Summary:
Thomas Palley disagrees with economists like Paul Krugman (faith in markets) that the high price of oil is due to fundamentals and believes speculation is to blame. The inventories argument ignores the extreme price insensitivity of oil. The only way demand can be lowered is by reduced economic activity (no recession yet). Furthermore, inventories should be down (incentive to sell), whereas they are up slightly. Financial markets' ability to mobilize tens of billions of dollars for speculative purposes has enabled traders collectively to hit upon a strategy of buying oil and quickly re-selling it when end users accommodate higher prices. Current oil price spike will be broken only by a recession that exhausts consumers’ capacity to buffer higher prices. Calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. (Published: 24/06/08)
Notes:
- proving that speculation is responsible for rising oil prices is difficult
- because speculation tends to occur during booms
- price increases easily masquerade as a reflection of economic fundamentals
- most economists dismiss the idea that speculation is responsible for the price rise
- reflects their faith in markets
- argue that if speculation were really the cause, there should be an increase in oil inventories
- because higher prices would reduce consumption, forcing speculators to accumulate oil
- the fact that inventories have not risen supposedly exonerates oil speculators.
- see e.g. Krugman
- picture is far more complicated than that
- because oil demand is extremely price insensitive
- In the short run, it is technically difficult to adjust consumption.
- e.g. the fuel efficiency of every automobile and truck is fixed
- most travel is non-discretionary.
- fundamental point: in the short run, reduced economic activity is the principle way of lowering oil demand.
- Thus, absent a recession, demand has remained largely unchanged over the past year.
- furthermore: relatively easy to postpone lowering oil consumption
- Consumers can reduce spending on other discretionary items and use the savings to pay higher gasoline prices.
- Credit can also temporarily fill consumer budget gaps.
- Although the housing boom in the United States – which helped in this regard – ended in 2006, consumer debt continues to grow
- America’s Federal Reserve has been doing everything it can to encourage this.
- Consequently, for the time being the US economy has been able to pay the oil tax imposed by speculators.
- contrary to economists’ claims, oil inventories do reveal a footprint of speculation
- inventories are actually at historically normal levels and 10% higher than five years ago
- with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings
- Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity
- root problem is that financial markets can now mobilize tens of billions of dollars for speculative purposes
- has enabled traders collectively to hit upon a strategy of buying oil and quickly re-selling it when end users accommodate higher prices
- situation that has been aggravated by the Bush administration, which has persistently added oil supplies to the US strategic reserve
- further inflating demand and providing additional storage capacity
- Absent a change in trader beliefs, the current oil price spike will be broken only by a recession that exhausts consumers’ capacity to buffer higher prices
- or when the slow process of substitution away from oil kicks in
- thus, economic fundamentals will eventually trump speculation, but in the meantime society will have paid a high price
- whereas oil speculators have gained, both the US and global economies have suffered and been pushed closer to recession
- This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible.
- Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.
- some unilateral populist action is possible
- a major form of gasoline storage is the tanks in cars.
- If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand.
- Given lack of storage capacity, this could quickly lower prices and burn speculators
