Sudip Bandyopadhyay’s Blog

Although volatility in most assets is sharply lower than it was in November, oil price volatility has continued to climb. This rise in volatility, and resulting near $30-a-barrel oil price, is reflecting the same imbalances in the energy market that $147 oil did last summer: namely inadequate investment in basic infrastructure to produce, deliver, store and distribute energy. Last summer, attention focused on shortages in production capacity. However, present underlying shortages in storage and transportation are creating massive price distortions across the energy complex.

Storage and transportation capacity provides the system with a buffer to supply-and-demand shocks by allowing it to run surpluses and deficits that smooth the normal cyclical swings in prices. As global storage capacity has failed to keep pace with growth in global demand over the past three decades, this buffer has shrunk relative to the size of the market, resulting in chronically higher than normal price volatility. Once infrastructure begins to constrain the ability of the market to run imbalances, prices have to create more of the adjustment process. Electricity markets are an extreme case of this. As power cannot be stored, supply must always equal demand, leaving price as the only mechanism to force the adjustment process. Accordingly, in free markets electricity is the most volatile of all assets. Due to inadequate infrastructure investment over the past several decades, oil is looking more like the electricity markets.

Last summer, inadequate production capacity and strong demand created a large deficit that quickly exhausted inventories. The lack of an inventory buffer necessitated sharply higher prices to bring demand down in line with supply to keep the market in balance (demand destruction). Due to the financial crisis, demand today has fallen far below supply, such that large surpluses are beginning to breach global storage capacity, requiring production shut-ins motivated by sharp declines in spot prices (supply destruction). Storage is the mechanism that creates the link between spot and forward prices. It is high time the leading oil producing nations start focussing on creating & enhancing  the enabling infrastructure for orderly development of the market.