Wednesday, March 05, 2008

Do People Care About Comments? People Do

A commenter wrote in another thread:
Can we talk about the media coverage on OPEC and oil prices? I'm not sure anything has happened recently except the fall of the dollar. But none of the major media outlets are discussing whether oil prices have effectively changed in euros or any other currency. This just kind of pisses me off. Even the president of OPEC referred to the drop in the dollar, but none of the media seemed to pick up on that and do any analysis.

Well, I happened to have discussed something along these lines with a good friend of mine who is far more knowledgeable about economics than me. So, I asked him to share his thoughts. Here's what he wrote.

***



As u can see above, while oil prices have increased 226% from 2003 to 2008, the price of the Euro, in U.S. Dollars, has increased by 30%. So no, Europeans are not paying the same amount in Euros for oil today as they did in 2003 or, for that matter, only a year ago.

There are various theories as to why oil prices have seen such a dramatic increase over the last several years. I would argue there are five reasons worth highlighting here.

1) Yes, as long as oil is denominated in dollars and the dollar weakens relative to other currencies, there will be that marginal impact on the price of oil. However, this accounts for only a part of the overall movement in the price of oil.

2) As long as emerging market economies the size of India, China, Brazil, and Russia develop at a rate that is 2 to 4 times that of U.S. GDP growth, demand for oil will continue to increase ahead of supply, driving the price of oil higher (you can google the rate of oil supply growth to compare it to the rate of demand growth if you're really interested).

3) As the price of oil has increased, so has demand from investors, both retail and institutional. Oil futures contracts are now finding their way into Average Joe's brokerage account via direct contracts or an oil ETF or a newly created commodities mutual fund. Of course, demand from alternative hedge funds and the like has increased exponentially since 2003. More recently, chaos in credit markets and weakness in equity markets have driven more money into the commodities markets. I wouldn't be surprised if these "investors" aren't behind as much as a third, if not more, of the increase in oil prices.

4) U.S. oil companies and stand-alone refiners did not build much additional refining capacity during the 90s when oil was cheap and it wasn't "worth it" for them to add refining capacity. Lo and behold, as the price of oil has increased since 2000, not much refining capicity has been added. Hmmmmm....

5) During the Clinton adminstration, when the price of oil increased a couple of percentage points, Bill would summon an OPEC meeting at the White House and threaten to release the U.S.' Strategic Oil reserves, which would promptly bring the price of oil back down. In the 90s, this effectively put a cap on the price of oil. Conversely, when asked what he thought of $4/gallon gasoline, President Bush answered, "$4/gallon gasoline? Wow! I didn't know that."

Hope you're happy for making me stay an extra hour at work.

13 Comments:

Anonymous Anonymous said...

5) is a nice "gotcha" moment, but I would bet that Bush knows that gas is "expensive." The American public has a dumb obsession with round numbers. Would you expect Bush to know when gas hit $3.94? No. Is there much of a difference between $3.94 and $4? No. They are both "expensive." That being said, maybe Bush should have done what Clinton did. On the other hand, I like high gas prices. Hopefully they will encourage more people to take public transportation, leading to decreased pollution and less traffic.

3/05/2008 4:23 PM  
Anonymous Anonymous said...

I like how this person has five reasons for the high price of oil and none of them mention Iraq.

3/05/2008 6:16 PM  
Blogger McWho said...

one additional point is that oil is generally priced according to USD on the world market (though they are beginning to move to euros), so while inflation impacts oil prices, exchange rates themselves do not so much.

3/05/2008 7:07 PM  
Blogger Armen said...

6:16, I'm no expert in the field but even I can tell you Iraq is NOT really a factor in the prices going up. (a) Iraq was not putting much oil on the market prior to 2003 (remember the whole sanctions and oil for food exception) and (b) to the extent instability in the region is a factor in driving up prices, that's captured by #3.

McWho, that's right. Back in the day the world markets agreed to use the USD because it was a symbol of stability, growth, blah blah blah. But for eight years our policy has been to treat the dollar as some third world currency to mask our enormous trade deficit. The more I think about this, the more I realize that we have incredible little control over our own economy.

3/05/2008 7:50 PM  
Anonymous Anonymous said...

Update on finals schedules so far (until the final version next week) for those who are interested:

Evidence (Swift) - May 5th at 11:30AM
Crim Pro - May 13th at 8:30AM
Antitrust (Shelanksi) - May 9 at 8:30AM
Corps (Gevertz) - May 5th at 1:30 PM
Civ Pro II (Amann) - May 8 at 1:30PM
Legislation - May 8 at 1:30 p.m.
Info Privacy - May 12 at 1:30 p.m.

3/06/2008 12:58 AM  
Anonymous Anonymous said...

i would like to hear what tacitus has to say about this

3/06/2008 7:00 AM  
Anonymous A Little Bird said...

The finals schedule will be available to students very soon.

