Economics 101. Though it is something that should covered in any basic economics course, listening to the rhetoric about oil prices from the two major candidates suggests that some basic principles of economics remain opaque to the body politic.
The reason that oil prices are going up even though there is no mismatch between current supplies and demand is that expectations of future price increases are causing producers to hold supplies off the market. If you had a stock that you believed will be worth twice as much 5 years from now as it is today would you sell it, or would you would hold on to it till you could sell it for a lot more? The same with oil.
People who sell a stock that later goes up drastically in price are called stupid. Oil companies that do the same with their oil are called public spirited. Politicians that demand that oil companies act in a pubic spirited way are called courageous. So far, the supply of courageous politicians has far outstripped the supply of public spirited oil companies. Thus, supply first contracted then held steady till the current prices were more in line with the futures market. As current prices have finally caught up with futures markets supply has started to increase (though not in the US, where political constraints have cut off most avenues of increase).
Why do people think that oil is going to be worth a lot more in a few years time, even though currently there is little or no mismatch between demand and supply? Because the demand for oil is expected to increase much faster than was thought just a few years ago. The main reason is the rise of China and, particularly, India. If those countries keep growing at the same rates they are now the demand for oil in the world will far outstrip the supply in the relatively near future.
That is why the futures markets were pricing oil so high. There is nothing exotic about a futures market. An oil future is just a promise to deliver a barrel of oil at a certain date in the future. The price of the future is simply the price at which the number of people willing to pay a dollar for the future barrel of oil equals the number of people willing to sell the future barrel of oil. A few months ago, as markets started to look at the implications of world wide growth rates and decided that a barrel of oil in the future was going to be worth a lot more than they had thought it would be. Futures prices started to rise and, as they did, so did current prices.
So the bad news is that future bad news is being priced into the current market. But that is a blessing in disguise. God’s Viceroy on Earth, the market, is telling us to drill.
Seriously, the futures market is just a signal. And the good thing about it is that, just as you don’t need to have a downward movement in current supply or upward movement in current demand to bring about a big increase in the current market price, you don’t have to have a big increase in current supply or decrease in current demand to bring about a huge decrease in the current price. All you have to do is convince the futures markets that the trends are in the right direction, that the future price of oil will not be radically higher than it is now, and the same mechanisms that have driven the current price of oil up can drive it down just as quickly.
There are two obvious things and as usual the most useful is the most painful. First is increasing supply. It is true that deciding to drill today would not mean any actual oil on the market for 5 to 10 years, but that doesn’t matter. It is the belief about the future tightness of supplies that has driven current prices up; reversing that belief can drive them down just as quickly.
The other thing, the non-fun thing, is keeping demand down. This can be done most efficiently by keeping the price of gasoline high. Advocating such a policy is also a highly efficient way to lose an election. That is unfortunate. As prices come down demand will go up, leadin us into the same problem we are in all over again. A tax on gas that went up as market prices went down such that the price was kept at around $4 a gallon would be a relatively painless way to avoid this. But of course, this solution makes far too much sense to ever be adopted in a democracy, let alone a democracy in an election year.
As for the effects of the oil prices on our economy are bad enough, our dependence on third world oil has an even worse effect on the political systems in those countries. There is a well-developed literature in both political science and economics on this question. In economics, the problem goes by the name of “the resource curse.” There is a well documented negative correlation between natural resources and democracy. The basic argument is that having a large, exportable commodity both increases the incentive to stay in power and provides the means to do so. The more oil you have as a proportion of your GNP, the more likely you are to be a dictatorship (case in point, Nigeria).
If you come from an undeveloped country that has a commodity as valuable as oil in large quantities the amount of money to be made by being the one that controls the rights to that commodity far outstrips the gains to be made from, say, starting a business or developing manufactures. Moreover, once you are in power, control over the commodity allows you to stay in power. Using the money it generates you can buy more muscle and political protection, as explained by Tom Hagen in Godfather I when arguing to the Don for taking Solatzo’s deal and going into narcotics (is there any principle of political science the Godfather doesn’t explain?).
