Tuesday, July 15, 2008

Keep it simple, stupid

NEW YORK - Oil prices fell harder than they have in 17 years Tuesday, as fears that record fuel prices are spreading broad economic pain exacerbated the third big sell-off in just over a week.

Light, sweet crude plunged $6.44, or 4.4 percent, to settle at $138.74 a barrel in an extremely volatile session. Prices at one point plummeted more than $10 from the day's high.

Mounting concerns about the risks inflation poses to the United States, the world's biggest oil consumer, helped spark the declines. Analysts also attributed the sell-off to Thursday's expiration of options contracts, which tend to increase volatility, and to computers programed to automatically sell once prices reach certain thresholds.

I'm no economist. But, there are some basic things I understand. The above is clear evidence of what happens with futures markets. Of which oil is a part. It is also a world market taking in influence not just from the US, but from around the world. Yes, we're the largest consumer of oil. But, we're also one of the most volatile in terms of influence. Again, as evidenced above. Just the threat of inflation sent the market plunging.

Now, imagine what would happen if we decided to go after more oil right here in the US. Hmm. Speculation of increased supply at some time in the future, you wonder?


But, we don't know how much that would be, you say. Doesn't matter. It's speculation. That's why they call it a futures market. It only matters when it comes time to settle. In fact, because of the volatility of the market, the gubmint is considering taking oil off the futures market. But, there are problems with that. Anyway, here's an interesting read:

The relationship between future and current oil prices implies that an expected change in the future price of oil will have an immediate impact on the current price of oil.
Thus, when oil producers concluded that the demand for oil in China and some other countries will grow more rapidly in future years than they had previously expected, they inferred that the future price of oil would be higher than they had previously believed. They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its initial rate.

Hence, with no change in the current demand for oil, the expectation of a greater future demand and a higher future price caused the current price to rise. Similarly, credible reports about the future decline of oil production in Russia and in Mexico implied a higher future global price of oil – and that also required an increase in the current oil price to maintain the initial expected rate of increase in the price of oil.

Once this relation is understood, it is easy to see how news stories, rumors and industry reports can cause substantial fluctuations in current prices – all without anything happening to current demand or supply.

Now here is the good news. Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. In other words, it is possible to bring down today’s price of oil with policies that will have their physical impact on oil demand or supply only in the future.

For example, increases in government subsidies to develop technology that will make future cars more efficient, or tighter standards that gradually improve the gas mileage of the stock of cars, would lower the future demand for oil and therefore the price of oil today.

Similarly, increasing the expected future supply of oil would also reduce today’s price. That fall in the current price would induce an immediate rise in oil consumption that would be matched by an increase in supply from the OPEC producers and others with some current excess capacity or available inventories.

Any steps that can be taken now to increase the future supply of oil, or reduce the future demand for oil in the U.S. or elsewhere, can therefore lead both to lower prices and increased consumption today.

To get to the point . . . drill now. If you don't think it that upon it's mere announcement prices would drop, you need to go back to school.

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