EconSouth (Third Quarter 2008)

John C. Robertson is a vice president and senior economist in charge of the macropolicy and applied microeconomic research group in the Atlanta Fed's research department.   Figuring Out the Oil Price Puzzle

A quiz: Gasoline prices during the first half of 2008 were higher than a year ago because of

  1. strong growth in global demand,
  2. the weak U.S. dollar,
  3. weak supply growth, or
  4. excessive speculation in oil futures markets.

"All of the above" would be a reasonable choice. But I would argue that (a) and (c) are the key factors in the current story of high energy prices.

At present, underlying global demand for oil is strong but is being tempered by high prices. Global oil demand is now more resilient than in the past in part because of subsidies protecting consumers in some countries and because of robust economic growth in very populous countries outside the Organisation for Economic Co-operation and Development (OECD). The weaker dollar has also contributed to higher oil prices, but it's important to note that oil prices in other currencies also hit record levels.

Prices up, consumption down
As oil prices reached record highs recently, oil consumption responded by falling in developed OECD countries, where consumers usually face market-based prices. An interesting question is what would have happened if prices had not risen. Here are some simple economic calculations. In the second quarter of 2008, U.S. gross domestic product grew by 2.2 percent year over year. Assuming a growth response of 0.5, oil demand would be 1.1 percent higher if the price remained unchanged. In the second quarter of 2007, U.S. oil consumption was around 20.6 million barrels per day (mbd), so, with constant prices, consumption would have been predicted to rise to above 20.8 mbd by the sescond quarter of 2008. But during that quarter consumption was only 20.4 mbd. That drop was surely related to the fact that oil prices averaged $124 per barrel in the second quarter—up almost 70 percent from the average 2007 price.

The supply-demand seesaw
All told, supply has not kept pace with demand growth, and this development is another important factor behind today's high prices. Cuts in OPEC production in 2006 and 2007 initially spurred the run-up in oil prices. And even though more recently OPEC has increased output, spare capacity remains very low. Moreover, non-OPEC oil-producing nations have failed to increase output despite favorable prices.

The fundamental supply problem is not one of global resource constraints. Most estimates suggest the life span of global proved oil reserves has not declined. In fact, proved reserves should be sufficient to sustain current levels of world consumption for several decades. The problem is more about accessibility (such as environmental and location issues and technological and labor constraints) and deliverability (refinery bottlenecks). These difficulties have caused the short-term cost of producing more oil to skyrocket.

Is speculation skewing the balance?
The usual counterargument to the supply-and-demand explanation outlined earlier is that oil prices were driven higher by speculation in oil futures markets by noncommercial interests (those unrelated to the physical oil market and without an economic need to hedge against oil price changes), with hedge funds and index funds identified as the primary culprits.

However, recent studies by the International Energy Agency and the Commodity Futures Trading Commission (CFTC), among others, have investigated this concern but have failed to find compelling support for the argument that excessive speculation in futures markets is behind the oil price run-up. For one thing, prices have also risen for most primary commodities, including those traded in futures markets as well as those traded in physical markets where little or no speculative involvement takes place: liquefied natural gas, coal, iron ore, minor metals, silicone, rice, bananas, and fish meal, among others. In addition, price increases across the commodity spectrum have not been particularly synchronized.

Perhaps even more importantly, if speculators are persistently driving spot prices higher than the equilibrium of the underlying supply by producers and demand by refiners and consumers, then an imbalance in the form of higher stocks should be apparent. In prior historical episodes of speculative bubbles (such as with tulip bulbs and silver), higher stocks were evident. In the recent run-up in oil prices, however, OECD oil inventories have remained well within historical norms during the past two years.

What specific role have noncommercial traders (such as hedge funds) played in price setting? The CFTC study shows that changes in commodity prices tend to be positively correlated with net long positions of noncommercial traders. But this correlation doesn't appear to have behaved differently in the recent period. In fact, the study suggests that noncommercial positions do not predict prices. If anything, the relationship is one of trend chasing—that is, price changes leading to changes in noncommercial positions.

Some people have also argued that increased investments in commodity index funds have pushed commodity prices above levels consistent with supply and demand. The amount of money invested in commodity futures contracts through index funds has indeed increased sharply in recent years, consistent with the marketing of commodities as an asset class and a tool for portfolio diversification. Most of these increases, however, appear to reflect valuation changes associated with higher prices. In fact, during the past year the number of futures contracts held by index traders has been relatively stable for the few commodities for which such data are available. In addition, these traders do not take delivery of the physical product. Thus, every long position held by a speculative trader unwinds before expiration of the futures contract. Averaged over time, the net demand from speculators tends to balance out.

Waiting for relief
In summary, the crude outlook remains relatively tight with little supply relief in the very short term, although more supplies appear to be on the horizon. Inventories are not unusually high, and demand is slowing, especially in developed countries. Finally, the available evidence does not support the argument that speculators have driven prices above the levels consistent with supply and demand.

So while price increases are still possible, demand and supply factors that will dampen the upward pressure on prices appear to be evolving.