Friday, June 13, 2008

On oil prices

The debate in the news the past few months seems to be how much of the increase in the price of oil has been by speculative investors, primarily an increase in pension and index funds investing in oil futures and commodities, and how much is a supply/demand thing.

Here's what we know:
Global demand is increasing.
Oil supply responds slowly to price increases.
An increasing number of investors are investing in commodities as a hedge against a falling dollar and rising inflation, driving up the prices of those commodities.

The Economist had this article in last week's issue, and I recommend reading it. It asks "Is it 'peak oil' or a speculative bubble? Neither, really."

It explains why it's harder for a speculative bubble to arise in the oil market. People can't hoard oil like they can other goods. The increase in investment from places like index funds are relatively small compared to how large the market for oil is. The article explains the problem with symmetries of the different grades of oil and gasoline. Diesel is in short supply whereas there is a glut of heavy heating oil on the market.

The article concludes it is essentially a supply/demand problem. New fields and new methods of extracting petroleum are slowing rolling out, but it takes time. Methods like converting coal to oil require that the price be greater than $75/barrel for such operations to be profitable. Thus, many such projects are only just getting underway.

"In the short run, neither demand for nor supply of oil is very elastic. It takes time for people to replace their old guzzlers with more fuel-efficient cars, or to switch to jobs with shorter commutes, or to move closer to public transport. By the same token, it can take ten years or more to develop an oilfield after its discovery--and that does not include the time firms need to bolster their exploration units."

Elsewhere in the issue is the issue of government fuel subsidies. Some countries (like China and Venezuela) lose money by subsidizing gasoline. This pushes the price artificially low and increases demand (ie: we move down the demand curve). So, cheap gasoline in China raises the price for the rest of the world. China can afford this policy because of their currently large budget surplus.

Interestingly, I read that prices dropped today after OPEC members began questioning the "unjustified" price of oil. So, if the answer to why oil is so high is mostly "pure supply and demand" then how far will the price drop when any speculative bubbles present burst? 33%? 10%? 1%? That's the question.

In any case, don't expect prices to fall quickly anytime soon.

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