Observations

The Economics of Oil

You regular readers will note that a frequent theme here at Observations is dissatisfaction with the major media, which does a lousy job of informing the public. It does a wonderful job of misinforming the public, however.

Recently, the subject of this institutionalized misinformation is in the realm of economics, including the national economy in general, and the housing market and the price of gasoline in particular.

Thomas Sowell had a great explanation for why more people do not accept the economist’s explanation for high gasoline prices: It’s because their reaction to the high prices is an emotional one, and an economist’s explanation does not satisfy the emotional need. Unfortunately, the politician’s explanation does satisfy that need, when in the effort to attract votes politicians place blame on the oil companies and the oil futures market, and promise to take care of all your problems if you will just elect them to office. The current Democrat presidential candidates are a case in point. This is the wrong answer to the question of why oil prices are so high, according to Sowell, but it is much more satisfying to blame “someone” for the problem, hence “big oil” is a villain as are greedy oil speculators.

Just to be sure that my instincts were correct about the high price of oil and the effects of speculation in the oil market on that price I did a good bit of research. I don’t claim to be an expert on this phenomenon, but I have been able to determine through reading that while speculators may, and I repeat “may,” have an effect under certain circumstances, that effect is small and other less emotionally satisfying factors have far more to do with the high price of oil. Unsatisfying answers like supply and demand, for instance.

That research produced a couple of interesting pieces, which I have included below. Unfortunately, I managed to somehow lose the sources for these, so while I can’t tell you who wrote them, I can tell you that I didn’t write them, except for a little rewording here and there.

Oil Prices Compared With Personal Income

We hear a lot these days about how gas and oil prices are at historical highs. But what we don't hear much about is how personal income is also at historical highs. Per-capita personal income has almost doubled in the last 15 years, from about $20,000 in March of 1993 to almost $40,000 in March of 2008.

Measured as a percent of per-capita personal income, gas prices through March 2008 aren't even close yet to the historical highs of the early 1980s, when 1,000 gallons of gas cost between 10-13% of per-capita personal income for 36 consecutive months, much higher than the 8.2% of per-capita income in March 2008.

The peak price of gas as a percent of income was in March 1981, when 1,000 gallons of gas cost 13% of per-capita disposable income. Gas today would have to reach a price of about $5.13 per gallon, before it would be an historical high adjusted for income.

Oil Speculation

With oil prices in the range of $120 a barrel, angry politicians are blaming the higher prices on everything from speculators to greedy oil companies. Last week some Democratic Senators demanded “urgent action . . . to adequately investigate whether speculators are driving up prices.”

Democrats are proposing to protect the American people from “greedy oil traders who manipulate the market.” Senator Barack Obama wants price gouging by oil companies to be a federal crime.

Everyone wants lower prices, but many politicians seem unable to understand that speculators actually smooth out wild swings in prices. Speculators make profits by buying oil when the price is low and selling it when it is high, and doing that protects consumers. Tensions rose last week because of Venezuela financing Columbian terrorists. Columbia looked like it might retaliate and send troops into Venezuela, the world’s sixth largest oil exporter.

There was an obvious risk that Venezuela’s oil exports could be stopped. Oil prices increased immediately. They didn’t wait for the war to actually break out. By buying oil now in order to set it aside if supplies are interrupted if the conflict escalates, is good for consumers. Storing oil for then will prevent what would have been even higher prices. Politicians obviously thought speculators were unjustified to start bidding up prices. After all, war might never occur. Yet, if speculators didn’t do that and Venezuela's shipments are halted, the much bigger increase in oil prices would surely cause politicians to really call for the scalps of everyone in the oil business.

The speculators are taking a real risk with their own money. If no war occurs and prices fall, few in congress are going to shed tears over the money that the speculators would lose. If war breaks out and prices only rise a fraction of what they otherwise would have gone up, who is going to thank the speculators for a job well done?

Speculators are actually extremely accurate in predicting the future. But it is not just in oil prices.