In my executive MBA class yesterday, the one I do by video teleconference, I covered Bob Murphy's piece on oil prices as an application of some of the economics of futures markets. One part of Murphy's article that I highlighted was the following:
When the major oil companies were making investment decisions during the 1980s and 1990s, they underestimated the explosive economic growth in countries such as China and India in the 21st century. Because of this mistaken forecast, the necessary infrastructure was not in place to adequately service the increase in oil consumption. Consequently, spare capacity margins have become extremely narrow, leading to price spikes.
Murphy goes on to point out how much the oil companies have invested in exploration in the last few years. Then I asked the class:
Knowing that now, what do you think will happen to the price of oil by, say, 2018? Why?
My idea here is that the investments oil companies have made, are making, and will make will cause the supply of oil to increase substantially, bringing the price down. One student, Rob Peterson [he gave me permission to use his name], agreed with the reasoning up to the last point about price. He argued that growth of many of the poor countries will shift demand even more, making the price higher than now.
So I offered him a $100 bet, at even odds, that he accepted: in 2018, the inflation-adjusted price of oil will be lower than an $80 average for the year. He's saying it will be higher. I tried to tilt it a little in his favor by naming the benchmark oil--West Texas Intermediate--which is sweet (low-sulfur) and, therefore, higher-priced. I hadn't realized how big a premium when I made the offer. But, oh well, a deal is a deal.