A Glimmer of Hope on Oil
By Arnold Kling
In forecasting oil prices, I tend to defer to the efficient markets hypothesis. In some sense, oil in the ground has to compete with bonds and other interest-bearing assets. So, a reasonable approximation is that oil prices should be expected to go up at the interest rate. So, if the interest rate is 5 percent, then oil prices should go up at 5 percent, plus something for storage cost. If people thought oil prices were going to rise faster than that, they would keep the oil in the ground. If they thought that oil prices were going to rise more slowly than 5 percent (if that is the interest rate), then they would sell oil and buy bonds.
So my tendency is to assume that markets are efficient and predict that oil prices will rise at the interest rate.
But perhaps there is an irrational buyer in the marketplace.
To guard against shortages, the U.S. and other nations have a combined 1.4 billion barrels of oil stored away, as governments have been steadily adding to their stocks since the shock of Sept. 11, 2001.
Maybe the irrational buyer(s) have driven prices above equilibrium levels. If so, then prices may turn around. We do not have to sell our petroleum reserves to drive the price down (although there is a reasonable argument that the reserve is a stupid concept). If we just stop adding to our reserves, that would reduce demand and perhaps cause a decline in price.
UPDATE: Allan Sloan points out that we could become a more rational buyer by using the forward market.
the $41.55 price for oil today is much higher than the $35.50 it costs for a barrel to be delivered next year. This disparity inspired Loews chief executive Jim Tisch, whose company has extensive energy holdings and plays financial markets like a violin, to propose a trade. Let’s sell oil out of the reserve, he says — not for money, but for oil to be delivered next year. We could get seven barrels next year for six today. We’re now buying 160,000 barrels a day for the reserve, which has 660 million barrels. But by trading rather than buying, we’d save taxpayer dollars, reduce the demand that’s driving up prices today, and spook the speculators.
However, this article quotes experts as saying that the additions to the strategic petroleum reserve are too small to have a significant effect on the market.
For Discussion. Even with some irrational buyers, in an efficient market should we still expect the price of oil to follow a path determined by interest and storage cost?