Tuesday, March 04, 2008

It's Still the Demand Inelasticity

Oil hits $103.95. Yawn. It seems rather obvious to me that the recent run up in oil prices has come primarily from a declining dollar and fears that inflation will errode the value of conventional (read: fictional) financial instruments. But when CNN runs an article suggesting that, but for all this insane "speculation" in oil, it would be trading at $60/barrel, I need to pull out my broken record player.

It's still the demand inelasticity.

I get the impression that most financial pundits cluttering the news these days have only recently even thought about commodities, and have spent most of their careers thinking about equities. Why is this relevant? Because, with equities, speculation can dramatically over-inflate the price beyond any immediate underlying value. There is no check whereby, within a relatively short time, the owner of that equity must demonstrate that the underlying assets actually have some real value now by selling them (and not merely selling the equity to another speculator). Not so with oil (and other commodities). At the end of the day (or, here, at the expiration of the contract), either a grass-roots consumer is actually willing to shell out cash for an oil-derived product, or not. Speculators cannot drive the price of exchange-traded oil higher than consumers are willing and able to pay at the pump. There is, admittedly, a bit of a lag here (most contract volume is at least a month out, and there is a delay between contract settlement and that price working through the refinery and distribution chain to the end consumer). But oil prices have been above $60 for some time--much longer than is necessary for these higher prices to reach the end consumer. Bottom line: unlike equities, there is a fundamental reality check imposed on commodity speculation. There simply isn't enough volume in long-dated contracts, nor enough spare storage capacity for arbitrageurs, to get around this.

I don't know what school of economics these pundits attended (OK, actually I do, but that's not the point), but where I come from, something is worth precisely what you can get someone else to pay you for it. This applies directly to consumables, and in light of the housing bubbles in parts of the US, a more inclusive definition may be "something is worth precisely what you can get the end-consumer to pay for it." Here, the end consumer seems willing and able to pay $100/barrel for oil. If that changes, for whatever reason, then the price of oil will change, regardless of "speculation."


Genghis said...

...thanks for another lucid summary of the oil fiasco about to befall us...unfortunately about as many will listen as they do to Bartlett in Congress as he 'cries out in the wilderness' hoping someone in Washington will actually pay attention...I'm sure I saw a couple of tumbleweeds rolling by on CSPANN last he was televised...

Jeff Vail said...

Dante's Peak (screen name) over at peakoil.com made this point even more succinctly: unlike equities, commodities are a zero-sum game. For every holder of a long contract, there is the balancing holder of the short side of that same contract. So every dollar someone makes in commodities, someone else loses (unlike the stock markets, where, so the theory goes, value can be created--not the place to get too deep into that issue right now). If speculators were driving up the price of oil, then there must also be speculators absorbing the equivalent huge losses in this speculation-driven price--and, of course, no one is willing to play that role, so the speculation argument falls flat.

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