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.

Originally published at The Everyday Economist and reproduced here with the author’s permission. 

One Response to "Strategic Reserves and Oil Prices"

  1. Anonymous ibid.   August 8, 2008 at 11:12 am

    Even though I agree with its thesis, I was disappointed with the article. Krugman’s position is not presented fully or accurately, there is at least one factual glitch, and the proposal for a multibillion dollar experiment with national security implications to settle a dispute among economists seems, um, impractical.First, there is a semantic issue: how large of an impact would speculation have to have before it’s considered important? Neither side in the debate has defined terms properly.Second, in a profession rife with Austrians, Krugman is hardly a market “fundamentalist.” And he probably does understand Keynes.There are several strands to Krugman’s argument, only some of which are reflected in the paper. One is that speculation should induce the speculator to store oil. While producers could serve as speculators, an argument I have also used, one might also expect that others would join the game, creating private stocks. It has been alleged by producers that tankers are being used as stores. Also, the SPR and similar facilities throughout the world serve as storage. How large are they vs. the size necessary to move price?Krugman also argues that iron ore, which is not traded on futures exchanges, has also shown huge price rises. While this is true, those rises have partially been due to the falling dollar, may not have run as far as oil (depending on what grade of iron ore one focuses on) and seem to have moved with somewhat different timing than oil. So, while Krugman’s argument makes some sense, it would be better to nail down the specifics.I also think the article is missing some points. First, the oil market has historically been one of the prime focuses for manipulation, from John D. Rockefeller to OPEC. Second, “speculation” literally means guessing in the face of uncertainty. So, a sign of speculation is volatility.Well, there’s more, but there’s less time than material to discuss.