Oil and the Future

On oil I will make one point adding and one point detracting from Tyler’s analysis.  First, on speculation remember that demand and supply are both very inelastic so relatively small changes in either can make a big differrence.  That means that speculation, if that is what you want to call it, can shift prices a lot without being very significant in total demand.  Because of this point Krugman’s analysis is quite right for iron ore but a little off for oil – indeed Krugman’s analysis of oil is difficult to square with his analysis of the California electricity crisis.

My disagreement with Tyler is an agreement with Caplan. 

Bryan Caplan notes that commodity prices always have fallen back down in the past and argues that is likely to happen again in the future.  I say no, the current price is your best (rough) estimate of scarcity (adjusting for storage costs), don’t expect mean-reversion, future returns (but not prices) are a random walk, and extrapolation is a dangerous method to apply to financial time series.   

No, two points.  First, commodities are not stocks and nothing need be a random walk.  Imagine, for example, that you can produce 10 units of commodity X but no more (fixed production).  Thus you produce 10, 10, 10…. Now you know that a big technological innovation is about to increase production possibilities to 20, 20. 20…..   Does the price today necessarily fall?  No.  Price today is determined by supply and demand, supply is fixed and if substitution across time isn’t very easy (you still have to get to work today, right?) then demand doesn’t have to fall much with expectations of future supply.  Thus the price is high until it drops, even if everyone expects the drop.

Finally, on oil – who really cares what the price is?  The issue is energy, not oil.  I am confident that the long run price of energy will fall.