One Good Biden Move on Oil and Two More Suggestions
With the increases in oil prices since late December, it’s time to look at some basic facts about oil prices and oil markets. Doing so will help us understand where the Biden administration has gone wrong and where it has gone right. Yes, you read that correctly: Biden has done one good thing, selling oil from the Strategic Petroleum Reserve (SPR). If he followed my advice, he would do two more good things: push to repeal the Jones Act and make clear that he will drop his opposition to fossil fuels. The sale from the SPR helps us consumers and reduces Russian’s oil revenues. Repealing the Jones Act also would help us consumers and allowing more domestic oil production would cause future prices to be lower than otherwise, making us consumers better off and hurting the Russians in the longer term.
This is the opening paragraph of David R. Henderson, “A Short Course in Oil Economics,” Defining Ideas, March 17, 2022. That wasn’t my original title but I liked this title, chosen by the editor, better.
Another excerpt, in which I explain contango:
In normal times, the relationship between the spot price of oil (the price you pay for delivery today) and the futures price for delivery in, say, a year, is one of “contango.” If you’re picturing people dancing in step with each other, you’re not far off. Contango means that the spot price is less than the futures price, but it also implies that the spot and futures prices move together.
Every so often, though, the futures price today for delivery in, say, a year is less than the spot price. This relationship between the spot and futures price is called “backwardation.” The spot market is telling us that oil is more valuable now than it will be, say, a year from now.
In such a situation, arbitrage can’t work, for one simple reason: there is no time machine that lets us move oil from the future, when it will be less scarce, to the present, when it is scarcer.
We are in that situation today. On Monday, March 14, the spot price of oil closed at $103.01, while the June 2023 futures price closed at $81.11.
Read the whole thing.
Mar 18 2022 at 5:08pm
The explanation of contango is confusing. Contango is when the futures price is above the spot price, not really that they move together per se.
Mar 18 2022 at 5:37pm
Correct. But in the piece, I explain why arbitrage means that they move together. Did you read only the excerpt or did you read the piece.
Mar 21 2022 at 3:19pm
You were right. I took the fact of contango and then ran with it to explain the implication that the prices move together. I figured that’s how they came up with the term.
But you’re right. I sent a change to the editor and he has made the change. Thank you for your careful reading.
Mar 18 2022 at 6:21pm
I remember sitting in a lunch with the CEO at an oil company I worked for. He said that he expected oil prices to go to $70 the next year. I checked the futures price and it was only at $55 for the next year. He wasn’t the type of guy you could ask, but I was curious as to why he was so confident that the market was so wrong.
Mar 18 2022 at 10:49pm
And was he confident enough to bet on it?
Mar 19 2022 at 9:24am
Presumably, oil company CEOs bet on oil prices all the time, at least implicitly, through their company’s production, investment, and hedging decisions.
Mar 19 2022 at 12:22am
In the article, you said:
I don’t understand the second point. What does it mean for the Strategic Petroleum Reserve to be run bureaucratically, rather than strategically? And why does that make it a good idea to sell off the SPR?
Mar 19 2022 at 3:07am
I would assume it means the reserve isn’t run to maximize profits?
Mar 19 2022 at 5:38am
Perhaps, but since large SPR sales are always in response to spikes in oil prices, they should always generate profits, unless you think oil prices are going up and up forever, and there is no evidence for that.
Mar 20 2022 at 10:04am
It’s run by the government and the oil is almost never sold no matter how high the price. We have plenty of oil for emergencies so there’s no need to store oil.
Mar 21 2022 at 3:22pm
What Mark said. There have been so many time where the feds have sacrificed wealth by not selling, even some times when there is extreme backwardation.
Thomas Lee Hutcheson
Mar 19 2022 at 8:40am
I agree with the Jones Act.
Drop opposition to (production of) fossil fuels, yes. Opposition to demand for fossil fuels, no. Becasue externalities.
Mar 19 2022 at 10:44am
I do not understand your reasoning here. Production and consumption are two sides of the same coin. If one believes Pareto-relevant externalities exist, then whether production or consumption (or some combination of the two) is reduced ought to be irrelevant.
Thomas Lee Hutcheson
Mar 19 2022 at 10:11pm
It is easier to get the right amount of demand reduction (a tax on net emissions of CO2 and methane) than to figure out the right amount of production reduction, project by project.
Mar 20 2022 at 9:54am
Perhaps, but then the reason to focus on demand rather than production is not “because externalities” but “because lower transaction costs.” As Coase famously demonstrated in 1960, it takes two to tango and merely invoking “externality” tells us nothing about who should internalize the costs.
Mar 19 2022 at 11:38am
The Jones Act looks a lot like international sanctions against the US except that we’re doing it to ourselves.
Mar 19 2022 at 9:16am
“while Biden can’t be clearly blamed for high oil prices today, his overall hostility to domestic oil production will certainly be responsible for prices a year or a few years from now being higher than otherwise.”
I’m not sure that I understand the timing here. Biden has been hostile to domestic oil production since he took office 1 year ago. So, if hostility affects prices with a lag of “a year or a few years”, then why can’t his hostility from 1 year ago be certainly responsible for prices now being higher than otherwise? My understanding is that fracking wells take about 6 months to bring online so that hostility would affect supply with about a 6-mo lag? Interestingly, Apr 2022 oil futures prices fluctuated around $50 dollars per barrel until about Jan. 2021, when they started steadily rising.
Another example of Biden’s hostility to domestic oil production was his nomination of Raskin as the Fed’s top bank regulator, withdrawn only a few days ago in the face of Senate opposition. Her nomination signaled to banks that they risked greater regulatory scrutiny if they lend to oil companies.
Mar 21 2022 at 3:24pm
You make a good point. But notice that I said “can’t be clearly blamed.” The lags really matter and I don’t know that a one-year lag is enough.
Mar 21 2022 at 3:25pm
I agree with you about the Raskin nomination, but notice that that nomination happened only about 6 weeks ago. Too recent to affect prices.
Also, I don’t think prices fell much when she withdrew her nomination but I would have to check the dates.
Mar 21 2022 at 3:32pm
Another good idea on Russian oil comes from Richardo Hausmann,
Arguing that the elasticity of demand for Russian oil specifically is very elastic and that supply is quite inelastic, he argues for a large tax on Russian oil. With those assumptions the incidence of the tax will fall on Russia, depriving Putin of lots of oil revenue.
Mar 21 2022 at 3:59pm
As Hausmann notes, though, the governments of virtually all the oil-consuming countries would have to agree to the tax. They would wrangle over proceeds. This is not a detail.
Mar 21 2022 at 5:22pm
You point out that other nations would have to agree. According to today’s WSJ website the EU is considering banning imports of Russian oil. And we’ve seen lots of agreement among nations for sanctions. So I’m not convinced that agreement among many major consumers is all that remote, especially since the tax revenues make this option preferable to a ban. So China does not go along. That reduces the elasticity argument, but it doesn’t remove it.
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