Beware of false prophets in the market for oil
In this Washington Post article, there is a discussion about how Sen. Obama plans to go after speculators, who he and his advisers see as destabilizing prices the prices of oil.
The only problem with this is that speculators are NOT destabilizing oil prices, and in fact, any intrusion into the futures markets and those where these supposedly evil speculators lurk, will most assuredly destabilize oil prices. We have to be sure about we do before rushing headlong to correct something that may not be broken. Public policy makers should follow the physician’s dictum, “Primum non nocere,” Latin for “first, do no harm,” instead of the politician’s dictum of “do anything, as long as it sounds good, no matter how much harm it might cause.”
First, recall our class discussion on the law of one price. If goods can be moved from one market to another rather costlessly, anytime goods are selling in two different markets at different prices, people will buy them up in the low-priced market and then resell them in the high-priced market. This is called “arbitrage,” buying in one market in order to resell in another. Arbitrage moves goods from lower-valued uses to higher-valued uses.
People who specialize in market speculation are risking their money on the movement of prices in the future. Essentially, speculators, then, bet on the direction of price movements. Speculators are taking part in a special sort of arbitrage, moving goods from one time period to another. If speculators think that the prices will increase in the future, they buy up such goods now, driving prices up now, and then sell these goods in the future, adding to future supply and reducing prices in the future from what they would be otherwise. If they bet wrong, they lose, they end up buying when prices are higher and then selling the good when the price has fallen, again adding to future supply, but buying at thigh prices and selling at low prices. So, when speculators err, they lose funds and are in less of a position to speculate further.
Those who tend to be good at predicting future prices, then, stay in the market and live to speculate another day. Poor prophets make losses when they buy high and sell low, and so, soon exit the market, as they run out of either their own funds or backers. Poor prophets of future prices do destabilize markets, but they lose money and soon exit the market. Good prophets make profits and stick around the market. Futures markets come to be dominated by good prophets. They buy up in periods of low prices, when goods would otherwise be put to low valued uses (since the market is relatively flooded) and move them to times when they are valued more.
One of the best known stories of speculators is the story of Joseph and Pharaoh. This Joseph is the one from Broadway musical “Joseph and the Technicolor Dreamcoat,” that starred Donny Osmond. This is, of course, based on the story from the Old Testament, where Joseph, a son favored by his father, was the victim of sibling jealousy. As the story goes, his brothers threw him down a well and stained Joseph’s prized “coat of many colors” with pig’s blood in order to deceive their father about Joseph’s fate. Slave traders rescued Joseph from the well and sold him as a slave. He came into the Pharaoh’s employ, became an adviser to the Pharaoh, and ultimately Pharoah’e second-in-command.
You should recall from this story that Pharaoh began having troubling dreams about seven fat calves followed by seven frail calves and seven full ears of corn (what Europeans called grain and later called maize when they ventured into the New World) followed by seven dried out ears of corn. Pharaoh didn’t understand the meaning of his dream, but Joseph easily figured that in meant that there would be seven years of bountiful harvests followed by seven years of famine, and he shared the meaning with the Pharaoh. Joseph, being a good economist as well as a good prophet, advised the Pharaoh to speculate in the market for grain, buying it up during the years of bounty and storing it during the years of famine, when prices would be much higher. Not only did Joseph and Pharaoh make great sums of profits (from Joseph being a superior prophet), but they also saved lives of people and livestock far and wide. In fact, Joseph’s father, on hearing that Pharaoh had grain to sell, sent his sons to buy grain, where, of course, they found their brother.
Speculators, when they are good prophets, move resources from where they are plentiful to where they are dear. In addition, they stabilize prices, by adding to demand when prices are low, increasing prices, and by adding to supply when prices are high, bringing prices down. Good prophets do good things and make good profits. False prophets do bad things and they make losses for themselves and destabilize prices for others.
We should note that all oil producers are speculators by necessity. Oil producers can extract oil more rapidly or less rapidly. The more they extract from an oil well or from an oil formation now, the less will be available from that formation in the future. If oil producers think that prices will be higher in the future, their opportunity cost of extracting it today is higher and they will extract less oil today. The lower they expect oil prices to be in the future, the lower the cost of extracting that oil today. One result of this logic is that by opening up the Atlantic Coast, the Pacific Coast, the Florida Coast and ANWR to drilling and exploration, the lower prices will be in the future, reducing opportunity costs of extracting oil now and reducing prices immediately upon even hints of discoveries. Another result of this logic is an understanding of why oil companies are not extracting everything that they can now, and why they are preserving oil for the future, unlike what many in Congress want oil companies to do with those oil formations.
The question for Obama’s advisers is “if they are such good prophets and know more about what will happen with the prices of oil than current oil speculators, why is it that they are not heavily investing in the futures market for oil, betting that prices will come down and trading “short” (look here in Wikipedia for a good explanation for trading “short”)? Who are the false prophets?
