Why Bryan Caplan Won His Gasoline Bet
By David Henderson
For some reason, I didn’t know about co-blogger Bryan Caplan’s bet about gasoline prices with Tyler Cowen, but if I had, I would have taken his side of the bet.
Notice Tyler’s argument, in Bryan’s words:
Why was Tyler so dismissive? As far as I can understand, he thinks that basic arbitrage theory implies that there can’t be predictable price patterns.
That argument is dead wrong, for a simple reason that was behind my reasoning in an Investors Business Daily article in 2000. (David R. Henderson, “America’s Free Lunch: Selling Oil From the Strategic Petroleum Reserve,” Investor’s Business Daily, April 17, 2000.) I later made it in 2004: “Sell High, Buy Low! (Actually, Don’t Buy at All),” TCS Daily, May 28, 2004.
Arbitrage goes only one way. Let’s say speculators expect a drought next year. Then they will buy one-year futures, which raises the price of one-year futures. Arbitrageurs will then buy on the spot market, thus raising the price on the spot market, and sell simultaneously on the futures market. End of story. Arbitrage works.
But now consider what happens if people expect, with higher oil prices now, that there will be more production a few years later. Why a few years? Time to drill, time to explore, time to discover. So futures prices a few years hence fall. But arbitrage can’t go the other way. You can’t shift oil from the future (there’s no time machine) to the present. So spot prices can remain high even though basic economics–high prices give an incentive to produce more oil in the future–mean that prices will fall later.
How does that relate to my article about why the SPR should have sold oil at the time? Because the price of oil was unusually high and the futures price was well below it. So the only entity that could engage in this kind of arbitrage was one that had a huge reserve that it was not planning to use, namely the SPR.
Two funny stories about this: When I had the idea, I emailed the late Bob Bleiberg, editor of Barron’s and proposed it. He pooh-poohed it, saying that arbitragers in the markets would just offset the SPR’s move. He didn’t get the one-way nature of arbitrage. So I published with Investor’s Business Daily. Other funny story: Larry Summers was Treasury Secretary at the time. He had pooh-poohed the idea the week before I wrote my piece. Within days of my article being published by IBD, Larry announced that the Clinton administration would sell oil from the SPR.
I remember pointing out this asymmetry in arbitrage in my energy economics class in April 2014 when the spot price of oil was still quite high. I offered to bet my students that within 2 years the price would of oil would be much lower. (Why 2 years? Because we had had high prices for quite a while, long enough for there to be a long-run supply response any day.) I had no takers. But we all got a pleasant surprise when oil prices fell by about 40 percent within a few months of my offer. My students were wise not to bet me.