3/06/2008 10:30 AM  
Blogger Tacitus said...

well, since someone actually asked for my thoughts, i'll give a stab at this immensely complicated question. i would also point anyone interested in oil politics over to an old friend's blog, www.oilandglory.com.

first of all, it is prudent to note that probably everything everyone has said impacts the price of oil marginally. i'm not sure that there is one factor that really predominates or can explain why the price has increased from under 20 dollars a barrel in 1998 to over 100 this year. there have been many factors in the rise.

i actually agree with the commenter that the iraq war has increased oil prices; initially, the prospect of a war put pressure on the price due to the regional instability factors, but since then it has also added demand pressure. planes and other instruments of war need fuel. this has had a ricochet effect across other industries (particularly civil aviation), which has diverted some refining capacity to various jet fuels, which then drives up the price of gas. and then trucks are used to transport crude oil, which drives up transport costs for oil and gas companies, and the price of gas goes up further...

there is a distinction as well that goes underappreciated, which is that gas prices and oil prices are not as tightly linked as one might think. as armen hints in point 4, diminishing refining capacity in the us has impacted american fuel prices. but at the same time, that factor does nothing to explain the precipitous rise in crude oil prices. conversely, the rise in crude oil prices over the past few years does not alone explain the rise in gas prices in the us, as pressures on the refining capacity also contributed.

i agree that demand side pressures have also played a huge role in the rising costs.

one factor that i think goes underappreciated that i'd bring up is the rising costs of production. in the early days of oil, in azerbaijan and parts of texas, oil was literally sitting just below the surface. you could dig it out (and the original prospecters did dig it out) with a bucket and shovel. they didn't really know how to refine it well, so it burned dirty and inefficient. well, we've learned how to refine it well, but it has become more costly. likewise, we've learned how to find it and extract it much better, but this has also become more costly. the biggest oil fields of our parents/granparents generation are in saudi, and the oil sits just below the surface. the pools are big and the oil comes out easy. the biggest fields of our generation are offshore and in places like the arctic. it takes a lot of money, time, effort and care to get the oil out. this has a bearing on price too.

demand for oil rises easily, supply, not so much, without huge extra costs. hence rising oil prices. does that explain the last ten years? maybe. the last time oil prices really spiked was in the 70s, when the threat of nationalizations and the advent of opec led western producers to seek out alternative sources (which opened up alaska, the gulf of mexico, south america and africa to a lesser extent). then the soviet union fell, and the majors went in there. so those events, and a good relationship with opec, set the table for an ease on prices through the 80s and 90s (other than the spike around the first iraq war). but it also made us a bit lazy. on expanding supply for the long haul, and now we're reaping the whirlwind of our laziness (that sounds possibly impossible, but a whirlwind of laziness is probably a good metaphor for law students -- and bloggers). anyway, those are my thoughts... carry on.

3/06/2008 1:06 PM  
Blogger Armen said...

Et tu Brute? The points are not my own Tacitus, but that of my friend.

3/06/2008 1:12 PM  
Blogger McWho said...

Punctuation man, seriously.

3/06/2008 8:07 PM  
Anonymous Anonymous said...

more exams:

Property w/ former College Jeopardy contestant: May 5th at 8:30 am

Contracts w/ professor formerly known as white-pants: May 12th at 8:30 am

3/06/2008 9:55 PM  
Anonymous Anonymous said...

Environmental law w/Doremus: 5/14 at 8:30

3/07/2008 8:38 AM  
Anonymous Anonymous said...

Thanks for staying an extra hour Armen. As usual, you kick the nytimes' ass.

But I'm not sure any of the explanations are sufficient:

The demand side growth is only 2-3% a year even if China and India are consuming oil at ever-greater rates simply because consumption growth is not growing by much in the U.S. and Europe. Granted oil is inelastic and prices can jump up a lot because of supply restrictions but I don't think that is the case here.

Supply side explanations that look at increased exploration costs or fields' production capacities don't have it right either. Exploration/development costs have increased but not as much in the last 10 years as would be needed to justify the current price increases. It probably is true that many fields are at peak capacity, with the exception of the Saudis.

Which brings me to the only explanation that seems complete...a political explanation. I have two hypothesis. The first is that the dollar is essentially on an oil standard. Oil is the only worldwide commodity with a limited supply, enduring value, and functioning markets. Interestingly, the last time oil prices rose as quickly was when confidence in the dollar was shaken. During the high inflation of the Vietnam War, the dollar declined in value and expectations were that inflation would continue in the U.S., furthering a decline in the dollar. The 1973 oil embargo followed shortly thereafter. Today, the dollar has significantly declined and the current account deficit suggests further decline. I think today's high prices may be a reflection of a lack of confidence in the purchasing power of the dollar in the future.

My second hypothesis is that the Saudis prefer periods of alternating high and low prices. Sustained high prices would drive the world towards energy diversification away from Saudi oil, so price fluctuation is a better long term strategy. I think that kind of price control is within Saudi power so long as other OPEC producers are near maximum, as the Saudis are the only ones with significant spare capacity.

3/07/2008 11:34 PM  

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