WSJ Editorial: We Can Lower Oil Prices Now

July 3, 2008

I read a very interesting opinion piece in the Wall Street Journal titled, We Can Lower Oil Prices Now. The author of the editorial is Martin Feldstein, who was chairman of the Council of Economic Advisers under President Reagan and is a professor at Harvard and a member of The Wall Street Journal’s board of contributors. What he says makes a lot of sense. Especially this (I hate to cut and paste so much of the article but I need it all to illustrate his point):

Unlike perishable agricultural products, oil can be stored in the ground. So when will an owner of oil reduce production or increase inventories instead of selling his oil and converting the proceeds into investible cash? A simplified answer is that he will keep the oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money obtained from selling the oil. The actual price of oil may rise faster or slower than is expected, but the decision to sell (or hold) the oil depends on the expected price rise.

There are of course considerations of risk, and of the impact of price changes on long-term consumer behavior, that complicate the oil owner’s decision – and therefore the behavior of prices. The Organization of Petroleum Exporting Countries (the OPEC cartel), with its strong pricing power, still plays a role. But the fundamental insight is that owners of oil will adjust their production and inventories until the price of oil is expected to rise at the rate of interest, appropriately adjusted for risk. If the price of oil is expected to rise faster, they’ll keep the oil in the ground. In contrast, if the price of oil is not expected to rise as fast as the rate of interest, the owners will extract more and invest the proceeds.

The relationship between future and current oil prices implies that an expected change in the future price of oil will have an immediate impact on the current price of oil.

Thus, 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.

That would explain why OPEC isn’t falling all over themselves to produce more oil. Why would they want to do anything that would lower the price? I do think it’s almost criminal for OPEC’s president to come out and make predictions on the price of oil. What does he think is going to happen when oil is trading at $140 and he says it’s going to $170? Surely he knows he has the ability to drive prices!

Anyhow, read the entire editorial. He makes a lot of sense.

3 responses to WSJ Editorial: We Can Lower Oil Prices Now

  1. OPEC isn’t interested in ultra-high oil prices for an obvious reason: high oil prices provide a tremendous incentive to research alternate fuel technologies – something that spells long-run trouble for OPEC countries.

  2. Jay, you can see the potential inverse relation between ultra-high crude prices and energy companies tied to that crude in the performance of DUG, which is 2X the inverse of the DJUSEN. Simply stated, when crude gets so high that folks stop driving, airlines stop flying, and people can’t fill their heating-oil tanks, companies like Exxon and ConocoPhillips take a beating, and DUG rises.

    Pardon my conspiracy theory, but where do you think all the money is coming from to push up the price of crude? Maybe, just maybe, money from the folks who produce crude and then funnel it into “Sovereign Wealth Funds” who then buy up crude contracts, sending the price even higher? Just a hunch.

    Yours,

    Bozo

  3. OPEC was never falling all over themselves to produce more oil as far as I can remember. We relied on the greed of individual producers to defect, grabbing profits but also increasing supply and controlling prices.

    Not sure why they aren’t cheating now.