[OPE] Reflections on the oil price controversy

From: Jurriaan Bendien (adsl675281@tiscali.nl)
Date: Tue Jul 15 2008 - 14:30:57 EDT

A while ago Paul Krugman argued: 

Faced with higher [oil] prices, drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production. As a result, the initial balance between supply and demand would be broken, replaced with a situation in which supply exceeded demand. This excess supply would, in turn, drive prices back down again - unless someone were willing to buy up the excess and take it off the market. The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding - an increase in private inventories of black gunk. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling. But it hasn't happened this time: all through the period of the alleged bubble, inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn't the result of runaway speculation; it's the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China. The rise in oil prices these past few years had to happen to keep demand growth from exceeding supply growth. http://www.nytimes.com/2008/05/12/opinion/12krugman.html

This argument just isn't very credible, given the relative "inelasticity" of world oil supply and demand, and it conflates shortterm and longterm trends. Chaudhuri replies to this line of argument in a punchy article:

"The biggest argument for speculation to be the single-most important cause for oil price increases in 2008 is: What else could have doubled the price of oil in one year?" "http://english.aljazeera.net/business/2008/07/200879184520258575.html

Chaudhuri elaborates:

"Consider first the oft-mentioned demand from "China and India" which is frequently put forward as the principal reason why oil prices are going up. (...) How can.. [the] small increase in demand increase oil prices by 100 per cent between July 2007 and July 2008? The supply of crude oil has been remarkably stagnant over the last three years. (...) It is the very short-term supply disruptions which seem to be more important for an increase in oil prices. Real disruptions may come from labour strikes in Venezuela [and Brazil], hurricanes in the Gulf of Mexico, and rebel attacks in Nigeria. Given that the demand and supply situation is so tight, even the slightest of bad news can increase the price of oil in the futures and spot markets noticeably. Asserting that the "weak dollar" is a significant reason behind the rise in oil prices has become as ritualistic as asserting that "China and India" are the cause. (...) However, for the first six months of 2008 the dollar has depreciated against the euro by only 7.5 per cent, while oil prices have gone up by about 50 per cent. Surely, both Americans and Europeans are paying much higher prices for oil than can be explained by a "weak dollar". The energy ministers of Saudi Arabia and Qatar asserted for the first time in public at the recent Jeddah meeting of major oil producing and consuming nations, that speculation in the oil futures markets was the most important reason why current oil prices are going up. (...) In a recent testimony to the Senate, a hedge fund trader presented data to show that outstanding speculative positions in all commodities futures has reached $250 billion by March 2008, as compared to only $13 billion at the end of 2003. (...) If speculation is what is driving oil prices up, then it stands to reason that such high prices should lead to an excess supply of crude in the world. There are signs that such an excess supply is indeed building up, albeit slowly, much like the way the excess supply of housing emerged in the United States. Fuel consumption has declined in the US sharply. We have already noted that oil consumption in Japan and Germany are actually decreasing. Consumers in China and India have been insulated from the high world prices of oil until very recently with domestic subsidies. However, China has raised the prices of various petroleum products amounting to an average increase of 18 per cent, and so has India, by 13 per cent. The decrease in the demand for oil will start strengthening soon." http://english.aljazeera.net/business/2008/07/200879184520258575.html

This is also more or less what the G8 luminaries are banking on - that, within the space of one year, or one and a half years, a more favourable supply-demand relationship for traded oil will be reached, causing the oil price to drop. Also, some financial steps at least could be taken to reverse the falling dollar exchange rate. But that is where Krugman's argument comes into play: the longer-term oil position is in fact that supply lags demand, plus, assuming the oil price has again dropped strongly in the future, then the large speculators start buying again (of course you can also make money from "shorting" on falling oil prices; all the speculator needs is a bit of price volatility). This would not happen only in the case that more profit could be obtained from some other source, at relatively low risk.

There can be no doubt that high oil prices wreak havoc on the economies of poor countries, and thus that they contribute directly to the food crisis. But leaving aside hungry people in some faraway country out of their field of vision as they ogle the balance sheets, there is nowadays increasing moral uncertainty about the justification of speculation as such. 

