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Oil prices already near highs when priced in GDP

March 1, 2011

I was thinking along the same lines, but I didn’t have the full day to devote to this.  Glad to see I don’t have to now! The price elasticity of Oil is low, and remains low. This means that demand does not change much ever for large differences in price in the short term.

We’re used to pricing oil in USD.  But another really good way to look at the oil is “How much of our work is devoted to purchasing energy?”  The reason this is a good question is because the amount of energy demanded doesn’t change even when the price for this energy changes. So asking how much “money” this energy costs is not as useful ask asking how much work it costs.

For this, you translate the total cost of oil USD into GDP terms.   This is what BAML did! Nice one. It turns out that in terms of Global GDP, the price of oil is already nearing the 2008 highs.

Then they point out that this demand elasticity has a huge kink.  It is strongly linear until a point, but at that point the world capitulates and destroys a huge portion of demand.  This dynamic was one of the triggers of the 2008 Lehman Crisis – remember $4.50/gallon gas?

Apparently, we are very near that point with the current prices of oil.  Ouch.

First, the part that demand elasticity causes huge jumps in price for minor disruptions in demand.    (h/t to the FT Alphaville blog):

the price elasticity of global oil demand will ultimately determine how high oil prices go. Broadly, we would argue that a 10% increase in oil prices pushes down global oil demand by about 0.5%. In other words, a 600 thousand b/d production disruption should impact Brent crude oil prices by about 15% or $15/bbl, in our view. This calculation is consistent with the jump observed in recent days in response to Libya’s output disruption. Worryingly, it highlights the risk of further price rises if more production is shut in.

Then worry that we are really close to the discontinuous break point for demand destruction:

In our opinion, if Brent crude oil prices hold at around $110-115/bbl in 2011, energy as a % of GDP would remain close to record levels (Chart 14), suggesting that the point of demand destruction is in short sight.Even when looked at on a quarterly basis, we find that oil prices are already very close to the exceptionally high levels observed in 2008 (Chart 15).

While this suggests to them that we have a spike and crash scenario coming, I think it is already here.  I am waiting on the “Crash” part. Combine this with any few random posts from Gregor.us and you can see a spiky future for oil.

By the way – you need to setup an RSS feed for both the FT Alphaville blog and for Business Insider.  These are some of the best sources for information on the web.  Plus you’ll find a good amount of quality IB reports.

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