Lessons from the Oil Market

The longer I study economic phenomena, the more I learn two truths. The first truth is how little I know. This is very humbling. There is just too much information out there for any one human being to process. The second truth is that this abstract thing we call “the market” can and does do what no human being or computer can—it does process all the pertinent information.

I am in awe of markets. Take something as seemingly simple as the price of a barrel of oil. Like any market-derived price, the price of oil at any given moment results from the interplay of two forces—supply and demand. On the surface, it seems like it should be fairly simple to figure out the price of oil since it all boils down to just two elementary factors. But this isn’t an easy task. Just ask all the highly trained and experienced hedge-fund managers, professional speculators, and others who have lost their shirt by betting incorrectly on the price of oil during the last couple of years.

The price of oil has gyrated wildly during the last few years. I can recall when oil sold for $3 and $4 dollars per barrel and the price range over the course of a year was less than $1. During this past year, the price has gone up or down more than four dollars in a single day, as the price of oil soared into the stratosphere, peaking at around $147 per barrel, before crashing back to earth in the vicinity of $40 per barrel.

What has been going on here? Has the oil market “gone crazy,” as some individuals assert? On the contrary, the oil market has been completely rational. It simply reflects the countless decisions that billions of people make every day about whether to buy or sell oil. You can debate whether some of those individual decisions were rational or not, but the market constantly did what markets do—it processed and reflected those myriad decisions. This fundamental nature of a market points to the inherent difficulty of predicting future market prices: Who can possibly foresee what billions of people will decide to do at any given point in time in the future?

Future demand and supply can only be “guestimated” by extrapolating from historical data and trends. But trends change and data are unreliable. Even when governments are honestly trying to tabulate how much oil is being demanded and supplied, they are incapable of doing so. Economic data-gathering is constantly plagued by measuring errors, unintentional oversights, and huge blind spots, such as “black markets” and “off-the-books” transactions. There is also the additional consideration that many of the oil-producing states have a strong monetary incentive to lie about how much oil they are producing. OPEC cartel members are known to cheat by producing more oil than their allotted quota, and certainly, during the last few years when oil prices were rising, do you really think that producers desirous of higher prices wanted to broadcast how much they were ramping up production? Indeed, as oil was selling for far over $100 per barrel this summer, in response to the perception that oil was scarce, supertankers filled with oil were floating storage tanks, waiting sometimes weeks to find a port ready to receive more supply. Once the perception took hold that oil was plentiful rather than scarce, the market balance tipped and the price of oil crashed.

Indeed, the oil price’s spectacular round-trip illustrates an old economic truism: High prices are the cure for high prices. On the demand side, high prices discourage consumption; on the supply side, they encourage more production. Here in the States, soaring gasoline prices induced Americans to reduce their miles driven by over 5 percent year over year. Meanwhile, regardless of what official statistics might have said, producers ramped up production to take advantage of record-high prices for their oil. Supply overtook demand, and the price plummeted.

There is another lesson for us in the round-trip of oil prices going from $40 to $140 per barrel: The oil market doesn’t operate in a vacuum, but is affected by macroeconomic phenomena. During the last few years, Federal Reserve-induced inflation generated a boom-bust cycle. The money created by the Fed’s credit expansion inflated many commodity prices, not just the price of oil, while decreasing the exchange rate of the U.S. dollar. Because of the current deflationary implosion in financial markets, demand for oil (both for use and for speculation) has plunged while the dollar has rallied. Oil’s price movements have been amplified, both up and down, by general financial conditions.

Looking ahead (full disclosure: I don’t have a crystal ball) it seems likely that the severe downturn in the global economy will depress demand for oil for quite some time. On the supply side, I distrust all the talk about “peak oil.” Predictions that the world is running out of oil have a long history. They have all been spectacularly wrong, because they don’t understand markets. I could write a whole article on the rosy prospects for future increases in the supply of oil, but suffice it to say here that continually improving technology, plus the removal of political barriers against developing known reserves, combined with the fact that much of the planet has yet to be explored for oil, and you have reasons for optimism.

Near-term, the most likely trigger for significantly higher oil prices (other than simply a reflexive bounce, such as occurs in many markets after a precipitous fall, or a general rise in commodity prices if the Fed’s unprecedented money creation triggers a major fall in the dollar) would be a geopolitical event. If Israel attacks Iran, the latter may sabotage the Strait of Hormuz. Perhaps a ruthless leader desperate for oil revenue (e.g., Putin or Chavez) will ratchet up tensions to inject fear of supply disruptions into the oil market.

All such projections are speculative. The only fact you can count on is that the market for oil will set its price, and we will have to adjust to it as best we can.