Tuesday, July 01, 2008

We Can Lower Gas Prices Now: Drill, Drill, Drill

SPOT PRICE + CARRYING COST = FUTURES PRICE

Harvard economist Martin Feldstein explains in today's WSJ that the relationship between future and current spot oil prices (see equation above) implies that an expected change in the future price of oil will have an immediate impact on the current spot price of oil.

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 than they had previously believed. They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its initial rate.

Hence, with no change in the current demand for oil, the expectation of a greater future demand and a higher future price caused the current price to rise. Similarly, credible reports about the future decline of oil production in Russia and in Mexico implied a higher future global price of oil – and that also required an increase in the current oil price to maintain the initial expected rate of increase in the price of oil.

Once this relation is understood, it is easy to see how news stories, rumors and industry reports can cause substantial fluctuations in current prices – all without anything happening to current demand or supply.

(MP: Also note that the spot price of oil will fluctuate even without speculators playing a role. After all, speculators have no control over the global supply of, or global demand for, physical barrels of oil. Speculators respond to market conditions, they don't create market conditions.)

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.

Increasing the expected future supply of oil would reduce today's price. 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.

10 Comments:

At 7/01/2008 9:20 AM, Blogger Sophist said...

Futures (an instrument, agreement, etc.)is not the same as future (temporal relation) and futures price is not the same as future price.

There are several dynamic effects in futures curves like in yield curves. For example, inverted yield curves have high short-term interest rates although low long term.

Simplistic thinking and analysis should not be allowed shift the focus away from the fact that some speculators have added a significant premium to energy prices for their own benefit. The task of every organized state that protects its citizens from crime, financial or otherwise, should be to identify and prosecute those speculators.

Shifting the focus to new drilling serves the purpose of forgetting the crimes of price manipulation by a class of funds who seek to make their wealthy clients even wealthier at the expense of the purchasing power of middle class.

Of course, we have here some wealthy clients of hedge funds who will rapidly strike back with aphorisms, ad hominen attacks and screaming, plenty of screaming...

 
At 7/01/2008 9:33 AM, Anonymous EJ said...

Sophist,

But you assume that a signifigant amount of the price appriciation is due to this fiancial manipulation and not actual future epxectations of higher prices. As Dr. perry has posted in recent days, the spot price of Iron and Oinions (both of which have no futures markets) have also appricated along the same scale as Oil. These products are only volnurable to "speculation" if the buys actually want to store the product. Therefore, they are not affected by hedge funds and the so on. The underlying factors of the recent price apprication is not some hedge fund looking to make money for its clients. It is legitamate expectations of future supply and demand dynamics.

 
At 7/01/2008 10:24 AM, Blogger Sophist said...

ej,

I explained before that speculation in oil prices was the driving force behind rises in other commodities. Moreover. you should try to avoid analogies, because they often turn out to be false.

Commodity buying orgy

The aboev article demonstartes how you can have rising prices with lower demand. it just takes some manipulation.

 
At 7/01/2008 10:54 AM, Anonymous EJ said...

Sophist,

I agree that higer energy prices do effect higher prices for other commodities as energy is an imput. However, iron ore for instance has gained in price ont he same order of magnitde as oil. Energy does not reflect 100% of the ocst of production of iron. The bulk of the increase in not the increase in energy costs. Likewise, corn goinf from $2 per bushle to $6 is not all energy. My point in the bulk of the price apprication if you want to call it "speculation" is not because of intnetial price manipulation but rather that expectations of future supply and demand merit such prices. Global oil output has stayed stagnent int he past three years, while demand has risen until very recently and all the long term forecats for oil demand show steady growth.

 
At 7/01/2008 11:59 AM, Blogger juandos said...

sophist whines yet again: "I explained before that speculation in oil prices was the driving force behind rises in other commodities"

No, you gave your poorly, very poorly informed opinion of speculation and its relationship to oil prices...

I see you had to go off shore to bolster your opinion and even then you had to dredge up the opinion of a precious metals pusher for it...:-)

Politicians Pile Their Baggage On Speculators

By ROBERT SAMUELSON

Tired of high gasoline prices and rising food costs? Well, here's a solution: Let's shoot the speculators.

A chorus of politicians, including John McCain and Barack Obama, blames these financial slimeballs for piling into commodities markets and pushing prices to artificial and unconscionable levels.

Gosh, if only it were that simple.

Speculator-bashing is another exercise in scapegoating and grandstanding. Leading politicians either don't understand what's happening or don't want to acknowledge their own complicity.

Granted, raw material prices have exploded across the board. From 2002 to 2007, oil rose 177%, corn 70%, copper 360% and aluminum 95%. But that's just the point.

Did "speculators" really cause all those increases? If so, why did some prices go up more than others? And what about steel? It rose 117% — and has increased further in 2008 — even though it isn't traded on commodities futures markets. (there is more)

 
At 7/01/2008 12:21 PM, Anonymous Anonymous said...

Juandos,

Good post.

Thanks for the links.

 
At 7/01/2008 1:01 PM, Anonymous Anonymous said...

SPOT PRICE + CARRYING COST = INTRINSIC VALUE

INTRINSIC VALUE = FUTURES PRICE

Haven't you guys ever heard of the efficient market hypothesis. By definition there has never, anywhere been speculative mispricing. Investors in aggregate are always perfectly rational.

And as we learned late last week speculators always buy low and sell high.

 
At 7/01/2008 1:31 PM, Blogger juandos said...

Glad to help anon @ 12:21 PM...

anon @ 1:01 PM says: "Haven't you guys ever heard of the efficient market hypothesis. By definition there has never, anywhere been speculative mispricing. Investors in aggregate are always perfectly rational"...

Hmmm, anon @ 1:01 PM, what do you think of the following: Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed.?

 
At 7/01/2008 2:12 PM, Anonymous Anonymous said...

juandos,

I did not know Greyhoond bus driver types like you are also economics experts.

Glad to help?

Are you a teaching assistant of Dr. Perry?

 
At 7/01/2008 3:44 PM, Blogger juandos said...

Hello anon @ 2:12 PM:

Can you tell me what a, "Greyhoond" is?

Curious minds want to know...

BTW how do you figure I'm a bus driver and why can't bus drivers, garbage men or any other sort of profession you care to name have a strong interest in economics?

I mean just because YOU bring nothing of substance or intelligence to the table so to speak, does that mean everyone else has to act the same way?

Again, curious minds want to know...

Hey anon @ 2:12 PM, do try to have a good day... It sounds like you could use one...:-)

 

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