The orthodox view is that the role of the speculator in a market economy is mainly (1) to absorb risk, and thus insure the value of capital investments, by using his own capital with the chance of monetary reward, (2) to add liquidity to the marketplace, compensating for volatility and facilitating market expansion, by making capital funds available that would otherwise be underutilised, or not utilised at all, (3) to allocate capital so that it is most efficiently used. But this whole reasoning doesn't hold much water in aggregate nowadays, when we look at what empirically happens in the world. 

"It is indisputable that the global glut of liquidity [what Jan Toporowski calls "capital market inflation"] played a role in the 'reach for yield' phenomenon and that this reach for yield led to strong demand for and supply of complex structured products," says Gerald Corrigan, a partner at Goldman Sachs and an éminence grise of the financial world." http://www.economist.com/specialreports/displayStory.cfm?story_id=11325347 The paradox is that the more capital funds are available which are insured against risk, the more bets are staked on future income and future wealth, so that the risks in fact proliferate. The gambit is to claim tomorrow's wealth today, utilising the credit system, but this leads to the overextension of credit in various forms, without however anybody being able to specify any limits to the game, other than observed empirical cases of business collapse, and without being able to predict adequately what the repercussions of such collapse will be.

In turn, that gives rise to the ideological problem, that curtailing speculation (through more regulation) would contradict the doctrine of free trade. 

The benefits of free trade are always supposed to outweigh the costs, if not in the short term, then in the long term. But even if free trade obtains more benefits than costs, the benefits and costs are empirically very unequally distributed between nations and social classes. That may not appear to be such a problem, if everybody is making gains in trade anyway, be it in unequal amounts (for example, poor people earn $2 per day instead of $1 per day), but it does become a problem if free trade becomes a zero-sum game, in which the benefits of some are directly and transparently at the cost of others. 

Because in that case, it becomes very difficult to convince a large number of people of the benefits of free trade - given that they are losing more money than they gain. And that creates conflicts among different fractions and strata of the propertied classes about the justification of claims to wealth, the corollary of which is recurrent crises of political leadership, and an increasing turnover of politicians - generating political instability, which contributes to further market uncertainty. 

It is not just that the more the complex web of financial claims and counterclaims expands, the more difficult it becomes to unite people over an economic programme that would benefit all - but that it becomes more difficult to evaluate what the costs, benefits or outcomes of any given economic programme will be, as such, anyhow. There are just so many different potential "stakeholders". And that leaves economic science with a bunch of metaphors and dogmas suggesting "what would be good for people". 

In the end, of course, people will act according to their own perceived interests, regardless of doctrine, but insofar as they do this, it confounds the conventional "rational actor" models of conventional economics. It is therefore hardly accidental that psychologistic "behavioural economics" becomes the vogue - all the economists can really do in this predicament is to describe the costs and benefits of economic action for individuals in their specific situation. But all that means, is that economics has little to say anymore about society as a whole, i.e. the ensemble of human relations in which individuals are located, socialised and acculturated. It becomes purely a defence of the goodness of private property relations, no more, no less. 

The confusing thing there is that more and more money is made, by people who use money that they do not actually privately own. Money seems to grow on trees, though actually it doesn't. All told, wealth-creation gets an added mystique thereby. It all seems to turn now on how you behave, and all economic problems can be then be reduced to the behavioural problems of individuals. To solve economic problems... all you need to do is change people's behaviour. But what if they don't want to change? In that case, they only have themselves to blame if they're poor. The dispute that remains is just which behaviours are most important, how you would specifically change them, and what effects that would have. But who can judge that best, and why?  

The Vatican went through 23 money-losing years until 1993, but the situation improved dramatically after a revised code of church law made clear that dioceses around the world should assist the Vatican. http://www.outsidethebeltway.com/archives/2005/04/catholic_church_facing_financial_crisis/  Perhaps that is the way of the future for Barack Obama in his likely future role of the "lender of the last resort".


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