The price of a gallon of gas crossed the $4 mark in Ames, Iowa this weekend. Many pundits are predicting higher prices as the price-per-barrel of oil is expected to reach $150 by the end of the summer. Each barrel produces 42 gallons of oil but there are taxes and surcharges added which raise the end-price per gallon for the consumer.
What is driving this exorbitant price of gas? I looked up some textbooks on economics and here is a brief summary of some of its basic principles. Equilibrium occurs at the intersection of a commodity’s market demand curve and market supply curve. Ceteris paribus, the equilibrium price and the equilibrium quantity tend to persist in time. An increase in demand causes an increase in both the equilibrium price and the equilibrium quantity. An increase in market supply causes a reduction in the equilibrium price but an increase in the equilibrium quantity. The opposite occurs for a decrease in demand or supply.
Let’s look at some data to which we can apply these principles. In 2006, the U.S consumed 20.7 million barrels of petroleum per day of which 9.3 million barrels per day went towards motor gasoline. In 2007, the average consumption of petroleum was 20.7 million barrels per day and in 2008 the numbers for January through May are not significantly different from the earlier years.
The total world consumption over the last three years has remained steady at about 86 million barrels of petroleum per day.
So the demand for oil has not changed significantly at all. And very surprisingly, the OPEC supply has in fact increased this year. Therefore, economic theory should predict a reduction in the equilibrium price. There has been no significant change in the oil market demand and supply over the last three years to warrant the skyrocketing prices in existence today.
Why then has the price of oil gone up so dramatically? The answer lies in the number of hedge funds in the energy markets over the last two years. Today, more money is flowing into commodities as a hedge against the falling value of the dollar and as an investment alternative to a volatile stock market. These funds are not traditional speculators but index speculators who have heavily influenced oil prices.
In simple terms what’s happening is the following. The OPEC countries are overcrowded with super tankers chartered by oil-producing governments to hold inventories of oil they have pumped but cannot sell. There are fewer buyers for this oil cargo at today’s prices, but there are plenty of buyers for pieces of paper linked to the price of oil next month and next year.
Sound familiar? This is exactly the bubble that burst in the home foreclosures that occurred earlier this year. Nobody wanted to buy sub-prime mortgage bonds, but there was plenty of demand for financial derivatives that allowed investors to bet on the future value of these bonds.
We are headed towards another financial meltdown in the coming months. There are now 634 energy hedge funds, out of which 210 are strictly energy commodity funds trading oil or oil futures, as opposed to the stocks of traditional energy companies like ExxonMobil. Large financial institutions like Goldman Sachs, Morgan Stanley, and Merrill Lynch have stepped up their participation in the energy markets.
The price of oil, therefore, is not being fueled by supply-demand economic factors, but by the value of the dollar and the interest rates in the oil markets. The investment in index funds has grown 20-fold from $13 billion to $260 billion during the last five years.
Upon further analysis, a new reality begins to emerge. I am as guilty in causing the hike in oil prices as anyone else. Why, you may ask? Because my pension fund and corporate and government pension funds and university endowments1 are all managed by the large financial institutions, which are allowed unlimited speculation in these markets. The Commodity Futures Trading Commission has allowed loopholes in its regulations that exempt investment banks from reporting requirements that are required of other investors.
Do I like the high price of oil? NO (Politically correct answer).
Do I like a high return on my pension fund? YES (Personally correct answer).
Certainly it is in my self interest that my pension fund does well as I approach retirement.
Notes
1. The financial geniuses at Iowa State University see good economic sense in sending out their Parking Division SUVs into every lane of half-vacant parking lots to issue $15 tickets to about a dozen or so illegally parked vehicles per day while spending about $500 per day or more on gas and salaries. Unfortunately, such expenses come from the taxpayers instead of the university’s lucrative endowments.
10 comments:
madhav:
two issues:
1. I recently read in the Economist that world oil consumption has actually increased; the US's fraction of import has certainly decreased, but world consumption has increased.
