Oil Prices 101

MARTIN FELDSTEIN explains oil prices:

The relationship between future and current oil prices implies that an expected change in the future price of oil will have an immediate impact on the current price of oil.

Thus, when oil producers concluded that the demand for oil in China and some other countries will grow more rapidly in future years than they had previously expected, they inferred that the future price of oil would be higher than they had previously believed. They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its initial rate.

Hence, with no change in the current demand for oil, the expectation of a greater future demand and a higher future price caused the current price to rise. Similarly, credible reports about the future decline of oil production in Russia and in Mexico implied a higher future global price of oil – and that also required an increase in the current oil price to maintain the initial expected rate of increase in the price of oil.

Once this relation is understood, it is easy to see how news stories, rumors and industry reports can cause substantial fluctuations in current prices – all without anything happening to current demand or supply.

Perhaps one interesting implication of this involves what we should make of all the talk about speculators. Someone who owns oil in the ground may be one of the so-called speculators. Such an oil owner who expects the future price of oil to be higher sees an incentive to keep barrels of oil in the ground today instead of bringing them up for sale today.

But Feldstein notes there can be good news to be found in understanding all of this about oil prices:

Now here is the good news. Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. In other words, it is possible to bring down today's price of oil with policies that will have their physical impact on oil demand or supply only in the future.

There is also much talk today that Congress should get busy and end the moratorium on new off shore oil development (among other suggestions about new oil supplies). A frequently heard response is that such a policy change would have no effect because it would necessarily be many years before any oil from such new projects would reach the market. But such a policy change would imply a lower future price for oil and this would mean a lower oil price today.

So, if you would like lower oil and gasoline prices today, then take note that the politicians who are calling for policies that would increase U.S. oil supplies in the future are supporting your interests, and the politicians who want to continue to restrict new U.S. oil production are not.