Again the solution, like the sliding gas tax mentioned above, is as obvious as it is politically impractical. Still, we can always hope for the return of the British Empire.
The reason that oil prices are going up even though there is no mismatch between current supplies and demand is that expectations of future price increases are causing producers to hold supplies off the market. If you had a stock that you believed will be worth twice as much 5 years from now as it is today would you sell it, or would you would hold on to it till you could sell it for a lot more? The same with oil.
People who sell a stock that later goes up drastically in price are called stupid. Oil companies that do the same with their oil are called public spirited. Politicians that demand that oil companies act in a pubic spirited way are called courageous. So far, the supply of courageous politicians has far outstripped the supply of public spirited oil companies. Thus, supply first contracted then held steady till the current prices were more in line with the futures market. As current prices have finally caught up with futures markets supply has started to increase (though not in the US, where political constraints have cut off most avenues of increase).
Why do people think that oil is going to be worth a lot more in a few years time, even though currently there is little or no mismatch between demand and supply? Because the demand for oil is expected to increase much faster than was thought just a few years ago. The main reason is the rise of China and, particularly, India. If those countries keep growing at the same rates they are now the demand for oil in the world will far outstrip the supply in the relatively near future.
That is why the futures markets were pricing oil so high. There is nothing exotic about a futures market. An oil future is just a promise to deliver a barrel of oil at a certain date in the future. The price of the future is simply the price at which the number of people willing to pay a dollar for the future barrel of oil equals the number of people willing to sell the future barrel of oil. A few months ago, as markets started to look at the implications of world wide growth rates and decided that a barrel of oil in the future was going to be worth a lot more than they had thought it would be. Futures prices started to rise and, as they did, so did current prices.
So the bad news is that future bad news is being priced into the current market. But that is a blessing in disguise. God’s Viceroy on Earth, the market, is telling us to drill.
Seriously, the futures market is just a signal. And the good thing about it is that, just as you don’t need to have a downward movement in current supply or upward movement in current demand to bring about a big increase in the current market price, you don’t have to have a big increase in current supply or decrease in current demand to bring about a huge decrease in the current price. All you have to do is convince the futures markets that the trends are in the right direction, that the future price of oil will not be radically higher than it is now, and the same mechanisms that have driven the current price of oil up can drive it down just as quickly.
There are two obvious things and as usual the most useful is the most painful. First is increasing supply. It is true that deciding to drill today would not mean any actual oil on the market for 5 to 10 years, but that doesn’t matter. It is the belief about the future tightness of supplies that has driven current prices up; reversing that belief can drive them down just as quickly.
The other thing, the non-fun thing, is keeping demand down. This can be done most efficiently by keeping the price of gasoline high. Advocating such a policy is also a highly efficient way to lose an election. That is unfortunate. As prices come down demand will go up, leadin us into the same problem we are in all over again. A tax on gas that went up as market prices went down such that the price was kept at around $4 a gallon would be a relatively painless way to avoid this. But of course, this solution makes far too much sense to ever be adopted in a democracy, let alone a democracy in an election year.
As for the effects of the oil prices on our economy are bad enough, our dependence on third world oil has an even worse effect on the political systems in those countries. There is a well-developed literature in both political science and economics on this question. In economics, the problem goes by the name of “the resource curse.” There is a well documented negative correlation between natural resources and democracy. The basic argument is that having a large, exportable commodity both increases the incentive to stay in power and provides the means to do so. The more oil you have as a proportion of your GNP, the more likely you are to be a dictatorship (case in point, Nigeria).
If you come from an undeveloped country that has a commodity as valuable as oil in large quantities the amount of money to be made by being the one that controls the rights to that commodity far outstrips the gains to be made from, say, starting a business or developing manufactures. Moreover, once you are in power, control over the commodity allows you to stay in power. Using the money it generates you can buy more muscle and political protection, as explained by Tom Hagen in Godfather I when arguing to the Don for taking Solatzo’s deal and going into narcotics (is there any principle of political science the Godfather doesn’t explain?).
Again the solution, like the sliding gas tax mentioned above, is as obvious as it is politically impractical. Still, we can always hope for the return of the British Empire.
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