The International Energy Agency (IEA) recently coordinated the release onto the oil market of some of the strategic oil reserves of the United States, Japan, and ten other countries that hold reserves. The release was motivated by the rapid run up in oil prices from about $95 a barrel at the beginning of 2011 to over $120 a barrel in April of this year. I will discuss the fundamental determinants of the sharp fluctuations in oil prices, the role of “speculators”, and why it was unwise at this time to release oil from these reserves.
After the initial huge increase in oil prices following the Arab oil embargo in 1973, the magnitude of the fluctuations in these prices has been impressive. In 2008 dollars (i.e., adjusted for inflation), prices were about $40 a barrel in 1973, rose to $75 in 1981, fell to around $20 in the mid 1980s, and then stayed low until the early part of this century. These prices rose spectacularly to reach over $140 a barrel before the financial crisis hit, then fell sharply, and they have been recovering rapidly since the world economy again began to grow more rapidly.
Fundamentals in the oil market, that is, the supply and demand for oil, explain the vast majority of the large fluctuations in oil prices. Demand for oil changes over time because of recessions that reduce world output and hence demand for oil, and also because of world economic growth, especially in the developing world. Economic development raises oil demand because the demand for cars, and hence gasoline, increases rapidly with development, and because manufacturing and other sectors increase their demand for oil-based inputs.
To get a feel for the effects of demand changes on oil prices, consider a 3% increase from one year to the next in world demand for oil. The induced increase in price depends on how responsive (or elastic, in economists’ terminology) is the quantity of oil produced to higher oil prices. Oil production is not easily increased in the short run, especially with Opec controlling about 35% of the world supply of oil. A typical estimate of the short run world supply elasticity for oil is quite low at about 0.1. This number means that to induce a 3% increase in the supply of oil would require a 30% increase in oil prices, which is ten times at large as the increase in world demand. This example shows that the low elasticity of supply implies that even modest changes in the demand for oil have very large effects on its price.
The sensitivity of oil prices to underlying shifts in the fundamentals is made even greater by the fact that the short-run elasticity of demand is also about 0.1. To show the effects of such low demand elasticity, suppose world production of oil falls by about 1.5%. This is about the magnitude of the reduction in world supply from the civil war in Libya that cut its daily oil output from 1.4 million barrels of oil to about 200,000 barrels. For world consumption to fall by a mere 1.5% would require a 15% increase in price, given the very low demand elasticity for oil.
The actual fluctuations in prices due to shifts in supply and demand would be smaller than in these examples. When Libyan production fell and oil prices rose, other oil producers raised their supply of oil to take advantage of the higher prices. But since the overall supply elasticity is also very small, that response was small, so that oil prices still rose by a lot. Similarly, when world demand for oil grows by 3% and oil prices increase, demand for oil falls because of the higher prices. However, since the elasticity of demand for oil is also low, that response is limited, so that oil prices would still rise by a lot. A general analysis of market equilibrium shows that given supply and demand elasticities of 0.1, the percentage increase in price, after taking account of all these adjustments, would still be 5 times (rather than 10 times) the reduction in supply or increase in demand.
Moreover, both supply and demand for oil are more responsive to prices over longer time periods. This implies that the price rise due to more permanent falls in supply would initially be quite high, but they would get smaller over time. A higher maintained price of oil induces consumers to economize on the use of oil by buying fuel-efficient cars, by carpooling, and by driving fewer miles. Companies would substitute gas, coal, and other energy sources for oil. Similarly, on the supply side, higher long run oil prices induce greater efforts to discover new oil fields, whether deep under the sea, or in other remote places. Inefficient oil fields would also be brought back into production since their higher costs would be covered by higher oil prices.
Of course, speculators also are active in the oil market. They may buy oil futures in the expectation that oil prices will increase in the future, or sell oil futures-go “short”- hoping that prices fall in the future. If their expectations are correct, they help stabilize oil prices by increasing supply when prices are rising, and raising demand when prices are falling. Put differently, speculation tends to be stabilizing when speculators are making money because they have correct expectations about price movements, and destabilizing when they are losing money because their expectations turn out to be wrong. Given that the fundamentals imply large price movements from rather small shocks to supply and demand, and that successful speculation tends to moderate price movements, it is hard to believe that speculation has played a major role in causing the large swings in oil prices.
When the IEA countries on June 23 agreed to sell 60 million barrels (half by the US) from their oil reserves over the subsequent 30 days, it basically acted as a speculator on oil prices. Since oil was in plentiful supply then at about $110 a barrel, the only economic, as opposed to political, justification for the move was the belief that the IEA countries thought oil prices were too high and would be falling in the future. Perhaps these countries are privy to special information not available to private participants in the oil market about the recovery of Libyan oil production over the next few months, and about whether the unrest in the Middle East and North Africa would spread to other major oil producers in that region. Special knowledge is required to justify the IEA’s intervention because otherwise that information would already have lowered the price of oil. Such special knowledge does not seem likely, given that the unrest itself caught all the major governments (and private participants) by surprise.
Moreover, government oil stocks should not be used with the intent to profit from special information. Instead the information should be made public (if not based on politically sensitive information). Strategic reserves should be a hedge against supply disruptions during wartime or other crises when oil is not readily available even at so-called market prices. The only two previous interventions by the IEA were due to large supply shocks: the Persian Gulf War in 1991, and the effects of Hurricane Katrina, although the world oil market continued to function without major supply disruptions during these crises. The oil market is presently functioning very well, despite the high price of oil, so there is no good economic case for selling oil from strategic reserves at this time.