Oil Drives the Market

Over the last week market prices have been reacting very negatively to oil prices and we will likely see more today when trading begins. One thing that is starting to be mentioned more and more in the news is the effect this will have on inflation in our country. Higher oil prices don't always cause higher inflation, however at current levels this is a major concern. Consumers should be weary at the pump with gas over $4.00 per gallon but they should also be weary at the stores they visit whether it be the mall or a grocery store. Prices are on the rise because transportation costs are increasing and producers are beginning to transfer these higher costs to consumers. With the economy as it currently is this is potentially frightening news because people are already strapped for money as is and with higher prices something has got to give. Some are calling for stagflation which is when growth in GDP and employment is slow while prices are rising. Every time stagflation comes up the next thing that comes to mind is the Fed, since we assume that the Fed can control economic conditions limiting the chances of actual stagflation. This is very true for the most part, but the past will tell us that stagflation does occur in the U.S. (1970s -Oil Shocks)

When combating this problem the Fed needs to use current and reliable data, not predictions from analysts at investment banks and oil and gas companies. Two numbers that I have heard recently are $150/barrel in July 2008 and then $250/barrel by the end of 2009. Don't forget that there are a million other estimates out there some below current market prices and some above (the consensus is probably above). I'm sure both the companies that issued these target prices were wrong in their predictions about current prices, so why are people so quick to believe them now. The quick answer is that people want to believe that prices are predictable and that we have the knowledge and information to effectively pick out precise targets. Well I'm here to say that things aren't as easy as it seems. Prices could go anywhere from here because oil markets are not trading on purely fundamentals anymore which can be seen from the $10 move it made on Friday. Traders are putting in longs and shorts that may backfire if the smallest bit of news hits the wires. Plus now OPEC and Congress are in the mix which means things must be out of line and need "correcting." Knowing that oil doesn't trade/price fundamentally makes it even harder to target a price. I just advise caution before making conclusions from oil price targets.

Peak Oil Theory

There has been a lot of discussion on the blog concerning oil prices and the next direction they will take. Peak oil theory posits that a scare supply leads to a permanently higher price level and there are many supporters of this theory. However there is plenty empirical evidence to combat this theory like technological advances mentioned in the post above, but that does not mean the theory should be discredited. Personally the theory seems rational and fits basic supply/demand models, but the theory is very simple in that it doesn't take into account exogenous variables that could potentially create problems with the model. I think an important thing to remember is that many of the predictions and opinions we hear on oil are based on a multitude of models none of which are completely comprehensive.

Interest Rates and Oil

This is just a brief follow up on my post on last Wednesday about oil. Similar to the interest rate theory discussed in David's post about OPEC & the Fed below, here are some interesting articles about the recent falling price of oil in relations to our economy, and how the Fed's less than expected interest rate cut has affected commodity prices.

The Politics of Oil

With oil prices crushing inflation adjusted highs, many people are wondering what the next move in oil will be. Oil is obviously intertwined with politics and we will see a different political regime in office next year so the agenda they create will have major implications on the price of oil. Click the title for an article from the Washington Post that discusses the U.S. oil interests and the War in Iraq.

My Two Cents on Black Gold

Oil reached another intra-day high today of $110 a barrel.

The obvious and most talked about question surrounding oil is if the current price is reasonable. Well, let's examine this question from a few perspectives.

First, let's consider supply and demand. According to recent data from the Energy Department's Energy Information Administration (EIA), crude supplies jumped by 6.2 million barrels last week, more than three times the projected 1.6 million barrels. Additionally, gasoline supplies increased by 1.7 million barrels, far exceeding the expected 300,000 barrels increase. Finally, there is a healthy amount of current U.S. inventory at 224 million barrels, which is 22.3 million barrels above last year and 18.6 million barrels above the 5-year average. Oil consumption is expected to decline within the next few months due to further deterioration of the U.S. economy and warmer weather. From underlying supply and demand fundamentals, we can generally conclude a well supplied market.

Second, let's examine OPEC. Last week, the cartel decided to leave current production levels unchanged. However, OPEC, along with the EIA, project a continual decrease in demand, and the federal agency predicts an increase in non-OPEC production for the next few months. It is unlikely the cartel will increase production at the next meeting, but current expectations provide some cushion.

Third, we need to talk about speculation. The ever weakening dollar is contributing to the high price of oil as investors seek safety in commodities to hedge against inflation. The depreciating value of the dollar also reprices oil, sending it through the roof. However, most investors are buying up oil because it is the bandwagon hot ticket. According to an article on oil from the Associated Press today, "many traders are buying simply because others are buying." No one really wants to miss an opportunity to bag the elephant, so everyone keeps on buying, unrelated to fundamentals, and mass psychology continues to push up prices.

Finally, what do industry experts, pundits, and academics have to say about this? In an interview last week with Maria Bartiromo, ExxonMobil CEO Rex Tillerson said the current market does not suffer from shortages, and the high price of oil does not reflect market fundamentals. Various fund managers have expressed their caution of commodities, especially oil, and many predicts a commodity bubble burst. I have exchanged comments with Ross School of Business Prof. Scott Masten, who specializes in transaction cost economics. With regards to interest rates and the theory of exhaustible resources, Prof. Masten states, "it is hard to rationalize the high prices [of oil] we are now seeing on the basis of scarcity. For a while, it seems like there was an imbalance between world-wide demand and extraction and transportation capacity that was keeping prices higher than they should be. But with the economy slowing, and no major supply disruptions, prices should be falling rather than rising."

My prudent conclusion: Oil prices will fall, at least in the short-term, but not dramatically. I would be interested in knowing other theories or futures predictions on oil.