Surowiecki on Oil Prices

Andrew Sullivan finds the discussion of the oil market by James Surowiecki illuminating. I’m not so sure. Let me begin with this confusion:

Between 2000 and 2007, world demand for petroleum rose by nearly nine million barrels a day, but OPEC has been consistently unable, or unwilling, to significantly increase supply, and production by non-OPEC members has risen by just four million barrels a day.

But wait a second – doesn’t the quantity demanded equal the quantity supplied at the market clearing price? If Surowiecki is trying to say that the demand curve shifted outwards along a fairly inelastic supply curve – then maybe we have a pretty good explanation of the rise in oil prices. The Excel file from the Energy Information Administration has some useful information from 2003 to 2007 including total world demand and total world supply – which both grew by about 5 million barrels per day from 2003 to 2006. During this period, OPEC supply grew by almost 4 million barrels per day. Now from 2006 to 2007, world demand growth seems to have outstripped world supply growth with the difference being world demand and world supply being either reported draw downs of inventories or the “statistical discrepancy”. Given their data has most of this difference being the statistical discrepancy – it is hard to pin down precisely what their data is telling us.

Surowiecki argues against the usual suspects – market manipulation by greedy oil companies or speculative forces – and he’s likely correct. But then he argues:

But there’s also something else at work, which the oil guru Daniel Yergin calls a “shortage psychology.” The price of oil—more than that of many other commodities—isn’t based solely on current supply and demand. It’s also based on people’s expectations about future supply and demand, because those expectations determine whether it makes sense for oil producers to sell their oil now or leave it in the ground and sell it later. Currently, the market is assuming that oil will become scarcer, and that global demand will keep rising, especially in rapidly developing countries like China and India. As a result, producers are asking very high prices to pump their oil. Now, it could be that these assumptions are all wrong—that the supply of oil will not be constricted going forward, that concerns about the Middle East are exaggerated, and that higher prices will lead people to cut back on energy consumption, shrinking demand. In that case, oil would turn out to have been hugely overpriced. But that won’t be because of sinister speculators; it will be because oil producers and oil users collectively misread the future.

Why would anyone assume that the assumptions of rising world demand and shrinking supply be wrong? What if they are correct? Then couldn’t the current market price be a rational response to these rational expectations? Which might leave one to argue that allowing the market to work is the preferred policy to all the nonsense we are hearing from politicians such as John McCain.