Common Sense: Irrational exuberance or gas and crude oil prices revisited

Jeff Whitten

Gasoline and crude oil prices have followed a similar script so far this year as they did last year. They rose during the winter, peaked sometime in the spring, then dropped.

Part of the reason for the rise is supply and demand. The world is running out of cheap oil. Demand is increasing because of the improving economic growth, more so in developing countries such as India, China and Brazil, but also to some extent in the U. S. and other developed countries.

Part of the reason for the increases is speculation about what will happen in the Middle East. Last year, fears of a protracted crisis in Libya, which has only 3 percent of the world’s proven reserves and produces about 2 percent of the world’s oil caused speculators to send the price of oil soaring. The turmoil spreading to Saudi Arabia, with 25 percent of the world’s proven reserves and 10 percent of world production, though less likely, would have had a much more catastrophic impact on oil supply and prices.

The worst case scenario did not happen, nor did a scenario as bad as the one priced into the market earlier in 2011. The Libyan rebels overthrew Col. Muammar Gaddafi and turmoil either never happened or subsided in other significant oil producers.

The impetus behind the rises in crude oil and gasoline prices this year is speculation about war with Iran, either initiated by Israel, possibly drawing the U. S. in, or initiated by the U. S.

Iran has 9 percent of the world’s proven oil reserves and produces about 5 percent of the world’s oil.

It has been speculated that if Israel attacks Iran, it will do so before the presidential election. However, if the market believed that Israel will attack Iran, it is odd that the prices have started down. You would think that given that the cheap oil is gone, that demand will go up unless there is another recession and that if Israel does attack Iran and this leads to a broader Middle East War, the futures price would just keep going up instead of peaking next year and then going down for the rest of the decade.

My first reaction to the run-ups in crude oil and gasoline was that instead of raising the prices based upon something that might never happen, the markets would do better to wait and see whether these events happened and set the prices based upon reality rather than speculation.

If they did that, the wild swings in prices could be avoided, along with the damage done to individuals’ pocketbooks and the national and world economy.

Part of the reason they don’t do things this way has to do with the futures market. Traders buy contracts for crude oil or gasoline for various months in the future and can either buy the crude oil when those months roll around or sell at market value (the most likely occurrence) before the contracts expire.

If futures contracts are higher than the current price for oil or gasoline, this can cause oil companies or other producers to hold the oil off the market until they can get the higher price.

The current price or price on the spot market was $104.87 as of last Tuesday. The futures contract price will be above the spot price until Sept. 2013 and peaks at $105.40 in Jan. 2013. Futures contract prices then decline to a low of $86.26 in Dec. 2020, the last futures contract quoted by the Chicago Mercantile Exchange.

Since the futures market causes some of the problems with the price of oil, gasoline and other commodities, that raises the question of why we should have a futures market at all, other than to make commissions for brokers.

One legitimate function of the futures market is to reduce risk. This occurs because a buyer knows how much a commodity will cost him in the future. The problem is that a lot of people, who do not buy crude oil or gasoline, are using the futures markets in other ways, such as for speculation.

Another function that has been suggested for the futures market is price discovery. However, given the wild price swings over the past few years, it does not do a very good job of setting a realistic and stable price.