Whither Oil Prices?

Every time there is an oil price spike as there is today, two things happen. First, various government agencies launch investigations to see if there has been something nefarious going on.  Second, despite the clamor for more drilling in the US, it is said that doing so won’t affect oil prices today.  This is always used as the argument to allow the rabid environmentalists to continue to keep the most likely places to find oil off limits.  The first is a silly waste of time.  Not once has manipulation of the markets been discovered.  The second deserves closer scrutiny, though.

Let’s say that is autumn and the wheat crop is in for the year.  You have bought it all up with the intent of releasing it into the market in such a manner as to maximize your profits.  With interest rates being positive the most will be released in the first month and the least in the final month before the next harvest.  (I’m assuming that there isn’t any seasonal variation in the consumption of wheat.  If there was the amounts would be adjusted accordingly.  Ignoring it doesn’t change the qualitative results, though.)  But now something terrible happens.  The Argentine and Australian wheat harvests are expected to their best ever.  They will have sufficient quantities to sell into the US market.  This wheat will come onto the US market in six months.

Clearly, you won’t be able to sell the wheat you had planned to sell in months 7 – 12 for as much as you had planned.  What to do?  Being rational, you will want to increase the quantities you sell in the first six months, even though it will result in a lower price.  You will do this because it will enable you to maximize your profits (which will now be lower than they had been expected to be before the bumper crops elsewhere) under the new price-quantity combinations that are expected to prevail.  Note that while the Argentine and Australian crops haven’t arrived yet the implications of their impact on prices have been factored into the plans of the holder of the US wheat.  The rational response is to recognize that the inventory is now less valuable and the needs to be sold sooner even though it means receiving a lower price.

Wherever you see (U)S wheat replace it with OPEC oil.  Wherever you see Argentine and Australian wheat replace it with US oil.  The analysis is exactly the same.  If the government allowed our oil firms to explore in the currently off-limits areas where we know there is plenty of oil, the current price of oil would decrease.  It would do so as OPEC realized that its inventories of oil are now less valuable than they were before.  In order to maximize their profits they will supply more oil into the world markets today.  This is a critical insight.  The expectation of more oil (or wheat) will cause the current price to fall from what it would have been.

The lower price of oil will be an enormous increase in the discretionary incomes of Americans, far greater than any targeted tax reduction would be.  It would reduce our Balance of Payments deficit.  It would employ, at rather handsome wages, many people.  It would reduce the incomes of some of the most unstable and mischievous regimes on the planet.  It is difficult to see why our political leaders continue to allow a small but vocal minority negatively impact our lives.

Posted by Jim