price. That, of course, begins the bidding as each buyer weighs how important it is to gain access to oil immediately or at least to lock in a price at the current level. This is classic crowd psychology.

Naturally, the whole process can work in reverse. As everyone who wants to bid on oil gets satisfied by the sellers of it (or its derivative contracts), the line on the buy side dwindles. Now the sellers are a bit panicked and offer lower prices as the few buyers left wait to see who can offer the best price. The price moves quickly and wildly up and down, but the system remains near capacity.

It is no secret that small changes in supply or demand in the oil market can have outsized effects on prices. The key element in queueing theory which explains the wild price gyrations is the fact that buyers arrive randomly. If buyers of oil arrived on the scene at only regular, known intervals seeking predictable amounts of oil (or its derivative contracts), then the oil price curve over time would move smoothly and only languorously up and down. Or, if the spare capacity in the market were large, then sudden increases in demand could more easily be accommodated and prices would not be nearly as jumpy. But with spare capacity razor thin, when a large group of buyers shows up unexpectedly, the only short-term rationing mechanism is price.

Doug Noland, an analyst for David W. Tice & Associates who posts his commentary on the firm's Prudent Bear site, provides an analysis that parallels queueing theory, but also adds more detail. Noland believes that the oil and commodities price break is not really the commodities bubble bursting, but rather the burst of what he calls a bubble in the "leveraged speculating community." He is referring to large speculators in the form of banks, hedge funds and even well-financed individual investors who borrow huge sums of money for the purposes of speculation. Some borrow 80 percent or more of their funds. That means a move of 20 percent or even less against them can wipe out their capital.

Many of these leveraged players have been heavily invested in the commodities market. So, it is no wonder they headed for the exits en masse when prices started to decline. Of course, their rush to the exits only exacerbated the decline and then caused other frightened investors to follow suit. The same is true in reverse for the financial stocks which many of the leveraged players had been short. The spectacular rebound of the battered financial sector is due in large part to the unwinding of short positions held by these same players. They were forced to buy back the financial shares they had borrowed when a small bounce in financials threatened them with total annihilation. The bounce in prices began when the U. S. government and the Federal Reserve announced a rescue of America's two largest mortgage lenders, Fannie Mae and Freddie Mac. The sudden move upward in financial shares lured other investors into those shares which led to further rises. All of this came in the face of continuing horrific news for the financial sector, news which is now being dismissed as backward looking.

Noland expects a reversal of recent trends in the not-to-distant future. But if current trends go much further, the coming reversal, he believes, could produce a major market crisis.

In the longer run, little on the oil front has changed. In fact, little on the commodities front has changed. Demand for commodities remains robust and Asian economies which are fueling that demand growth continue to grow, though perhaps at a little slower rate. For metals and food crops, there is confidence that new mines and additional plantings will eventually result in a glut and bring prices back down to pre-bull market levels. And, while prices for both metals and food crops are down for the moment, a glut doesn't seem likely to materialize anytime soon.

But for oil the forecast of an eventual glut may be misplaced as we head into the peak oil era. Surely, prices will continue to fluctuate, probably wildly. But it seems doubtful with peak production likely within the next decade that a long-term glut will develop in oil unless the economies of the world collapse sending demand into the cellar or a miraculous substitute for oil is found and quickly deployed.

As is so often the case in markets, price makes the news rather than the other way around. Prices move and then an army of paid analysts and financial journalists create explanations for the move after the fact. The only sure explanation for a move up is that there are more buyers than sellers, and the only sure explanation for a move down is that there are more sellers than buyers. Queueing theory doesn't go much beyond this except to add system capacity to the equation.

Like so many other phenomena, price moves in the oil markets are often read to mean what people want them to mean. The fact that so many have opted for the most optimistic explanation for the sudden turnaround in prices is an indication of just how much the religion of neoclassical economics still permeates the market watchers. Price is supposed to fix all problems according to this religion.

However, it may soon be demonstrated that the map is not the territory. Price movements in the short run contain very little information of importance for long-term planning. To pay too close attention to every decline in the oil price would be the equivalent of halting construction on one's home every time the sun comes out believing that a new era of permanent sunshine and balmy weather obviates the need for shelter. It is just such thinking that has prevented us to date from deploying the vast amount renewable energy we'll be needing in the not-to-distant future.

Kurt Cobb
August 11, 2008

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