Petroleum Speculation Thread N+1
I wrote something about crude oil, inventories and contango below and there were 57 comments including one, from Aaron which refered to this post in the future indicative.
A lot of the discussion is Krugman pro and con (mostly con). I think I will review my take on his arguments here as an introduction.
I had intended to write another post to clarify a particularly hand waving part of my old post (that is to report on a relative clarification in my own thoughts). I don’t think this is the focus of interest, so I will put that after the jump.
Krugman argued that the sharp increase in the price of crude oil was caused by increased demand and the fact that suppliers were already pumping just about all that they could pump (hence an almost vertical supply curve). I assume he thinks that the sharp decline is due to decreased demand. He is convinced that speculation in oil futures has not had a large impact on the spot price.
My recollection of his argument is that it was based on 4 claims (modified in part to respond to things I just learned skimming the older thread).
1) Oil is consumed and storage costs are significant. This makes analogies to housing, Nasdaq and tulips inappropriate.
2) Certainly people speculate in oil futures. The question is whether this is currently moving the spot price far from where it would be without speculators.
3) Pricing rules can determine prices, but don’t shift supply and demand curves. If spot prices move up automatically following futures prices, one would expect supply to exceed consumption — that is growth of inventories.
4) When an almost vertical supply curve meets and almost vertical demand curve, supply and demand can cause prices to move quickly huge amounts back and forth.
OK back to my “model”. Just to recall, the model assumes that the oil companies have formed a cartel and that it has become more difficult for them to keep each other in line. The driving force is low expected excess capacity (to ship and refine oil by them or to pump it out of the ground for their suppliers) makes it hard to punish a company which sells petroleum products at a price lower than the secretly agreed markup on the price of oil.
In a model, this would make them impose low inventories of crude oil and gasoline on each other and make them lower the markup increasing the price of crude and reducing the price of refined products including gasoline compared to what it would be if they could precommit to their cartel.
The really shaky part is I then claim that low inventories make them bid against each other more fiercely in the spot market so that all of the benefit from their reduced markups goes to oil exporters (and maybe then some). This is shaky, because I have forgotten the little I knew about the mechanisms of the the oil spot market and it probably isn’t the mechanism which I would need for the argument to make sense and … lots of stuff.
So I have a new way of putting it. Each Oil company can’t hold large inventories as that would give them an incentive to break their cartel (dumping the gasoline before the other companies can retaliate and benefiting from the increase in the price of crude oil). I will just assume that large inventories of crude oil are needed to keep refineries working at full capacity. If the refiners can’t hold as much crude in inventory, their suppliers will hold more. Now the price of crude includes the cost of holding that inventory essentially the oil exporters are supplying oil *and* storage. The price is higher than the price of just oil.
Now I do *not* believe that this model has anything to do with the real world. I do not think the OIL majors are colluding and I don’t think they would act like agents in game theory if they were. I don’t think their markups or storage costs are anything like large enough to fit the huge shifts in price. In fact, I agree with Krugman.
My old post was an exercise in economic theory. Fortunately commenters used it as an invitation to talk about the real world.