Crude Oil Price
Roger Lowenstein wrote an article about the price of crude oil in the New York Times. He makes some interesting points.
Crude oil price is about $70 now, down from above $145 a few months ago. On June 5th and 6th, there were price run ups of about $5 and $10. Federal Reserve economists calculated a GDP drop of 0.5% based on this rise in price. This is a pretty large impact to the GDP. And until the current financial crisis, energy prices seemed to be the hot topic of the day.
There are two camps on the cause of the price increase. One group says it is due to the fundamental supply and demand picture. With limited supply of oil and demand increasing, especially in India and China, the price was bound to go up. Generally the price of each barrel of oil is based on the marginal cost of production (cost of the last barrel). If anyone charged more, others would undercut that price to sell more barrels. But if supply is limited, then the marginal cost is not relevant, because there is no next barrel to produce – this causes the price to increase to the point where people will not buy or use oil any more. This is called the price of demand destruction.
The other group suggests that the rapid increases in price is due to speculators and investors who buy and sell 500 million barrels of oil a day on the Nymex, while the world only consumes 86 millions barrels of the physical product every day. This includes institutional investors such as Harvard University who buy and hold oil futures, sometimes for long periods, as part of their investments.
The stock market is different from the commodities market as far as speculation-driven prices are concerned. When speculators buy and sell stock of a company, 99% of the time it is the same stock – it is not increasing or decreasing the number of stocks and the stocks are not being consumed, they are merely exchanging hands. If the price of the stock goes up or down, it only affects the holders and no one else – and hence price bubbles can last for a long time. On the other hand, for commodities such as oil, the commodity is consumed daily to run the businesses and lives of most people. If the price of the commodity is driven up by speculation, it affects everyone in the economy. When this happens, demand destruction sets in and prices start to come down. Thus oil price bubbles should be short lived.
two thoughts:
1. even for stocks there is a big options/ futures market which creates more demand/ supply than the no. of physical outsanding shares. and as future prices affect the spot (and vice versa) so I would think that the it is not very different from the commodities world.
2. Prices for oil in the next 3-10 years will depend a lot on costs for other forms of energy. We all know that oil is becoming a scarce commodity and the balance point will be where it makes other sources of energy more viable.. e.g. right now $90-110 mark for crude makes oil sands more viable. Similarly there will be breakeven points for other sources of energy which will eventually drive reasonable levels of price for oil.
Aditya, I agree with your point #1, but that was not what I was saying. I think that part is similar betweek securities and commodities. But my point was that the difference is that the stock never gets consumed. You buy and hold and sell. But with commodities, it eventually gets consumed. And the price will drive the level of consumption, to a point.