A Question for Paul Krugman
By Arnold Kling
Early in 2007, the price of oil was $60 a barrel. Recently, it has been above $130 a barrel. Which of the following does Paul Krugman believe:
(a) market fundamentals justified $60 a barrel then, and they justify $130 a barrel now; or
(b) market fundamentals justified a much higher price in 2007?
I believe that (b) is more likely to be true, meaning that we had what Tyler Cowen calls an “anti-bubble” in oil.
We know that Krugman does not believe that today’s oil price is out of line with fundamentals. Krugman’s view, in effect, is that if speculators artificially boost the price of oil, then supply will exceed demand, and the excess has to go somewhere. Where are the inventories? cUPDATE: I should clarify that “where are the inventories” is the question that Krugman is asking. It is not my question.]
This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet they did not. So is Krugman forced by his model to conclude that the price of oil of $60 also reflected fundamentals?
My view is that inventories are not a reliable indicator of supply-demand balance vs. speculation. Inventories, and the futures-spot differential, also reflect interest rates and “convenience yield” (or option value).
Steve Randy Waldman writes,
Krugman says that futures prices are too low to cause people to withhold physical oil and sell forward, as required to affect spot prices. But whatever forward price curve he shows me, I can posit an invisible “convenience yield” large enough to make hoarding oil worthwhile.
In a different post, Mark writes,
while it may be possible to store grains and other commodities in non-traditional forms, if the claim is that’s what’s gong on now, why store grains in (what I presume are) more costly non-traditional methods when, with stocks this low, there is plenty of storage space available?
That is another good question. I think that I have to argue that non-traditional storage methods (keeping oil under sand, storing wheat as crackers) are in fact less costly (at least for large adjustments) than are changes in the quantities held in storage tanks and silos.
On oil, I’ll basically repeat myself.Just suppose that the “true” long-term price of oil is $100 a barrel. But we had $60 in early 2007 and $130+ recently.
At the “too-low” price in early 2007, demand would be higher than it ought to be, leading to depletion of oil stocks. However, I would expect the depletion to take place under-sand, since there is not enough above-ground inventory to satisfy excess demand. In order to induce producers to deplete their reserves, we need either a high interest rate, a path of futures prices with little or no increase, a low convenience yield (or option value), or some combination of the three.
Fast-forward to today, with the price over $130 a barrel. At the “too-high” price, demand is now lower than it ought to be in the long run. Producers are leaving more oil in the ground than they would otherwise. To induce them to keep production low, we need either a low interest rate, a path of futures prices with an unusually high rate of increase, a high convenience yield (or option value), or some combination of the three.
There has been a dramatic decline in interest rates over the past two years, so that we do not necessarily need to observe an increase in the futures-spot premium to say that the incentive to hoard has increased. Moreover, as Waldman points out, we can always appeal to the unobservable “convenience yield” (or perhaps tell my option-value story).
The other folks (Krugman, most notably) seem to want to say about the commodities markets, “Silos and storage tanks are not filling up. The futures prices are not high relative the spot prices. So you can’t blame the rise in prices on speculation about future demand and supply.”
My reply would be that there are other ways to store commodities. Oil can be stored under sand. Wheat can be stored as crackers. Also, the futures-spot price differential is affected by interest rates and changes in the fudge factor known as “convenience yield.”
What I say is that you cannot possibly have prices in these markets that fail to reflect speculation about future demand and supply. I do not think it is reasonable to claim that the oil market was in long-term balance eighteen months ago and is in long-term balance today. Either speculators vastly under-priced oil back then or they are over-pricing it now, or both.