2. Economic theory needs to be modified slightly. Supply here is slightly different because OIL cannot be grown or manufactured and is a fixed asset. So one way to look at the supply is in terms of "remaining oil" in the ground. That is decreasing and thus the higher prices.
:-))
Arun,
Thanks for the insightful observations. My blog uses mainly post-2006 data. The data from 2001 to 2006 certainly indicates the points you are making about increased demand for oil in China and India.
In 2004, China’s demand was an extra 0.9 mbd (million barrels per day) – in 2007 it slowed down to an extra 0.3 mbd. The global demand growth has also decreased from an extra 3.6 mbd to 0.7 mbd after 2006.
What is puzzling is the price of a barrel of West Texas Intermediate Crude, a commonly-used benchmark. In December 1998 it was $11.28, in 2001 it was $19.33, in 2005 it was $59.43, in 2006 it was $62.03, in 2007 it was $91.73, and last month it was $125.39.
Whatever the Economist says about world oil consumption (which many other sources say has decreased or is almost stagnant in the last two years from its levels in 2006), the oil consumption has not increased that much since the end of 2006 to warrant the staggering price per barrel of West Texas Intermediate Crude.
This was my motivation for the blog – I don’t believe we are being given the right explanation by the cognoscenti. Perhaps there have been studies on projections in the supply of oil, which as you say is bound to decrease, and this may explain the rise in prices. But it still does not explain the explosion in the price per barrel that we are witnessing today.
I too looked around and found that world oil consumption has increased, but less than the increase in production. Conditions in Africa, Iran and Venezuela, drop in $ value plus speculation on futures are probably what are driving the price up. But somehow, I too get a feeling that it is speculation that is main cause. Quoting from an article "since September 2003, the total number of open crude oil futures and options contracts rose by 364 percent. Meanwhile the global demand for petroleum rose by just 8.2 percent."
when US entered Iraq,the price of Oil was $ 27.Now it is $ 140.Thankfully,after the elections,US will leave Irag.You can guess the price of Oil.Moreover,the sub prime crisis would have reached the shores of Oil Derivatives also.
Anbu
Clarification and data sources: My apologies for not citing the sources in my blog.
One data source that I used:
http://www.gravmag.com/oil.html
I think some clarification is required in what I wrote. The main point I was trying to make was that the production-consumption figures from 2006 onwards as compared to those from 2002 to 2006 do not explain the unusually large spike in the price today, considered solely from a supply-demand perspective. One reader correctly pointed out to me that a 42-gallon barrel of oil produces only 19.5 gallons of gasoline.
Year Consumption
2002 74 mbd
2003 79.6 mbd
2004 82.3 mbd
2005 83.7 mbd
2006 84.6 mbd
2007 85.3 mbd
2008 87 mbd
If you average the consumption in 2006, 2007 and projected 87 mbd in 2008, it comes to 86 mbd. There is no question that worldwide oil consumption increased by 11.4 percent from 2001 to 2006 largely due to the demand from China and India. In that time frame the price of a barrel of West Texas Intermediate Crude (WTIC) increased from $19.33 to $62.03. Last month WTIC was at $125.39.
http://www.economagic.com/em-cgi/data.exe/var/west-texas-crude-long
What is hard to explain is the doubling of WTIC from its 2006 price of $62 to $125 in May 2008 when the demand is projected to have gone up by only 3 mbd from its 2006 level.
Either we are at a critical equilibrium point with respect to production capacity or some other factors are involved.
Dear Prof. Prabhu,
Our common friend Ram Prasad forwarded me your thoughtful blog on the oil price spike. You are in good company here -- George Soros and Meghnad Desai have recently written op-eds fingering the speculators on this specific issue. In line with what you have written, Soros has pointed to the growth of oil/commodity contracts in global investor portfolios. He has called this rise in oil prices a bubble. I have no doubt that technical factors such as this are contributory to the spike.
