Monday, June 2, 2008

Explaining Oil Prices

Apparently there are still lots of people out there who think that oil prices are the result of a conspiracy, monopoly power, or bad public policy. They say if we could do something different, oil prices could go back down to where they were at the start of the decade.

There is a grain of truth in each of their theories. Years ago, a few gasoline stations got caught fixing prices. Opec originally got together in order to create monopoly power. Part of the high demand for oil comes from the tragically incompetent U.S. tax incentives for heavy trucks just four years ago. Speculators have driven up the price of oil at various points this year.

Yet none of this comes close to explaining a tenfold increase in the price of a basic commodity. There is no secret stash of oil that Opec or anyone else could open up in order to drive prices down. Energy efficiency has increased, so it is not the cause of oil price increases. Many of the same speculators that last month drove oil prices up have now driven oil prices down below natural market levels, but that will not last long either.

In the long run, there is no getting around the amount of oil that is involved. If the world wants to keep using this much oil, we are going to have to pay a lot, because no one at this point has a magical way to create oil.

I have a hard time explaining oil prices. Jeremy Siegel does a much better job of it in this interview from last week (along with Witold Henisz):

What’s Behind the Flare-ups in Oil Prices?

If you read this interview, and especially if you compare the various comments from readers, the one point you have to come away with is how much is unknown. The people who say they know what’s going on are the people who have their heads in the sand.