Home Buddies – Home Ownership Coach – Houston, Texas

Gas, Oil and the Economy

With the American economy in a recession and a heated election race, oil prices have taken center stage. The President visited Saudi Arabia to apply pressure on OPEC nations to produce more oil…is this the answer to oil prices? Having Middle Eastern countries produce more oil is not the answer. We are witnessing one of the biggest phenomenons ever in the history of oil market dynamics.

Although politicians would like for Americans to think OPEC is the problem, it’s not. Normally, if you increase supply while demand remains constant, you then have a reduction in price of any commodity. However, it didn’t happen when OPEC gave in to the political pressure and increased the amount of crude oil they will supply – prices still continued to rise. OPEC had no affect on prices because the supply and demand of oil is not what is driving prices up.

Supply and demand for crude on the trading floors has caused prices to spiral but the blame cannot be squarely put on the shoulders of traders. Unfortunately, the blame is on a lack of information provided to traders. Countries like China do not release how much crude they are producing so research firms have to make their best guess as to how much oil China consumes and produces.

Traders use this information and then make bids based on future prices of oil. These futures bids allow airlines and other industries that are dependent on fuel prices to hedge against sharp increases in fuel. You can start to see the problem since China and India have gone through industrial growth which greatly increased their consumption of oil. Traders know that demand for oil in the future will increase; however, they are not so sure about the supply so they “fear” a possible shortage. At this point I would like to make clear: there is no evidence which states that we will have a shortage of oil.

Markets do not take into account things they do not know. Markets only function on the information they have. So what we are left with is a wide range of opinions on what the real state of oil supply will be in the future. For now that means high oil prices.

So what can be done about high oil prices and what are the effects on the economy? Well congress would like to blame traders but they are just reactors to the market. The market is setting oil prices, not the traders. We can’t blame OPEC. They would rather have prices stabilize because, if prices continue to rise, people change their behaviors. We are already seeing this change occur as the first 100mpg vehicles start hitting showroom floors in January of 2009. This change in behavior would mean less oil is in demand. Ultimately, lower oil demand will cause markets to adjust and we will see a drop in oil prices. At some point, the oil futures market will do the same as the current real estate market and correct itself.

Cliff Pape
Home-Buddies