If only speculation explained gas prices
After I wrote my last piece on gas prices, a number of you e-mailed to urge me to place more of the blame on speculators. So I spent a couple of days looking into the speculation explanation, and am walking away with two main conclusions: First, speculators probably aren’t the problem here. Second, the things that are the problem here are really, really scary.
Speculators are an easy bad guy, says Michael Greenstone, an energy economist at MIT. “They’re a malevolent other. They’re thought to produce nothing of value, and so blaming them has a long and rich history.” But it’s worth understanding what exactly you’re saying is happening when you place the blame on speculators. “Speculators make money by pulling oil off the market, putting it in inventory, and selling it later,” Greenstone continues. So if you’re seeing speculation, you should be seeing a massive run-up in inventory. And we are seeing a bit of an inventory bump, particularly in recent weeks. But not enough of one.
James Hamilton, an energy economist at UC San Diego, has studied not only the current oil prices, but the 2007-2008 run-up, in great detail. “Speculation is a convenient scapegoat for people who can’t be bothered to look seriously at the numbers,” he says.
The last time speculators got this much attention was in the price run-up of 2007-2008. If you read Hamilton’s detailed paper (pdf) on that period — no one can accuse him on not looking seriously at the numbers — you’ll hear about two major forces in the oil market, both of which are scarier, in the long-run, than speculators. On the supply side, Saudi Arabia. On the demand side, China. And caught between them, the global economy, and our wallets.
Traditionally, Hamilton says, Saudi Arabia, the world’s largest producer of oil, would smooth out spikes in demand. But around 2007, Saudi Arabia stopped. They left oil in the ground, assuming they could sell it for more later. Hamilton calls this “the beginning of a new era for oil pricing dynamics: without the Saudis’ willingness or ability to adjust production to smooth out price changes, any disturbance to supply or demand will have a much larger effect on prices than in earlier periods.” Greenstone agrees with Hamilton, and says that this can hardly be overstated. Saudi Arabia is the one player with the power to really do what people think speculators do: take enormous amounts of potential oil off the market because they think they can get a better deal later.
But that was 2007-2008. Is Saudi Arabia part of the story now? It appears so. Not only did they slash production in March, but they’re freaking everybody out by offering accounts of their production volume that don’t make any sense.
On the demand side, China — and other developing nations, but mostly China — is the 800-pound gorilla in the room. “China was a net exporter of petroleum up through 1992, and its imports were still only 800,000 barrels a day in 1998,” writes Hamilton. “By 2007, however, China’s net petroleum imports were estimated to be 3.7 mbd, making it the world’s third-largest importer and a dominant factor in world markets.”
Here’s what Hamilton argues happened in 2007-2008: Everyone knew that the world was demanding more oil, but they had made two assumptions that turned out to be mistakes. First, they thought that higher prices would lead to a lot less oil use in rich countries, which would allow what oil we did have to stretch further. Economists call this ”elasticity,” and oil turns out to have a lot less of it than we thought. Second, they thought we — or, more specifically, Saudi Arabia — would be able/willing to increase production much more dramatically than proved to be the case. But they weren’t. So supply held relatively steady even as demand shot up and demand held relatively steady even as prices shot up.
So what ended the 2007-2008 oil crisis? A global recession more sever than anything we’d experienced since the early 20th century. But now the same factors are reasserting themselves. Demand from both developed and developing countries has returned. Saudi Arabia is tapping the brakes. Now add in turmoil in the Middle East. Now look at the price of gasoline and note that demand isn’t falling.
“The key question you should be asking is the following,” says Hamilton. “Is the current price too high in the sense that the physical quantity being produced is greater than the physical quantity being consumed? If yes, then where is the difference going, and what mechanism accounts for that?” Left unsaid is the “if no.” But if no, then who is supposed to start using less oil in the coming years, and if the answer is no one, then how, absent recurrent recessions, are we supposed to make what oil we have go around at a price the global economy can handle?
On some level, speculation is an easy problem to handle. It’s a problem you can crack down on. The same can’t be said for China, Saudi Arabia or the world’s dependence on oil.