China, India and Oil Prices
Lots of folks these days are looking to lay blame for spiking oil/gas prices. Some of them gaze towards China and India, which do represent a large part of new growth, although not the majority of aggregate demand. Others have blamed the oil companies, oil speculators, and so forth. Paul Krugman is not amused with the argument that speculators are the problem:
Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil — the actual price people pay to have a barrel of black gunk delivered?
The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.
Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.
Any effect on the spot market has to be indirect: someone who actually has oil to sell decides to sell a futures contract to Joe Shmoe, and holds oil off the market so he can honor that contract when it comes due; this is worth doing if the futures price is sufficiently above the current price to more than make up for the storage and interest costs.
As I’ve tried to point out, there just isn’t any evidence from the inventory data that this is happening.
This is all way above my paygrade, of course, so I cannot comment directly on Krugman’s argument. I do, however, have a general question about all of this since I do not understand how the global oil market works.
OK, China has been growing at double-digit rates for many years now, although it looks like we are in for a bit of a slowdown in the near term. Still, even at slightly under 10%, that’s pretty fast growth. So here’s the question: if oil prices are a product of higher demand, and if a lot of this demand comes from places like India and China, why have prices moved up this rapidly?
Krugman charts oil prices over the past 9 months or so, and the price rise is dramatic, starting at 70-something dollars a barrel last summer to where we are now, in the mid-130s.
I know that China growth estimates have not changed radically during that time, and if anything, they have been revised downward. No startling news from India that I’ve heard either. So are we left with everything being explained from the supply side?
Very confused here . . .
I certainly agree that the demand is really what’s driving the oil prices. I’m not sure about the argument that speculation has nothing to do with it though–I wouldn’t be surprised if there was at least some effect on the price.
Now, the reason for the rapid increase lately isn’t the growth rate of the Chinese and Indian economies, but rather the growing wealth of individuals. It has more to do with the wealthy purchasing more gas guzzlers as status symbols and embracing a wasteful lifestyle.
I’m hoping that the recent increase in prices in China will help decrease demand, but I’m not holding my breath.
I’d still like to know what accounts for the sudden rise in prices, though. It’s not like all the Chinese millionaires sprang fully formed out of the economy one fine August day in 2007 – it’s been somewhat of a gradual thing over the past few years. Hmm . . .
Stan,
You are thinking in USD here and the US Fed has been totally out of control printing Fiat money to fund the US Govt.’s profligacy due to all the wonderful demands for funding this and funding that the American people make of their representatives (attempts to bail out Countrywide and bankrupting Fannie Mae is the newest version of that one). The end result has been a major deflation of USD value in world markets. As Oil is priced in USD (still as of yet being the reserve currency of choice for petroleum producers – not much longer I bet), you and neither has that total economic idiot Paul Krugman (sorry couldn’t resist) haven’t looked at the effect of the dollar’s depreciation on oil prices. And yes, demand has had a major impact on price, but also restrictions on petroleum product production, misguided biofuel/ethanol substitution concessions to Iowan farmers in order to be seen to be “doing something” about “global warming” (junk science in my book). In fact, I would go to say that govt foolishness in intervening in markets and in irresponsibly printing money is perhaps the major factor in rising prices.
ChinaMatt, consumer consumption of oil products is only one part of the equation and not necessarily the major one. While it is fun to rail against profligacy or wealth, including the do gooder birkenstock Sierra Club crowd not willing to give up their SUV’s
, the major driver of demand is industrial and the growth of mass consumption as China and India’s economies grow. BTW, I too hope that the recent increases will decrease demand here, but am doubtful. One reason for the increases is to correct for shortages, as the govt. mechanism of price controls inevitably led to shortages as the producers (even state owned as they are here) had no incentive to increase production of petroleum products to meet demand when every gallon of gas they sold was sold at a loss.
Just read an interesting short and concise article on price controls that explains things way better than I…. http://mises.org/story/3025
Terry, you’re right. I would like to see a chart tracking the value of the dollar against the price of oil for the past 12 months. I’m sure this is readily available, but I have not come across it. I think we already know what that chart will look like.
Thanks for bringing up this factor (which I forgot about)!
Here’s something that confuses me even more. China reduces its subsidy, which will lead to higher prices and ought to lead to reduced demand, yet there are those who claim this will increase both supply and demand. That strikes me as weird. Then we have Obama saying that drilling offshore in the US will have absolutely no impact on prices and that too strikes me as impossible. Whatever happened to supply and demand determining prices and prices determning supply and demand?
Stan, I’m a little surprised you’re having trouble with Krugman’s commentary, so forgive me if this explanation is more than what you needed: the passage you quoted is simply an explanation of how futures markets, which is where speculators operate, affect prices. The “bet” analogy stands in the way of Krugman’s explanation:
When someone buys an oil futures contract at $150 a barrel to be delivered in 6 months, he’s counting on the fact that the spot market price, or the price paid for “on the spot” delivery, of oil will be at least $150 a barrel in 6 months. If it’s less than $150, he’s obviously paid extra. If it’s more, he can be happy that he bought it for a lower price negotiated beforehand. If he’s an oil speculator, he can resell that oil for the spot market price of more than $150 a barrel. Supply and demand still drives the spot market price of oil, but all that happens in the futures contracting process is that either the speculator or the oil producer will lose a bit of money they could have otherwise had if they hadn’t agreed on a contract.
The only part in which he argues that speculators aren’t to blame is when he says that the data isn’t showing that speculators are indirectly affecting prices by causing sellers to hold back inventory… I’m not really sure you could attack this argument unless you looked at the data.
With respect to the massive jump in the price of oil per barrel, Terry’s libertarian keyword-laden paragraph certainly touches on (what I think is) part of the problem. Broadly speaking, in my opinion it is both the depreciation of the dollar and double digit inflation in the Gulf region that have driven this massive jump in prices. (That’s really all that I have to say about that, since both phenomena are widely reported.) The key thing to remember, as Terry says, is that the people who sell oil receive payment for it in USD.
Well, I’m not surprised to have trouble with this issue generally (lots of disagreement recently). However, I appreciate the explanation and agree with you on the dollar, as Dan also pointed out.
All the Op/Ed activity on this is being driven by all the political hand-wringing, which is fun to watch. Always good to know what the “right answer” is though, so one can make even more fun of the politicians as they run around in circles. Heh heh.