We have to look beyond today’s oil prices, today’s oil demand and today’s oil extraction costs. We need to think about future conditions of the world, especially future conditions in oil producing regions such as the Middle East and especially the Persian Gulf. What are the concerns there?
Well, one concern is our own presence in Afghanistan and Iraq. Is that stabilizing or destabilizing the region? In other words, what effect does our presence there have wars have on the region and on oil prices? What should cause everyone “pause” (the French word for “stop”) is the last remaining part of the Axis of Evil (because North Korea is being so good these days–sure), Iran, and its threats of nuclear devastation of Israel. The greater the threat of confrontation between Israel and Iran, the greater the chance of disruption of oil through the Persian Gulf, the higher the future price of oil and the higher the opportunity cost of extracting oil today.
The high price today guides us learn to conserve oil, guides us to explore more for oil, and guides us to look more for alternative energy sources. In addition, it preserves oil in the ground from being used today to drive one SUV so that it can be used in the future to drive fifteen Mini Coopers the same distance. In other words there really is something worse than high oil prices, and that is prices held artificially low, allowing frivolous current use of oil and then, running out in the future. High prices of depletable resources keep us from running out before we develop more sustainable alternatives.
Some see Obama as soft on Middle Eastern Terrorist and soft on the Iranians, especially when he suggests that he would sit down and talk with the President of Iran. If the likelihood of Obama becoming the next President of the United States is seen as encouraging the Iranians to take action against Israel, then it could even be possible that Obama’s very success could be destabilizing the price of oil. Of course, that is remote, but it is more likely than speculators being wrong about the chance of disastrous Middle Eastern conflict.
-MC
June 27th, 2008 at 9:51 pm
Perhaps Sen. Obama should focus on developing alternatives to oil, such as Ethenol gas. Obviously, the demand for less costly transportation is rising rapidly. If there were cheaper, more efficient substitues, the demand for oil would surely decrease. Thus, saving it for the future and decreasing the current price. The key here would be for corn producers to stay competitive in their pricing. Surely, this raises the concern that the production of corn would inhibit the production of more important crops such as wheat and make those lands less fertile for future use. However, when this method becomes overwhelming, we can then resort back to oil as our primary source of gasoline. It seems to me that it could work, at least for while. The greatest thing about our economy combined with the peoples’ will to “come out on top” is that it always seems to fix itself. However, if people disrupt this cycle by jumping in to fix every problem at the first sight of trouble, the market will be jepordized and cannot “save itself” with the law of demands.
June 29th, 2008 at 3:26 am
It is constantly being brought to my attention about gas prices, gas crisis, and future gas shortages. Honestly, I think I agree with Erika Andrews. I think Senator Obama and future Presidents should look for more alternatives to gas. I think we should realize that even if the gas price issue is solved, that still leaves a problem of global warming and how gas emission from our automobile, big or small, affect that. It seems as though today: gas prices, and tomorrow something else. I don’t know what to think anymore. I look on the news and people are steadily complaining about gas prices and how we can just solve the problem by drilling in our reserves. The truth is that there is no easy way to fix this problem. Plus, it has been recently drawn to my attention, that some countries are going to be given, or already have, permission to drill off of the coasts of Cuba. This, in itself, is a threat to America because people drilling could be tapping into our reserves. There is always one person saying that they are more right with the other. I think that America should focus more on America, drill our own soil, and only trade with other countries to strengthen our trade and trust with other countries. We need to re-evaluate what is good for our country in the long-run rather than worry about the now. The decisions we make right now will effect the FUTURE, and whether or not, Obama sits with the president or leader of any nation, someone will not like it,and it will cause a chain-reaction of something else to happen. Inflation is inevitable. I think we need to find alternative ways to almost everything to prevent stuff like this controversy from happening.
June 29th, 2008 at 4:10 pm
The current prices of gas should not be all that surprising. Many predictions stated that a gallon of gas would cost around $4 this summer. Consumers are only noticing now because it is directly affecting their budgets. Sen. Obama’s plan may be beneficial, but government intervention doesn’t necassarily fix economic problems. Both Obama and McCain plan to change a policy enacted by then President Bill Clinton. While I also agree that investigating alternative fuel is a worthwhile investment, its benefits will not affect consumers in the near-future. For a more immediate impact, consumers should make a dedicated effort to reduce consumption. Improving maintenance of vehicles and planning of outings that require driving will reduce consumption for the individual. Lowering the demand for oil will cause prices to decrease and allow for greater preservation of oil.
November 4th, 2008 at 8:05 pm
Obama is being projected to win Penn. Looks like the betters have this one in the bag. It’s early yet.
November 4th, 2008 at 9:12 pm
Reasons why betters would pick Obama over McCain:
-Poor economy
-Credit crisis
-Poor Rating for Pres Bush
-Obama’s Message of reason for change
-Voters not being able to connect with McCain