Arnold Kling  

The Oil Cycle

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In Catherine Rampell's list of sectors that had the greatest sales growth last year, I was struck by how many of them are energy-related. Assuming that farming was driven by ethanol, the top four sectors were essentially oil plays. Oil prices were high for much of last year, and my guess is that at today's price the oil sector may not look so strong.

But will today's prices persist? One month ago, Dave Cohen wrote,

Today's NYMEX WTI oil price, about $45/barrel, is dangerously, outrageously low. Crude oil is not some "inconsequential penny stock" as Clive Maund pointed out, but that's how it's been priced (321Energy, November 19, 2008). I am going to talk about how oil prices get set in a futile attempt to understand what future prices might look like. I find little reason for optimism regarding the market's ability to provide a coherent oil price signal reflecting future scarcity of this precious non-renewable resource.

Read the whole thing (pointer from James Hamilton. Yesterday, I actually went so far as to speculate in oil by purchasing shares in an exchange-traded fund linked to the price of WTI.

We'll see what happens in a few years. If oil prices stay low because the world's economy shrinks, then oil will be a bad investment. If oil prices stay low because alternative energy suddenly becomes cheaper, my guess is that the rest of the economy will be strong enough to make up for my losing a bet on oil.

COMMENTS (5 to date)
kebko writes:

The difficult thing about speculating on oil is that so much of the market is influenced by political actors, not economic actors. I'm not sure how you fit Venezuela, Mexico, Iraq & the rest of OPEC into a model that is based on supply & demand. How do you predict the price when there are billions of barrels sitting in the ground in these countries that corporations would be pumping like crazy if there were functioning markets in those countries? How do you fit the fickle political will of the Venezuelan peasant class and Chavez's Machavellian reaction to that into an economic model on the price of oil? What would the price of oranges look like if militants kept poisoning orchards in Florida? The price of oranges would say little about long term costs.

Kevin writes:

What if oil prices fall because the variable cost of alternative energy is low but the capital costs are high? What if the government is the only financier of those capital costs because they're unprofitable investments? I think you presume too strong a relationship between the cheapness of alternative energy and the strength of the economy.

Also, you probably know this but in case any readers don't, WTI is in a record contango, so if prices stay where they're currently at, we'll be reading next year about how oil prices are 25% higher than they were a year ago, and USO will have returned zero.

floccina writes:

The great thing about "purchasing shares in an exchange-traded fund linked to the price of WTI" is that it is a hedge. If you like the current price of gasoline you can buy say 10,000 worth and sell off a bit each year as you buy gasoline. If gasoline goes up you make money on the ETF and if gasoline goes down you save on gasoline at the pump.

One warning the ETF only attempts to match WTI and with the futures price of oil so much higher that the current price (some people are calling it super contango) people are saying that the etf could fail to match by a good margin.

MattYoung writes:

Your bet on future oil prices may have one problem.

If there are two operating points, one at $150, the old equilibrium point; and second, $50 the new equilibrium point.

Say the industrialized economies has settled on $50, and we will do anything to keep it, even drop back the economy if we have to. That is the $150 is unsustainable.

R Houck writes:

This is an interesting topic to discuss because there is no nation in the world that doesn't thrive without the use of oil. The move away from oil to alternative energies is one that has been in the making for a long time and it is a shame that it is coming so slowly. It makes sense for the US to reduce its dependence on foreign oil by focusing on domestically produced alternative energies because by doing so more jobs will be created helping to put a spark back in the US economy.

I also agree with the notion that if oil prices stay low and the cost of alternative energy drops then oil will become a bad investment. The use of alternative energy is the wave of the future and as it becomes more dominant the demand for oil will shrink making it a poor investment. My thought is that as technology supporting alternative energy becomes more efficient oil will slowly be replaced with domestic sources of energy. This in effect will hopefully strengthen the US economy by making alternative energy production a dominant factor while lessening oils impact.

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