Expectations and Oil Prices

Martin Feldstein says if we lower the expected future price of oil, that will lower the price today:

We Can Lower Oil Prices Now, by Martin Feldstein, Commentary, WSJ: Although most experts agree that financial speculation was not responsible for the surge in the global prices of food and energy, many people remain puzzled about the source of these remarkable price rises. Economics offers a simple supply-and-demand explanation and reason for optimism about the future of commodity prices. In the case of oil, economics also suggests how policy changes today that affect the future could quickly lower the current price of oil. …

The relationship between future and current oil prices implies that an expected change in the future price of oil will have an immediate impact on the current price of oil.

Thus, when oil producers concluded that the demand for oil in China and some other countries will grow more rapidly in future years than they had previously expected, they inferred that the future price of oil would be higher… They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its initial rate. …

Of course, a rise in the spot price of oil triggered by a change in expectations about future prices will cause a decline in the current quantity of oil that consumers demand. … A rise in the expected future demand for oil thus causes a current decline in the amount of oil being supplied. This is what happened as the Saudis and others cut supply in 2007.

Now here is the good news. Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. In other words, it is possible to bring down today’s price of oil with policies that will have their physical impact on oil demand or supply only in the future.

For example, increases in government subsidies to develop technology that will make future cars more efficient, or tighter standards that gradually improve the gas mileage of the stock of cars, would lower the future demand for oil and therefore the price of oil today.

Similarly, increasing the expected future supply of oil would also reduce today’s price. That fall in the current price would induce an immediate rise in oil consumption that would be matched by an increase in supply from the OPEC producers and others with some current excess capacity or available inventories.

Any steps that can be taken now to increase the future supply of oil, or reduce the future demand for oil in the U.S. or elsewhere, can therefore lead both to lower prices and increased consumption today.

I agree in theory, but I’m not so sure we can change expectations enough to make much difference, and if there are environmental costs that aren’t fully internalized into these markets, lowering the price might not be the most efficient policy anyway.

James Surowiecki thinks there’s a “shortage psychology” at work:

…But there’s also something else at work, which the oil guru Daniel Yergin calls a “shortage psychology.” The price of oil—more than that of many other commodities—isn’t based solely on current supply and demand. It’s also based on people’s expectations about future supply and demand, because those expectations determine whether it makes sense for oil producers to sell their oil now or leave it in the ground and sell it later. Currently, the market is assuming that oil will become scarcer, and that global demand will keep rising, especially in rapidly developing countries like China and India. As a result, producers are asking very high prices to pump their oil. Now, it could be that these assumptions are all wrong—that the supply of oil will not be constricted going forward, that concerns about the Middle East are exaggerated, and that higher prices will lead people to cut back on energy consumption, shrinking demand. In that case, oil would turn out to have been hugely overpriced. But that won’t be because of sinister speculators; it will be because oil producers and oil users collectively misread the future.

The difficulty for Congress, of course, is that none of the problems that have driven up the price of oil lend themselves to a quick fix, and most, like the boom in global demand and the inaccessibility of certain oil fields, aren’t under our control at all. That’s what makes speculators a perfect target: by going after them, Congress can demonstrate to voters that it understands their pain, and at the same time avoid doing anything that might require real sacrifice from Americans. Our dependence on foreign oil, together with the fiscal fecklessness that has helped reduce the value of the dollar, means that there is no easy way out of where we are. But in an election year that’s hardly a message that anyone in Washington is going to deliver.

Brad DeLong has an idea:

…I think that Obama ought to be proposing a big oil tax, with substantial parts of it used to pay for people’s FICA and extend the EITC phaseout range. This:

  • raises revenue, and puts us in a much better position for long-run growth
  • improves national security by reducing our long-run dependence on foreign oil from unstable parts of the world
  • helps on the global warming front
  • makes America a less unequal country

I think that that the Democrats ought to offer America a choice between:

  • Paying higher gasoline prices but also paying less in Social Security taxes
  • Continuing to leave our national and economic security hostage in the hands of unstable political-military events in the Middle East–which requires that we spend a fortune continuing to project a huge amount of military power into the Persian Gulf for essentially forever.

This seems like a no brainer to me.

What happens to Social Security if, say fifty years from now, when young people today are ready to retire, we invent a new technology that substantially reduces oil usage, how would we fund Social Security? Do we want to put reduction in oil usage and funding Social Security at odds?


Originally posted at Economist’s View and reproduced here with the author’s permission.

One Response to "Expectations and Oil Prices"

  1. Juan   July 7, 2008 at 4:44 pm

    Mark,I’m afraid that most commentators are unaware of what has been a changing oil price regime in which trade in financial instruments (futures, swaps) came to determine prices of the physical crude oils. Expectations enter the picture to the extent they come to be driven by and drive the financial trade and, as we know, not all expectations are all so rational.Nothing in my above should be controversial unless relatively basic research has not been done.