Kling's Oil Speculation Question

Arnold Kling poses a question for Paul Krugman. Here's how I would answer.

Kling writes:

Early in 2007, the price of oil was $60 a barrel. Recently, it has been above $130 a barrel. Which of the following does Paul Krugman believe:

(a) market fundamentals justified $60 a barrel then, and they justify $130 a barrel now; or

(b) market fundamentals justified a much higher price in 2007?

...We know that Krugman does not believe that today's oil price is out of line with fundamentals. Krugman's view, in effect, is that if speculators artificially boost the price of oil, then supply will exceed demand, and the excess has to go somewhere. Where are the inventories?

This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet they did not. So is Krugman forced by his model to conclude that the price of oil of $60 also reflected fundamentals?

The "fundamentals" price of oil depends on a number of factors that cannot be perfectly foreseen. Among these are (1) will the world enter a deep and prolonged recession in 2007, and (2) will global oil production in 2007 be higher than it was in 2006? Today, we know that the answer to both questions is no, and conditional on knowing that answer, we can see that $60/barrel was too low a price. But a year ago, no one knew those answers.

Likewise, the price of oil today is very much dependent on the answer to questions such as (1) will the world enter a deep and prolonged recession in 2008, and (2) will global oil production in 2008 be higher than it was in 2007? Today, we do not know the answer to these questions. If the answer is yes, the price of oil today is much too high. If the answer is no, the price could still be too low.

As for the specific question of "where are the inventories," let's be a little more precise about the question being asked. The correct question is, Did the movement along the demand curve that resulted from the increased price show up as an increase in inventories? The correct answer is, no, it was offset by a shift in the demand curve for newly industrialized countries and the oil producing countries. For example, China may have consumed a half million more barrels of oil per day in 2007 compared with 2006.

Where are the inventories? China already burned them.

Comments

[GH]

Beware. There are two kinds of oil. There is currently an excess of sour crude, and a shortage of sweet crude. This is what allows Libya and Saudi Arabia to say there is an abundance of supply and that the price is higher than it should be, yet the price to continue higher. The Iranian tankers are full of sour crude.

This conflation of the two kinds of crude is being purposely planted by various players - the same ones who are hiding their manipulation behind the word "speculation"... This is the latest favorite style of lying: use an ambiguous word. Various media that should know better are happily playing along to attract eyeballs.

[Whidbey]

I think your analysis is workable, but GH has shown the market is split with a cost and price differential that matters greatly in the US refinery market. Sweet is the scarce commodity, while sour is not scarce possibly. What matters to my thinking is the possibility of a major recession in which unemployment rises steeply forcing the USA into demand destruction. Then oil is surplus everywhere and we start the price cycle all over again, 35 dollar oil etc. If this happens we will never have an energy policy that matures alternatives. God help us if we do it all over again.

[Still Laughing]

That was a great analysis. But I still think what investors now really need to start pondering is: regardless of the current supply and demand and any shocks that happen in the future, are we reaching the point where the current price now justifies capitalization required to develop the infrastructure and technology of a replacement energy source? Oil is not a in an economic vacuum. It is subject to the same substitute good laws of any commodity.

I think there are two groups of people who are calling the high price speculation: those that want it to be because it's just so expensive and those that realize that the high price invites substitution. In other words, the very existence of the high price is why the price will crash. I think it's also why even executives in oil producing companies are starting to make divergent statements about oil prices. There are those that want to reap the short term profit (so they say, "the price will go up to xxx"), and those that realize a substitution scenario would have a far greater and lasting negative impact on their firms (and they say "we're supplying more than the price would suggest" in an attempt to drive the price down.)

[Alan von Altendorf]

Sorry, Professor, I think war risk doubled and, as GH noted, light sweet crude production declined vs higher dollar (debased dollar) demand for gasoline, diesel and jet fuel.