Oil Prices: On the Spot and In the Future

Oil and gasoline prices have come down noticeably in the last 3 weeks. We were marveling this past weekend to think that paying less than $4.00 a gallon to fill our own tank felt like a "bargain" – even though it was $3.99! – and there was actually some psychological lift in not being so tense about the prices we would encounter over the course of our specific journey.

Congress adjourned last Friday for five weeks and left Washington without acting on the oil-price issue. In some sense, this is all right: we will be able see how these erratic markets are trending before they enact legislation that has longer-term ramifications. The trade-off that led to a stalemate involved the Republicans who want to lift the ban on off-shore drilling and the Democrats who want to curb speculation in oil markets. We've received some correspondence from readers expressing concern with the latter issue, which argues that the high prices result from excessive investment in the oil markets by investors who are just trying to drive up the price for their own gain.

Commodity prices in general have risen sharply in recent months and it's possible that heavy buyer interest aimed at purely financial gain has contributed. But this gets really tricky, particularly when futures markets play an important role, and curbing "speculation" may constrain participants who perform real economic services.

For instance, one airline that has been relatively successful of late is Southwest. They are known for skilled use of futures markets to limit their exposure to rapidly rising fuel costs. They've bought a contract for a quantity of fuel at a price set today, but they won't take delivery of the fuel for, say, six months. If jet fuel prices go up, they'll save considerably over what they would pay if they waited six months to determine the price. The trick is that the transaction is two-sided: someone has to take the other side of Southwest's bet. Southwest is hedging its fuel costs; the other party is speculating against Southwest. This type of speculating is important in helping markets for commodities trade more smoothly. [If prices fall instead, the airline will over-pay for their fuel, but they'll at least have a fix on their cost structure well in advance. We mention Southwest, not because it's the only airline that does this, but because they have received publicity for managing this pretty well.]

Can increased speculation, though, raise the current price of a standardized product, like jet fuel? First of all, the futures markets in which speculators operate reflect buyers' and sellers' expectations of where prices will go tomorrow or next month or six months from now. Futures prices can be higher than today's cash, or so-called "spot", price; futures prices can also be lower than spot. Over time, the relationship can switch around, a result of movements in either spot or futures or both. So there's no formula linking futures market speculation and spot market movements. You can see that in this graph.

Second, speculators in futures markets never actually want to own any oil. So if speculators buy in these markets as prices might be rising, the speculators must then sell out before the contracts expire, so they don't have to take delivery of thousands of gallons of jet fuel they have no need for. Thus, while their buying might raise futures demand sometimes, at other times, they would push down on the markets with their selling to get out of contracts. See, we said this was tricky. It's become more complicated with a growing number of commodity funds that in fact have as their business buying and selling in commodities. And it's some of those funds that Congress is concerned with.

Let's return to the underlying fundamentals in these markets: good old supply and demand. Here's a graph of world petroleum demand and supply over the last 15 years or so.

We see that demand for the actual petroleum products exceeds their supply. Inventories have been falling relative to demand. Now, if someone were buying oil for the sake of driving the price up, then they would be hoarding the oil and inventories would increase. But that isn't happening. The world is using the petroleum too quickly and supply can't keep up. And in fact, what did happen to turn the prices downward in mid-July was a report that Americans used less gasoline; final demand fell. Then the stock of gasoline went up, but it did so because American drivers were using less, not because someone outside the petroleum industry was hoarding oil.

So we see that speculators are apparently not influencing the day-to-day cash price of oil. If some law were enacted to regulate their participation in futures markets to keep them from pushing up those prices, that might keep them from over-reaching. But it would also interfere with the expressions of price expectations in the markets and with the ability of real oil-related businesses to hedge their upcoming oil needs.

We're not commodity analysts or energy specialists, though, and we don't want to carry this argument too far. What we can offer is that the solutions to our current energy squeeze will likely have to come from all sides and there are no quick fixes. We can hope Americans continue driving less; they are already buying smaller, more fuel efficient cars and hybrids and almost no SUVs. Even China's efforts to cut pollution during the Olympics are probably helping lower usage of petroleum. But with the world economy growing, especially the developing countries, it's also true that we're going to need more supply. U.S. demand for petroleum has decreased 3.4% in the last year, while that in India is up 10.7%, China 5.7% and "developing countries", mostly Africa, up 5.4%. Thus, the price of oil is less and less a problem the U.S. can solve on its own (except to restrict consumption) and more a global issue. Yes, we are developing alternative energy sources, but we also still need to get to more of the oil. In the end, we think the U.S. Congress will see the need to lift the ban on offshore drilling, not so much to ease the U.S. dependency on foreign oil, but to let more of that foreign oil serve other countries, so they can keep on developing.