EconSouth (Third Quarter 2008)
A quiz: Gasoline prices during the first half of 2008 were higher than a year ago because of
"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
The supply-demand seesaw
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?
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
So while price increases are still possible, demand and supply factors that will dampen the upward pressure on prices appear to be evolving.