Tag Archives: speculation

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.

Bubble Talk

Recently, there has been a great deal of talk regarding oil prices and the possibility of a bubble. Predictions of $200 oil are now becoming more common. Folks like Paul Krugman don’t believe that prices are out of line with fundamentals. However, given the fact that oil prices have risen over 100% in the past 52 weeks, this must mean that something is wrong. Either we had the price wrong last year or the price is wrong this year. Arnold Kling therefore poses the following question:

Early in 2007, the price of oil was $60 a barrel. Recently, it has been above $130 a barrel. Which of the following does Paul Krugman believe:

(a) market fundamentals justified $60 a barrel then, and they justify $130 a barrel now; or

(b) market fundamentals justified a much higher price in 2007?

I believe that (b) is more likely to be true, meaning that we had what Tyler Cowen calls an “anti-bubble” in oil.

We know that Krugman does not believe that today’s oil price is out of line with fundamentals. Krugman’s view, in effect, is that if speculators artificially boost the price of oil, then supply will exceed demand, and the excess has to go somewhere. Where are the inventories?

This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet they did not. So is Krugman forced by his model to conclude that the price of oil of $60 also reflected fundamentals?

Meanwhile, James Hamilton answers:

Where are the inventories? China already burned them.

So where do I come down on this question? I believe that we are in the midst of an oil price bubble. Let’s look at some of the facts:

1. As I have previously stated, the fact that oil prices are rising must faster than the real rate of interest (which may, in fact, be below zero) is causing oil companies to leave the black stuff in the ground.

2. Changes in daily futures prices for oil exhibit positive long-run persistence, which can suggest behavior consistent with herding.

3. The Federal Reserve is incredibly accommodative at the moment.

In my mind, there are too many factors that are pushing the price up that are beyond what the fundamentals would dictate.