The Price of Oil

We have now seen a couple of years of a wild run up in the price of oil followed by an equally drastic and even more sudden collapse. So what the heck is going on? David Cohen has a close look in The price is not right. Conventional economic theories do a lousy job of predicting oil prices, it seems, and so does everything else. The short answer: nobody knows.

Right now the price of oil is hovering in the mid to high thirties while the marginal cost of production (producing new oil) is in the low sixties. That makes it pretty clear that nobody is going to invest billions in new production unless they are pretty sure that the price will go way up again. If nobody does invest in new production, production will fall and, of course, prices will rise.

Oil is one of the most central items in the World economy, so the inefficiency of the market in predicting and thus stabilizing prices is a serious threat to economic stability. Cohen's long article is illuminating but doesn't suggest any magic bullets. A few quotes that I like:

Theoretical niceties that capture expectations about price keep academic economists busy, but what are they really modeling? Here we approach what I will call the Central Mystery of oil pricing. What is modeled is the collective behavior over time of all the traders of physical and paper oil with an active interest in futures contracts, including the all-important front month. And in the end, as General "Buck" Turgidson said in Dr. Strangelove after the planes were in the air, we must finally "admit that the human element seems to have failed us here."
....

Is that why we're on the verge of a 2nd Great Depression, a downturn caused by a 20-year credit binge, a ponzi scheme, in finance, because everybody knew what was going on because the markets were so god damn efficient?


The strategy this suggests to me is Joseph's Seven Lean Years, Seven Fat Years strategy. The US has should buy and store oil while it's cheap, expanding the strategic oil reserve, and prepare for the next spike. Another good idea is energy efficiency.

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