The Corner

Oil Markets Revisited

While few people are all that interested in the goings-on in world crude oil markets these days (we all seem have bigger economic fish to fry when oil prices are hovering around $50 per barrel, a third of what they were only a few months ago), a couple of interesting papers that recently crossed my desk suggest that those markets continue to remain both interesting and important.

U. Cal. econometrician James Hamilton, for instance, has a new paper out titled “Causes and Consequences of the Oil Shock of 2007-8.” While the story he tells about what caused the price spiral largely tracks my own (i.e., don’t blame speculators, big oil companies, the Federal Reserve, OPEC, etc.), more interesting is his discussion of the macroeconomic consequences that followed from the same. In short, he concludes that “Had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession” (p. 40). 

While my colleague Bill Niskanen remains skeptical of this proposition, Cato economists Jagadeesh Gokhale and Alan Reynolds are more sympathetic with that analysis. If Hamilton is right, then all this talk about the need to radically restructure the rules governing global capitalism in general and the financial sector in particular to ensure that the economic meltdown of 2008-9 never happens again is largely misbegotten.

Another useful read comes from the European Central Bank in the form of a paper titled “Will Oil Prices Decline over the Long Run?” As you can guess from the title of the paper, it was published prior to the price collapse, but only days before the whirlwind hit in October 2008. While the paper’s discussion of the causes of the oil price spiral is consistent with Hamilton’s, the authors further argue (persuasively in my opinion) that a cap & trade program to reduce greenhouse gas emissions is unlikely to have any significant impact on future oil demand. That’s because the increases in oil prices that would follow would be relatively modest in percentage terms compared to the much larger price increases in percentage terms that would hit coal markets. Demand for crude oil is just not price sensitive enough for those price increases to have much impact on consumption. In fact, it’s likely that oil demand would actually increase to some extent because market actors would have a strong incentive to switch from coal to oil in either a carbon tax or a cap & trade world.

While the paper has lots of good analysis and interesting argument to offer, it is instructive to pay particular attention to its main claim; “The likelihood of sharp reversals in [oil] prices is not particularly great.” This on the very eve of the largest price collapse in the history of the oil market … a useful reminder that, as Vaclav Smil and James Hamilton have both pointed out (particularly, here and here), forecasts about the trajectory of crude oil markets are difficult if not impossible to spin intelligently. 

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