Expectations and Oil

Maybe the news is that the political wind in the U.S. is shifting in favor of more domestic drilling.

If it's that, then certainly the fact that President Bush lifted the executive branch ban on offshore drilling, and called on Congress to lift the legislative ban could be affecting traders' minds. They could be right or wrong in their speculation, but it certainly seems sound to me to base the price partly on future supply and long-term expectations.

I don't understand economists like Menzie Chinn and Paul Krugman who seem to suggest that the price of oil today has only to do with spot supply and demand, and nothing to do with expected long-term supply. Wouldn't it be perfectly sane to bid up the price if you thought that the fields would run out in the future? It would even be the most efficient thing for the world and everyone. If we're going to run out sooner, conserve more now.

Certainly we know that the announcement allowing drilling should cause the price to fall, but the magnitude of the effect could be pretty small.

How much oil is really available in these newly opened fields, compared to the total world supply? And perhaps the market already expected that drilling would be allowed eventually?

According to Intrade.com, the odds of an attack on Iran by September 30th, 2008 have dropped from 25% as of July 8th to 7% today. Let's say a trader expected a 100% increase in the price of oil in the event of an attack with probability = 25%, and zero change if not. Then a weighted average return would have been 25% as of July 8th and is down to 7% today. That would justify a large position reduction for any sensibly managed hedge fund.

Also, since volatility in oil prices has been rising, a risk model based on mean-variance theory would suggest an even larger position reduction in oil futures. Finance geeks will appreciate that a doubling of volatility, with no change in the expected return, implies cutting your position size not in half but by 75% -- because the denominator of the mean/variance calculation contains volatility squared.

Interestingly, odds of an attack by March 31, 2009 have not changed much at all and still hover near 40%. A more meaningful reduction in geopolitical tensions could therefore imply an even larger reduction in speculative demand for oil.

If it is expectations of more drilling why have the stocks of the oil drillers fallen by more than 10% so far this month?

Oil stocks have been crashing for two weeks.

With respect, I submit that you did not quote the relevant statement. It is: "...I will also ignore his disingenuous remarks concerning how allowing drilling offshore and in ANWR [1] would somehow affect gasoline prices today in a noticeable manner." If you see the linked EIA report, you will see there is confirmation with respect to the magnitude of effect.

In regard to John Thacker's point, I understand as well as the next economist the idea of present value; the point is when the expected time of production is a decade in the future, then it is highly unlikely for that spot price ten years in the future to have a substantive impact on the spot price today (unless the discount factor is very close to unity). I think Paul Krugman is well aware of the same math I am. In any event, I am happy to be associated with Krugman in one of John Thacker's criticisms -- it means I must be right!