Volatility is the key factor in oil prices

  • By James McCusker
  • Saturday, August 28, 2004 9:00pm
  • Business

Economists old enough to remember the OPEC oil crisis are like Washington State Cougar fans who attended the famous “Snow Bowl” Apple Cup game in Pullman. No matter how bad the weather might be on another game day, “this is nothing like it was back in ‘92 when the Cougs beat the Huskies in the snowstorm.”

Oil prices have climbed enough to be worrisome for our economy, but the old enough economists are right: This is nothing like it was in the 1970s. The recent run-up in the price of crude oil is not the kind of supply crisis we had then. There are no lines at filling stations, no odd-and even-day rationing, and no motorists (unwisely) hoarding gasoline in jerry cans in their garages.

In the early part of the 1970s, OPEC, in a power play related to the Arab-Israeli conflict, suddenly constricted the supply of oil – pushing the price from $3 a barrel to $12 per barrel. In 1979, the Iran-Iraq War began, and by 1981 crude oil had hit $35 a barrel.

Still, while recently increasing oil prices aren’t a 1970s rerun, they have raised three good questions for economists: Are energy costs high enough to slow down or stop the current economic recovery? Are speculators to blame? Is there anything we can do about the situation short of government regulation and rationing?

Regarding the first question, it is certainly true that the increased cost of petroleum products, including gasoline and diesel fuel, has to be absorbed somewhere in our economy. We are already seeing higher costs in such areas as commercial freight and airline travel, with consequently lowered consumer demand. Overall consumer spending will also be dampened by the higher prices of gasoline and, later, home heating oil.

But if crude oil prices settle down to $40 a barrel or below, the economy can probably adjust without too much damage. Consumers are remarkably agile at adapting to change, and the forces of recovery are simply stronger than the increased costs. If crude remains at or near the $50 per barrel level, though, there will likely be an increasingly visible, and painful, impact.

Exactly where crude oil prices might stabilize raises the second question – about speculators and the role they may be playing in today’s higher prices. Professor Neil Bruce, chairman of the economics department at the University of Washington, says the futures market for crude oil is a natural outgrowth of the petroleum industry.

“Both sides of the market equation, producers and refinery operators, place a high value on price stability, so they tend to want to hedge in the futures market in order to reduce uncertainty,” he said. “There has been an enormous increase in uncertainty in recent times, though, because of the Iraq war and other factors, and the price volatility that this generated has attracted speculative demand in the futures market on top of the demand increases resulting from economic growth, especially in China.”

Just how much of the crude oil price increase is due to futures market speculators isn’t known with any precision. A major part of the price increase is undoubtedly due to real economic factors such as global economic growth superimposed upon a relatively fixed production and refinery infrastructure. Speculators didn’t cause the initial upward price movement, but, as Bruce says, “they made the rise happen faster.” The market’s twitchy response to news from the Middle East suggests that speculation is a significant factor in the most recent price run up.

But before we light the torches and march through the village and up to the speculators’ castles, we should remember that the high prices may attract those who believe that $50 or even $45 a barrel is not sustainable by real demand – and their market actions will hasten the return to lower prices.

Is there anything we can do about speculative demand and volatile prices? Yes. We should be building up a reserve of crude oil stocks – much like the strategic petroleum reserve but with the sole purpose of market smoothing. The reserve has its own purpose – keeping about a 30-day supply on hand in case disruptions create a national emergency.

But just as the Federal Reserve uses its cash and Treasury securities holdings to preserve orderly markets, the Energy Department, or perhaps the Fed itself, would use this new crude oil reserve to buy and sell futures in order to reduce price volatility and market uncertainty.

There is no doubt that it would work. A market petroleum reserve cannot make real supply and demand variations disappear, but it can reduce volatility in the market, and that by itself will discourage speculators. It is certainly worth a try.

James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101,” which appears monthly in The Snohomish County Business Journal.

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