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Why Has the Price of Oil Decreased So Significantly?

Name: Robert Palasek
City & State: Livermore, Calif.

Question/Comment: Why has the price of gas decreased so significantly? This seems way more than an incremental adjustment to supply and demand. Is there something non-linear going on?

Paul Solman: Brace yourself for a very long answer.

The price of gas reflects the price of oil. Roughly speaking, since there are 42 gallons in every barrel of oil, a $1 change per barrel will eventually mean a roughly 2.5 percent change in the price of gas at the pump.

I started responding to oil price questions here on the Business Desk when oil was something like $140 a barrel. Now, with oil at $35, and gas down accordingly, I'd like to dilate on the issue. (And thanks, Robert, for giving me the pretext to use the verb "dilate" for the first time, save for a NewsHour story about my clogged artery back in 2002.)

Back in April 2008, with oil at about $110 a barrel, I wrote:

The price of oil reflects several factors:

1) Demand has increased as China, India and other countries have joined the world economy and boomed;

2) Supply has been increasingly uncertain, due mainly to war in the Middle East. Lots of war. And terrorism. And there has been much talk of "peak oil"; decreasing world reserves, that is, because we've hit our peak and the oil that's left in the ground is increasingly expensive to get out and refine;

3) Oil is priced in dollars while the dollar is plummeting, meaning anything priced in dollars (like oil and gold) rises in price.

4) What else are you going to invest in? Stocks? Bonds? Real estate? The more people invest in oil, the higher the price.

5) Speculators have jumped into the market, seeing the huge rises in the price of oil. Must be a good thing, right?

Of course, oil is down almost 10 percent since your e-mail. In other words, speculation is probably a big part of the recent story.

By early July 2008, oil had gushered to $145 a barrel, and the Business Desk featured this exchange:

John Mann of Ventura, Calif.

Question/Comment: "Do you believe that some of the run-up in oil prices is based on speculation in the commodities markets? My understanding is that the amount of funds et al. playing in oil futures has risen more than 70 percent in the last several years and that this is the true reason that the price of oil has doubled in the past year?"

To which I answered:

"Yes, I do, but there's a great debate about this, as I mentioned before. Paul Krugman, the New York Times columnist and a formidable economist, says the futures market doesn't set the price in the so-called "spot" market -- the market for oil you actually buy. Actual supply and demand does, he argues -- as does another person who presumably knows more about this than I do, Leo Melamed, whose biography identifies him, rightly, as 'the founder of financial futures markets.'"

On June 25, he wrote:

Accusing futures market speculators as the main source of the problem for high oil prices is the modern equivalent of beheading the messenger of bad tidings....
Speculation, such as occurs on the futures markets, can only effect underlying prices in a temporary fashion, for a day or two, and then only on the margin. There are speculators who believe oil price[s] are going up and who buy futures contracts. An equal number of speculators believe that prices will fall and they sell. The idea of blaming those who anticipate that prices will rise for the subsequent time period is not rational. To achieve a long-term or permanent effect in underlying prices, such as has occurred in oil, has to be based on either supply demand fundamentals, an unusual natural dislocation, government action, or manipulation.

In the case at hand, the oil rise is a consequence of both fundamentals and government action: A global increase in demand, and the debasing of the U.S. dollar. That, coupled with government inaction: A failure over many years to institute a coherent and comprehensive national energy policy.

If the price rise is the result of manipulative activity then someone is intentionally buying and hoarding the underlying physical supply in question...."

As I e-mailed a finance professor friend who sent me this quote, the literal eminence grise Zvi Bodie (he has a grey beard):

"Melamed is understandably defensive (given his legacy) and thoroughly wrong. The fact that for every seller, there's a buyer would, by the same logic, suggest that a stock market crash (or boom) is not caused by speculators. Sure, fundamentals will prevail over time, in some utterly un-pin-downable but theoretically airtight way. In any market, presumably. But as Keynes remarked (in 1923, no less), in the long run, we're all dead. And anyone who thinks buyers and sellers aren't setting the price in the indefinite interim -- with their fears, hopes and prognostications -- is talking nonsense. Anyone try to sell a house lately?"

Upon re-reading Melamed, I'd further point out that his argument is circular. "A long-term or permanent effect in underlying prices, such as has occurred in oil," he writes. If it is "permanent," then sure, the fundamentals of supply and demand are bound to be setting the price. But the "permanence" of today's price is just what we're debating. And how can he possibly know whether it's permanent or not?

But don't go betting your nest egg on my say-so. I certainly wouldn't (and haven't). Keep John Kenneth Galbraith's quote in mind, as I should. And even if I'm right and speculators have driven up prices, it could be years before they come back down. When the NASDAQ composite index (the Dow Jones industrial average of high tech, you could say) starting rising in the '90s, I thought I detected a bubble forming at a price of around 1,200 (1996). Imagine my surprise when it rose to 2,000, 3,000, 4,000 and 5,000. It took six years for the price to dip briefly below 1,200, and even now, in the slough of market despond, it's around 2,200. Fair warning."

Two weeks later, oil had dropped to below $130.

Here's Fabiano from Toronto's question in mid-August 2008:

"I would like to understand how 'speculators' affect the price of crude oil. I'd like to know who these people are (in general) and how they operate."

By this time oil had dripped down to $120 a barrel and my answers to your questions had thoroughly convinced ME, at least, that the price of oil had indeed been sweetened by speculators now sour on the investment. That induced me to actually put MY money where my mouth was (which gave me yet another reason to root for the price of oil to drop.) I wrote:

"I'm on record on this page (and elsewhere) as saying I think speculation is a factor, perhaps a large factor, in the price of oil lately. And indeed, the price of oil has dropped by almost 20 percent since I wrote that, in response to an e-mail here.

But I should warn you: lots of very thoughtful economists consider me all wet. OK, that's out of the way, so on to your questions.

1. Who are the speculators? Anyone who has bought or sold a commodities contract involving oil. If there's more demand for oil at a given price, the price rises, like it does for anything else, say your house. Less demand means the price goes down. An economist friend and I are actually speculators, betting the price will go down, though I confess it's more to learn how the market works through actual experience than to make money.

2. Speculators generally operate by buying either futures contracts or options. (We bought options.) With futures contracts, you lock in a price for a given date in the future and either get or owe the difference between that price and the actual price when the date arrives.

Options cost money. They entitle you to a payment if oil falls below - or rises above - a given price by a future date, depending on which way you're betting. If oil doesn't hit the price, you simply forfeit the cost of the option. You make money if the price of oil falls (or rises), compared to the price you bet on, by more than the option's cost.

There's another way to speculate, one could argue. If you have oil, you could keep it in the ground, waiting for the price to rise. If you believe speculation is part of the current story, this should be happening. And from people I've talked to in the industry, it is."

I'll share the other lessons thus far at some other time. But the main lesson is, I think, the answer to your question. There's been nothing linear about what's happened, no one-to-one relationship between any tangible cause I've been able to isolate - less oil in the ground, more demand -- and the price of oil during the past year. Or on any other commodity I've looked at.

-- Posted January 7, 2009 | Comments (8) | Permalink