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Even The Mere Threat Of Drillling Will Bring Down The Price Of Oil
Even The Mere Threat Of Drilling Will Bring Down The Price Of Oil
By DON M. CHANCE | Posted Monday, August 25, 2008 4:20 PM PT
One of the most contentious issues of late has been the question of whether increased drilling for oil would reduce the price of oil today.
Certainly increased drilling will not bring an immediate increase in the supply of oil. But many people, even so-called experts, believe that the effect on the pump price would not be felt until the oil is actually at the pump, possibly years later.
In fact, the price will fall well before the first hole is drilled. Even the possibility of increased drilling will bring down the price of oil. It already has.
Almost everyone knows that supply and demand determine price in a market. But that knowledge seldom goes beyond understanding how supply and demand themselves are determined.
The belief that the current quantities demanded and supplied are the sole determinants of price misses an important point. Both current and expected future demand and supply interact to determine the quantity demanded and supplied in the current marketplace.
That is true because oil, and indeed almost everything else, is storable.
When a quantity is storable, the amount a producer will supply and a consumer will demand is not independent of future expectations.
Take the case of Robinson Crusoe, an example used in some economic texts. Crusoe is a simple case because he is both the supplier and the demander.
Stranded on an island with some corn, he might consume all of it in the first year if he expects to be saved in the second. If he does not expect to be saved in the second year, he will consume some of the corn and use the rest as seed corn.
His consumption might also be affected by other factors. If he feels weak, he might consume more today; if he feels strong, he might consume less. Crusoe will hardly ignore his expectations when deciding how much to plant and eat.
Thus, the current price of any storable commodity will be affected by expectations of future supply because producers use those expectations to determine when to bring their product to market.
Oil is an excellent example because it has a long storage life. Every drop of oil consumed is on the market for only a small fraction of the millions of years of its life.
Oil is also inexpensive to store. Futures prices suggest a cost of less than one-half percent a month, a portion of which is the financing cost.
If producers expect increased supply in the future, the incentive to bring oil to market later is reduced.
If storable commodities are affected by expectations of future prices, we might think that nonstorable commodities would be unaffected by expectations. That is true only more or less in theory, because in practice virtually all commodities are storable.
Even a highly perishable product like fresh fish is nonstorable only at the final stage of production, the step between being caught and cooked. Fish are, of course, stored in the water, but producers determine the rate of catch. If world governments declare a moratorium on tilapia fishing to start later, the expectation is of a decreased supply of fresh tilapia.
Even in that case producers will increase the current catch and consumers will increase their current demand, knowing that tilapia will be off the menu soon. Frozen tilapia might even become a reasonable substitute, thereby increasing the effective storage life of the commodity.
Electricity also appears to be essentially a nonstorable commodity, it being consumed almost immediately after being produced. But the production of electricity requires the storage of raw materials.
In short, a pure nonstorable commodity is virtually an academic construct. While some commodities have limited storability, most are storable in some form and therefore are affected by expectations.
One so-called expert has argued that the recent failure of an energy trading firm is what actually brought down oil prices of late. Energy trading firms are intermediaries between producers and retailers and trade contracts for current and future delivery of energy, thereby facilitating risk transfer.
To argue that the failure of one firm in this competitive market would reduce prices would be like arguing that the failure of an insurance company would lower insurance premiums. And if we believe that the failure of an energy trading firm would reduce prices, markets would have to be terribly slow to take several weeks to fully absorb that information into the price.
Expectations that are unrealized will cause a reversal of the initial price impact. If intentions are not backed by actual drilling, prices will rise. The market will tolerate a period of discussion, but if the drilling naysayers win the debate, prices will head up and sharply. The rise and fall of oil prices are likely to mirror this debate.
Speaker Nancy Pelosi is arguably the most powerful woman in America. But if she wants to see her real power, she should bring the drilling issue to a vote. Only a Fed chairman could have so much impact on market prices.
Chance is a professor of finance at Louisiana State University