I am no expert on this topic, but IMHO there are two distinct issues here. One relates to the price of the short-dated futures (2008, 2009 futures); the other relates to the long-dated ones (eg 2016). Demand for oil is highly inelastic in the short-run, and this is why using smooth supply-demand curves may be problematic. As far as the long-term is concerned I have seen people quote the parallel with the spike in whale oil, a couple centuries ago, to argue that long-term demand is elastic. Reasonable people I know disagree in applying this argument to the present case pointing to the lack of medium-term promise of any existing alternatives. Only time will tell.
The spike in short-term futures could be attributed to reasons other than speculators as well.
- Geopolitical conditions: the throttling of Nigerian oil supply, Israeli jawboning in relation to Iran, among others
- Supply shortfalls for 2008: I have seen various projections -- Barclay's is projecting a net deficit
- Demand shocks: the earthquake in China is rumored to have destroyed large power installations , resulting in massive purchase of oil in the open market
- Inflation hedge: it appears that oil is the new gold, and the preferred way to hedge inflation.
On the other hand, the spike in the prices of the long-term contracts is a source of greater puzzlement to me. Not only have the long-dated futures spiked, they have spiked with volume. As Lord Desai puts it only astrologers pretend to be able to forecast events that far out. Also data relating to the factors impacting, as well as trends of, supply has been around for a while. It's odd that so many people should suddenly (< 6 months) herd to one side in the interpretation of this data!
As regards the role of speculators: as you know many futures exchanges publish data on the net position holdings by trader category: specifically commercials and speculators. I remember reading that the change in commercial hedgers' position last month was net long; the speculator position change was net short. Also, if you remember the price action last Friday when oil spiked by $10 a barrel, this was attributed to short-covering by the speculators. If these statements are true, then it would seem to somewhat exonerate the speculators.
-Ramesh Subrahmanyam
Ramesh,
Thanks a lot for your well-informed comments. Hopefully there will be some discussion and dialogue on this issue as we "common folks" begin to understand the real reasons for the oil hike. I am not at all an expert in economics but just out of curiosity I looked at the data and tried to make some sense out of it.
My gut tells me that there is some manipulation happening on a global level to get us all to happily accept some other larger plan – but I cannot be certain about this.
You may find the article at the following link interesting.
http://www.alternet.org/workplace/87474/
US Treasury Secretary Henry Paulson said on Saturday speculators were not to blame for surging oil prices, with "all the evidence" pointing to tight supply and strong demand as the main cause.
"Financial investors don't create trends. They may sometimes follow trends," he told a press conference here after a meeting of Group of Eight finance ministers.
He said there had been no significant increase in global oil production capacity for the past 10 years, calling for new investment to tap sources of fossil fuels as well as alternative energy.
Earlier, Finance ministers from the Group of Eight industrialised nations called for an urgent boost to global oil production and a probe into the recent wild swings in energy prices, including the role of speculators.
http://timesofindia.indiatimes.com/Business/Dont_blame_speculators_for_surging_oil_prices_US/articleshow/3128526.cms
Wonder how much of his investments are in the hedge funds. Note that he does not quote any known facts to justify the "supply and demand" story.
Amrit:
Read this article by William Engdahl - the last sentence tells us where Paulson was working before he became the Treasury Secretary.
http://www.globalresearch.ca/
index.php?context=va&aid=8878
http://timesofindia.indiatimes.com/articleshow/3027279.cms
http://www.nytimes.com/2008/05/21/business/21oil.html?_r=1&adxnnl=1&ref=business&adxnnlx=1214684330-/D/c4Vo6k6eIcVzfnLjkQg&oref=slogin
Read the above interesting predictions made 2-4 years by an Indian origin analyst -Arjun "Spike" Murti in Goldman Sachs on how oil prices would soar.(Unless Goldman Sachs were themselves in on the conspiracy?).
And the latest on this is we may need to wait for 20 long years for oil prices to fall down to more reasonable levels of $75 per barrel
http://www.indianexpress.com/story/323174.html
It is interesting to note that Arjun Murti who predicted this spike in prices 2 to 3 years ago , quashes off the suggestions about speculators driving up the oil prices. “Oil markets are driven by fundamentals. Our response to the notion that it is merely a bubble is that you are still seeing no supply growth. If the price isn’t real, where is the supply?” he said.
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