Beating the Oil Barons

Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories, because higher prices would reduce consumption, forcing speculators to accumulate oil. The fact that inventories have not risen supposedly exonerates oil speculators.

But the picture is far more complicated, because oil demand is extremely price insensitive. In the short run, it is technically difficult to adjust consumption. For instance, the fuel efficiency of every automobile and truck is fixed, and most travel is non-discretionary. Though higher airline ticket prices may reduce purchases, airlines reduce oil consumption only when they cancel flights.

This illustrates a fundamental point: in the short run, reduced economic activity is the principle way of lowering oil demand. Thus, absent a recession, demand has remained largely unchanged over the past year.

Moreover, it is relatively easy to postpone lowering oil consumption. Consumers can reduce spending on other discretionary items and use the savings to pay higher gasoline prices. Credit can also temporarily fill consumer budget gaps. Although the housing boom in the United States – which helped in this regard – ended in 2006, consumer debt continues to grow, and America’s Federal Reserve has been doing everything it can to encourage this. Consequently, for the time being the US economy has been able to pay the oil tax imposed by speculators.

Unfortunately, proving that speculation is responsible for rising prices is difficult, because speculation tends to occur during booms, so that price increases easily masquerade as a reflection of economic fundamentals. But, contrary to economists’ claims, oil inventories do reveal a footprint of speculation. Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity.

The root problem is that financial markets can now mobilize tens of billions of dollars for speculative purposes. This has enabled traders collectively to hit upon a strategy of buying oil and quickly re-selling it when end users accommodate higher prices – a situation that has been aggravated by the Bush administration, which has persistently added oil supplies to the US strategic reserve, further inflating demand and providing additional storage capacity.

Absent a change in trader beliefs, the current oil price spike will be broken only by a recession that exhausts consumers’ capacity to buffer higher prices, or when the slow process of substitution away from oil kicks in. Thus, economic fundamentals will eventually trump speculation, but in the meantime society will have paid a high price.

Whereas oil speculators have gained, both the US and global economies have suffered and been pushed closer to recession. In the case of the US, heavy dependence on imported oil has worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.

But some unilateral populist action is possible. A major form of gasoline storage is the tanks in cars. If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand. Given lack of storage capacity, this could quickly lower prices and burn speculators.

Originally published at Thomas Palley’s weblog and reproduced here with the author’s permission.

6 Responses to "Beating the Oil Barons"

  1. Guest   June 25, 2008 at 12:17 pm

    I don’t see what’s ‘strategic’ about the Strategic Petroleum Reserve when we don’t use it to smooth oil price spikes even when they’re at inflation-adjusted and nominal highs. What are we reserving ~53 days’ worth of oil for? Armageddon? Do we even have an energy policy?

  2. steve brassey   June 27, 2008 at 12:29 pm

    if miles driven remain the same, it does not matter if everybody has 1 or 20 gallons in their tank at the end of the day

  3. Guest   June 27, 2008 at 10:05 pm

    Why can we be sure that speculation isn’t driving up oil prices? It’s not because the stupid people who believe such nonsense. It’s because the smart people who claim to believe it can’t come up with a better story.Take this blog and this claim– "Inventories are actually at historically normal levels and 10% higher than five years ago." May of 2003 was when President Bush claimed "Mission Accomplished." Iraqi production was offline and the Venezuelan strike was just ending. U.S. inventories had been seriously depleted by two major outages. That’s why you have inventories — to deal with emergencies and then you have to replenish them. Which we haven’t really done, particularly when inventories are adjusted for consumption. The problem is that without another War or Hurricane Katrina, we are still drawing stocks. Year over year, we are down 50 million barrels. That trend is unsustainable and cherry picking the data won’t change that conclusion.If there were a serious speculative bubble, we’d start seeing problems finding storage space. It ain’t happening. today, total U.S. commercial inventories are about 950 million barrels (crude and products). In 1998, it went over the 1.1 billion barrel mark. Exceed that level again and maybe there is a speculation story. But saying that since we are not actually running out of inventory, we can’t disprove the speculation story is poppycock! There is a clear criterion for proving the speculation story and it’s not there. Saying, "but it’s really complicated" does not relieve the speaker of the obligation to empirically prove an assertion unless one is speaking from the well of the U.S. Senate. One cannot logically relieve oneself of a burden of proof by saying "But the picture is far more complicated". To an economist it is simple. Prices are rising while inventories are falling. Consumption exceeds Production. Supply is greater than demand. Saying "But the picture is far more complicated" doesn’t change that. Keep It Simple Stupid. Entities (assumptions) out not to be multiplied except from necessity. When people deliberate make it more complicated without good reason, they just admitted losing the argument on merits. And saying that one "doesn’t believe the fundamentals argument" doesn’t logically prove the "speculation argument." You can’t prove that 2 + 2 = 5 by disproving 2 +2 = 7. And it’s even worse when you say, I can prove 2 + 2 = 5, because I don’t believe that 2 + 2 = 4.And saying that because more pension funds are buying oil futures oil prices are going up is another logical non-sequitur. More people are using the internet. Is that causing aluminum prices to rise?I believe that if speculation were causing oil prices to increase then intelligent people would have intelligent arguments and good evidence to prove it. Since they do not have good arguments and good evidence to prove it, it logically follows that the speculation story is bunkum. This is dangerous stuff in an election year.

