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.