Fluctuations in Oil Prices, Speculation, and Strategic Reserves-Becker

 

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.

Comments

[NEH]

There is a little more to the issue of releases from the Worlds Strategic Oil Reserves and "profiteering" by the Nations which hold Reserves. That is, the specter of the World's economy rolling over back into recession. Consumer confidence is extremely sensitive to price increases in energy costs and consumption. Such that higher energy prices translates into higher prices across the board and reduces the perceived well being of the Consumer which in turn drives down consumption and hence production. Resulting in recession. The release of reserves is intended to drive down energy costs, stabilize other costs and in the process, increase Consumer confidence and hence purchases driving the Economy forward out of Recession. At least that seems to be the idea.

As for the "Libyan issue" and their impact on World Oil Markets they only represent approx. 2% of total world production. At 48 gallons per barrel of oil this represents less than a gallon, 0.96 gallons, to be exact. This doesn't even cover the losses that occur in production. So the Libyan issue is not of any real importance, other than it shows that the market is essentially irrational and can be manipulated. Now, in regards to the "Arab Spring" and the possibly disruption of the rest of the 98% of supply, this could be become a problem driving speculators to load up on oil contracts driving prices ever higher and in the end eroding Consumer confidence to the point where a Recession becomes a real possibility...

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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.

[TANSTAAFL]

In truth, a barrel of oil contains 42 gallons, not 48.

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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.

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[NEH]

Tanstaffl, You're right. A barrel of oil is 42 gal's. My mistake. So Libya's impact is even less, at about 0.84 gal. per barrel. And so, the argument still holds...

[Jack]

One IS reluctant to denounce the writings of prize winning economists as Hrsht but every once in a while it seems the only rational option:

"Fundamentals in the oil market, that is, the supply and demand for oil, explain the vast majority of the large fluctuations in oil prices."

SHOW me ANY shortfall of supply that would warrant bidding up prices five fold in such a brief time.

And........... "Oil production is not easily increased in the short run, especially with Opec controlling about 35% of the world supply of oil."

........ are we to take this as a "fundamental?" or one of the several examples of price manipulation?"

As for the elastisity -- it is true that in the short run it's difficult for most consumers to respond to price gouging. But! over time I am confident that US economic creativity (enhanced by the leadership and vision of the Obama admin) can and WILL show the world that conservation (ala the rapid increase in auto sales of "fuel sippers" Chevy Volt tech and substitution will constrain US demand, while in emerging nations (China et al) simply not be able to afford $4 gasoline will constrain demand from those quarters.

"OPEC" in past years seemed to be aware of and tailor their production in so as not to rile their wasteful US oil addicts, which leads one to look closely at the (obviously) manipulitive effects of our own "futures" market.

An observation: While prices (seemingly stablized over $50) has spurred lots of costly shale frakking projects, here in Alaska, a tripling (at least) in prices has hardly created the effort from the oligopoly that controls the N. Slope that one would would have predicted. Instead, awash in an embarrassment of profits, with the value of reserves fattening their balance sheets, they appear to be holding back production in hopes of an (oil soaked) Repub majority here being hustled into rolling back the slight increase in Alaska's owner share of its oil.

Libya? If they shut down entirely despite their nation (like most oil producting states) being heavily dependent on oil income it would amount to 2% of world consumption. In recent years they've been producing more than the agreed upon OPEC cartel amounts.

http://www.eia.gov/cabs/libya/pdf.pdf

"Fear of "unrest" and supply constriction expanding to Saudi Arabia? Doubtful; they've been a lot more mature and sensible in oil policy for many decades.......... and what would be the result?

In the short run, a grand opp for our price manipulators to run prices yet higher, thus crippling any chance of the US coming out of DEEP recession and tanking the economies of the rest of the world, with a bit longer term political impetus to become less dependent. ie. Rapidly adopt the "Boone Pickens's" switch to NG powered "eighteen wheelers" and a RUSH to send the most wasteful fleet of gashogs to the crusher in favor of hybrids, gas sipping economy cars, along with the rapid adoption of NG powered cars, hopefully led by the Obama admin which already has the "vision thing" and seemingly does not OWE our oil industry.

Ha! for those considering a new rig, for about the same money a Chevy Volt perhaps equipped with a "Screw OPEC" sticker is going to be a lot cooler ride to the golf course than a 12 MPG Expedition or a Cad CTS that can more than double the national speed limit.

[Andy]

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Great post, the market will corrects the demand/supply and price of the oil and it seems unnecessary for the IEA to release the oil.

I am also convinced of your view that the oil price at $110/barrel is also working well for the economy, the intervention of IEA will not benefit in the long run as most of the government interference to the economy.

[Jack]

Best -- you seem well-trained and contentedly naive. Thanks for stopping by.

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[Jack]

Ahh! Breaking news! Mortgage scammer sent to prison for 30 years.

(Like many US sentences it seems too long for a 58 year old --- perhaps 8-10 which is a long time, and not being allowed back into finance, could, with direction and parole do some good on the outside?)

Anyway good to see a few being brought to justice:

http://www.loansafe.org/virginia-mortgage-broker-facing-30-years-prison

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