  4. Anonymous   June 28, 2008 at 12:01 am

    In his post, the previous Guest writer overlooks a "simple" economic rule – that of demand v/s supply. If there is a huge wave of buy orders that drives up the price sharply, and it will stay there because in the short run oil prices are inelastic. Add to that with a slight supply shortfall. The previous author should answer a simple question himself/herself; why have oil prices doubled when there are no actual shortages yet? In the past, oil prices only rose sharply when there were actual shortages – rationing or outright unavailability.The oil futures rise is ‘simply’ due to a vast amout of US dollars piling into that market. In a sense, it is no different from the housing market and again, the authorities are looking the other way. Why, probably so that the investment banks can suck money out of the average consumer to recover their losses in the housing market.

  5. Frustrated Guest   June 28, 2008 at 11:27 am

    How do I deal with the previous poster who believes that “in the short run oil prices are inelastic”? The idea that “prices” (or oil) are “inelastic” shows that economics cannot be learned late the night before finals (and probably under the influence of Red Bull and illicit stimulants).Let’s get the lingo straight. “Oil supply” can be “inelastic with respect to price” and/or “Oil demand” can be “inelastic with respect to price.” That means the quantities don’t change much even when prices do. Conversely, it means that it takes a big price change to induce small changes in the amount of oil that people want to buy. In 2007, the world had another robust year of economic growth, especially in Asia where lots of families bought their first car ever. That probably means that the world wanted about 2% more oil. But global oil production was unchanged from the year before. So how did we balance supply a demand? Some came out of inventories. Boys and girls and conspiracy theorists – Understand this! When speculators sell out of inventory, they keep prices from going even higher and that’s what happened last year. But they alone did not have enough oil so it took a big price change to balance the market. This year, speculators probably won’t sell more so it will take even larger price changes to balance the market. And when we speak of supply and demand, let’s make sure that we speak of supply and demand FOR THE SAME THING. Increasing demand for apples doesn’t raise the price of oranges. Buying more auto insurance doesn’t increase the demand for automobiles. They may be related, but they are not the same thing. And — you can even buy weather futures without causing global warming.Oil futures are NOT the same thing as oil! Oil futures are the right to buy/sell oil. But they are not oil unless held to expiration. Most often the contracts are settled for cash before expiration. Cash, not oil, changes hands. That’s what the commodity funds are doing.Buying October oil futures won’t alter the amount of oil available for refining in October, unless the purchaser actually accepts delivery AND stores the oil. If they do that, it will show up in the inventory statistics. That story is not happening because inventory is declining. On the other hand, if the purchasers accept delivery but immediately resell on the spot market, there are offsetting simultaneous purchases and sales and no net effect on prices.If this is not clear to the conspiracy theorists, they need to limit themselves to caffeine and skip the Red Bull.

  6. Kevin   July 5, 2008 at 12:20 pm

    For people who want to see a good explanation of the basic economics of speculation, there is an excellent slide presentation by the International Energy Agency. It is sad that they had to begin by reminding even sophisticated audiences about elementary economics. However, the first few slide do it very well.