Thursday, May 22, 2008

RE: Skyrocketing Oil Prices Stump Experts

"Skyrocketing Oil Prices Stump Experts" is the headline of a Washington Post article today. Perhaps the experts... aren't.

From the article: "People don't get it," said Sen. Herb Kohl (D-Wis.) at a Judiciary Committee hearing yesterday at which senior oil company executives were grilled about prices. Kohl said: "Demand is not crazy. Why are prices going crazy?" The article quotes from a wide variety of people that are allegedly experts, and they basically say they don't have a clue.

The answer is simple, really. The prices are high because a number of events occurred that tend to create pressure for prices to rise (e.g. increasing global demand), and people who choose to invest in oil futures have gotten auction fever. That drives the prices of future oil deliveries up, and the higher the prices go, the more "feverish" the investors get.

Joe's Story
As the price of oil futures are bid up, it has a carry-over effect on current prices. Over-simplifying, and exaggerating to make the point clearer, suppose Joe has 1000 gallons he wants to sell today to a gas station, he paid $1.50/gallon, he plans to sell it for $2/gallon, and oil futures that are about to "close" are selling at $1.50/gallon. Before lunch, the price for the futures that are about to "close" are driven up to $1.75/gallon, an increase of almost 17% in a few hours. Now Joe's gotta figure after he sells his gas, he's got to buy more at $1.75.

Joe could sell the gas for what he already planned to, make the amount of profit he already expected, buy his next shipment of gas for whatever the market cost is at that time, and mark up his price accordingly. That's the way most of us want Joe to see it. But Joe doesn't see it that way. Joe figures, the gas I have is worth a lot more this afternoon than it was this morning. I'm going to charge the gas station $1.75/gallon this afternoon. And he'll make a lot more profit at the expense of the person who pumps it into his car later. Or maybe he's worried that he'll be accused of price-gouging, so he decides to sell it for only $1.70/gallon.

Good ol' Joe. It's not his fault, it's "just basic supply and demand". Except that the faster he raises his prices, the more it feeds the auction-fever frenzy of the oil future speculators.

If you haven't figured it out, Joe represents the people at the big oil refineries and distributors that decide how much and when to increase their prices.

Who's fault is it?
Well, the market pressures are what they are, and they've been creeping up. The oil future investors have been over-reacting to market pressures because their exchange medium is auction-based. The big oil companies' price setting policies have been exacerbating the problem.

What can be done?
There are several options: change nothing, lower demand, increase supplies, or regulate distribution.

1. Change nothing and the prices may soar to wild heights. I've heard people talking about the "extreme" possibility that gas could go over $5/gallon at the pump. That's nothing, over $20/gallon is possible. Why? Because when auction fever runs amok, prices have no top-end in the short-run. Have you ever been in an auction, started bidding, gotten caught up in it, and bid way more than you really thought the item was worth? It happens every day in every auction-based market. Remember the incredibly high prices of tech-stocks before the tech-bust? Same thing. Dangerous? You bet. Bad enough that nations can go to war to "protect their national interests". For example, oil was a major factor in Japan's expansionist policies leading into World War II -- they wanted to secure the oil resources their economy was becoming dependent on.

2. Lowering demand is not likely at all, and if a major effort were made, it would accomplish too little to cool off the auction-fever.

3. Increasing supplies is technically more plausible, but you'd have to get a majority of oil-producing nations to glut the market to stop the auction speculation frenzy. Those nations only have so much oil, however, and the faster they pump it out, the faster they run out, and they don't have anything to replace that income with, so they want to try to stretch it out. Plus they're getting much higher prices, so they're not as worried about the consequences as others are.

4. Which leaves regulation. There are many ways to regulate, each with their own strengths and weaknesses, from both practical and economic perspectives. Unfortunately, anything that will seriously cool off the oil futures speculators will cause a separate set of negative effects.

What will be done?
Things will keep going just like they have been, and one of two things will happen. The oil market will stabilize enough to cool the investment speculators enough for the last ones in to lose a lot of money, and then prices may start adjusting more slowly. Or, the price increases will continue to rise rapidly and cause repercussions that are so painful, governments will begin increasing regulations, and they'll implement them haphazardly and with increasing severity until there's a global crash.

What should be done?
For many decades, industrial nations have periodically had banking crises characterized by panics that are similar to run-away auction fever, and they've created more and more mechanisms to avoid panic and to intervene when panic does occur. Some of these mechanisms are always-present regulations, and some are regulatory powers that only kick-in under specific circumstances, and only until circumstances improve. It hasn't been perfected, but the overall effect has worked very well for a long time now in the banking industry.

Similar efforts should be made to regulate commodity markets, such as oil. For instance, if retail prices increase by more than a specified percentage in a specified period of time, oil companies could be prevented from increasing their profit-margins. This particular interference in the marketplace would not cause the long lines that rationing causes, but it would effectively cap the oil companies profits until markets stabilized.

Okay, so I used the topic of experts being puzzled to rattle on about some ramifications of high gas prices and espouse what I think would be an improvement. Getting back to the starting line, I don't know why anyone is puzzled. The market for oil prices is an auction, and the investors playing in it have gotten auction-fever. The question shouldn't be what's driving the high prices, it should be what we're going to do about it, if anything.