Monday, February 2, 2009

Improving the Economy by Smoothing Oil Price Cycles

Much of the economic history of the past four decades relates to oil price volatility. This brief note suggests a way for the Obama Administration and others interested in stability of oil pricing to smooth out the pricing cycles, with benefits to the world at large. The recent wildness of oil pricing has ultimately been bad for both producers and refiners of petroleum as well as for users of the refined products.

The brief history of oil prices since 1970 is as follows. Around 1970, the "Seven Sisters" pushed prices of Arabian and other oil down from $3/barrel to around $1.80/barrel. In response, OPEC was formed. Taking advantage of the U.S. defeat in Viet Nam, shifting attitudes to "economic imperialism", the ability of Arab oil producers to embargo oil to the U.S. in response to the 1973 Israel-Arab was, and other factors, the price of oil imposed by OPEC rose to about $12/barrel by 1975. The U.S. and the Western world de facto supported that price by "persuading" their banks to lend to poor countries so they could continue to "pay" for the now very-pricy oil. By the early 1980s, the Iran-Iraq War allowed OPEC to triple the oil price to about $36/barrel. At the peak of the hysteria after that war erupted, it was said that the then-small spot market for oil spiked into the high $40's per barrel.

About 18 years later, despite general price inflation, the spot price of oil, which was then a large market, dropped not much above $10/barrel.

Oil then went on a decade-long rise, peaking at what now looks like a blow-off top in price near $150/barrel. In half a year, the price fell by at least $100/barrel.

It is submitted that as part of the excessive financialization of so much of the Western world, the oil market has also been excessively placed in the hands of traders. Oil is ideal for long-term, fixed price contracts. Oil fields require large, long-term investments before they become productive. They typically have long lives, and labor is not a high part of the marginal cost of production. Gross profit margins once a decent find is in production are very high. The price of the marginal barrel of oil in the world is irrelevant to an efficient market price.

We must remember that the cost of hedging, and the cost of volatility, are real costs.

We also are aware that market pricing signals are helpful to producers and consumers. These signals were not present when the Seven Sisters and then OPEC effectively formed a cartel. There is, however, no need for a gigantic market such as oil to primarily be priced off of the spot market.

This blog therefore raises the question of whether cooperative meetings should be held involving governments of oil importing and oil exporting countries, integrated oil companies, and other parties, with the goal of moving most oil contracts to long term, fixed price status, but retaining a futures market.

Benefits would include greater stability in the world economy, fewer dollars "lost" to frictional trading costs, and a greater ability to plan for a transition to a non-petroleum-based "green" energy system.

The concepts that apply to oil also apply to other commodities, especially those that have long lead times to generate production and that are readily stored, such as metals.

Copyright (C) Long Lake LLC 2009

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