Strategic Reserves and Oil Prices

I was fortunate enough to receive an advanced copy of Paul Davidson’s article on oil speculation prior to its publication in the July/August issue of CHALLENGE (here is a non-gated version). Davidson shares my view that speculation coupled with low interest rates are causing rising oil prices and offers a solution.

As I have previously expressed, the rise in oil prices cannot be fully attributed to supply and demand because interest rates are at historically low levels (short-term real interest rates are negative). Thus there is little incentive to extract oil from the ground when the rate of interest is below the rate of growth in the price of oil. As Davidson points out, Keynes explained this phenomenon using the Marshallian idea of the user costs. He explains:

…if oil prices are expected to rise tomorrow then producing a barrel of oil today involves the cost of foregone larger profits that could be obtained by holding the oil underground to produce tomorrow in order to sell at an expected higher price. Clearly such expectations of future oil prices should affect the oil producers’s decision of how much oil to produce today if they are interested in maximizing the return on already existing investments. In other words, the recognition of a user costs factor means that both Krugman’s argument that higher prices due to speculation will induce an “excess supply” and The Economist’s assertion that producers will not hold oil reserves underground because this always means a lower return on investment already undertaken are not correct. The concept of user costs suggests that leaving more oil underground may enhance total profits on the producer’s investment if prices are expected to rise in the future (more rapidly than the current rate of interest). And what better indicator of future prices exists today, then the benchmark oil price determined in the NYMEX and ICE futures market?

So how can the price be brought in line with market fundamentals? Davidson suggests selling between 70 and 105 million barrels of oil from the Strategic Petroleum Reserve (SPR). Doing so would significantly reduce the price of oil, squeeze speculators, and alleviate some of the government’s current budget deficit. Also, since the SPR can pump up to 4 million barrels per day, the government could pursue such a policy for a couple months without significantly reducing the reserves. Barack Obama has recently signed on to this idea (as well as changing his position on offshore drilling).

If my hypothesis regarding oil prices is correct, offshore drilling will not be enough to reduce the price of oil because significant changes in supply are unlikely to take place absent higher interest rates. The Fed has signaled that it will not help in this regard as it announced today that the federal funds rate will remain unchanged. Thus, if the government really wants to “do something” about the problem, this is likely the best scenario. It is certainly better than Obama’s previously floated idea of offering a $1000 energy rebate check or the Clinton-McCain gas tax holiday.

4 responses to “Strategic Reserves and Oil Prices

  1. I’m put off by a few aspects. Davidson rejects the market price as being unsupported by supply and demand. The supply-demand-futures relationship is so tight at the margins, I don’t think it is for academics to pick a price. I think we could use, for instance, a vibrant international commodities market to set prices.

    Not liking the price the market comes up with, he suggests the government intervene in supply by selling part of the SPR. I’m not certain of the SPR’s strategic value, but if we’re going to let the Feds use it for price manipulation, I think I’ll short life, liberty and happiness.

    Lastly, why will a limited and — by definition — fixed supply supplement from the SPR tame the wild wily speculators more than a substantive and open ended supply enhancement from drilling? The promise of more oil coming online in 8-12 years should encourage the big integrators to pump what is profitable at current prices, irrespective of the future price discounted against a small (even negative) real interest rate.

  2. Response to jk.

    If speculators are badly burned by sales from SPR this time and if they realize that the government still has plenty of crude in the SPR and will use it to burn speculators if they raise the price again above what supply and demand warrants, then all speculators will think twice before trying to cash in on another oil bubble.

    The fact that crude prices have already declined by approximately 15% from their high just a month ago — should suggest that speculation had a lot to do with the current price — and the talking head experts were saying oil will exceed $200 per barrel by 2009!

    There still is some speculative froth in the current price of $118.

    Furthermore, if the US sold crude at its peak of $148, and then bought back (or takes oil as royalties on government properties) at a price of $100 a barrel, look how much the government would profit from selling at a high of $148 price and buying at a lower one of say $100 per barrel..

    But of course jk probably thinks it is not proper for the US gvernment to profit from the oil bubble while gvernment action deflates the bubble– while it is part of his “life, liberty and pursuit of happiness” to permit private indivduals and firms — including middle east producers including Iran — to profit!!

  3. jk would enjoy equal parts thrill and amazement should the Federal government execute profitable trades in the commodities market.

    I just think that recent declines have been pushed by expectations of future supply from more drilling, and that more drilling is a better method to remove the “speculation premium” than the SPR.

  4. Drill here Drill now.. let the cards fall where they may.

    Speculation, supply, whatever the ultimate end, allowing the harvesting of any or all resources WILL continue to drive prices down.

    As I write this comment, BBL price about to drop below $116. Why? Because of prior speculation? Or because there are legislators calling for allowing a vote to end SOME of the restrictive policies our government has adopted over the years?

    Over abundance is ALWAYS a winner in my book.

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