Expectations and oil prices

The debate rages about who is responsible for the 100% increase in the price of a barrel of crude oil over the last year - speculators? fundamental supply and demand factors? Or a combination of influences on the market. Martin Feldstein’s article in the Wall Street Journal today is excellent in linking price volatility to the low price elasticity of demand and supply in the market in the short run.

He writes:

“With a very low short-run price sensitivity of demand and little scope to raise supply in the short run, even a relatively small increase in corn demand by the high-growth economies can lead to a very large short-run rise in the price of corn.”

So what scope is there for prices to fall? The International Energy Agency has released a report downgrading their forecast for oil demand among the leading advanced nations that form the OECD (demand could actually dip this year instead of a forecast rise). But they do not see much scope for oil prices to fall much below their current level because of production and refining shortages, highlighting in particular the difficulties non-OPEC nations are having in adding fresh supply. Our ageing North Sea oil fields are a good case in point here.

But Feldstein offers a slightly more optimistic outlook on the steps that we can take now to bring the price of crude down from the dangerous highs of June 2008 - the key, according to his article, is to bring down price expectations.

“Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. In other words, it is possible to bring down today’s price of oil with policies that will have their physical impact on oil demand or supply only in the future.”

“For example, increases in government subsidies to develop technology that will make future cars more efficient, or tighter standards that gradually improve the gas mileage of the stock of cars, would lower the future demand for oil and therefore the price of oil today.”

But how strong will such forward lookign strategies be in a market dominated by speculators looking for short term gains? My view is that best bet to bring down prices in the near term is for millions of people to think long and hard about their need for gasoline, cut out as many of the marginal journeys as possible and make their economic votes felt at the pumps.

The rest of Feldstein’s article can be found here

BBC report on the latest IEA forecast