The Oil Supply and Petroleum Economics

Many have blamed the rapid rise in oil prices in 2007 and the first-half of 2008 on speculators. But if we somehow banned speculators from trading oil futures and options, would the price of oil drop back down to pre-2007 levels? It is not clear that it would.

The link between high oil prices and speculators is understood to work as follows:

1    Oil analysts and traders believe that oil prices will rise in the future due to a combination of increased demand from China and India and due to slowing or even reduced supplies from "peak oil".

2    Seeing the writing on the wall, speculators start buying up oil futures and options today, believing they will be worth more in the future. This buying up of oil futures immediately raises their price, due to basic supply and demand.

3    The price of oil should fall once these futures mature because speculators have no need for a physical delivery of oil - where would they store it?

4    However prices, on average, do not fall - in fact they rise. It could be because someone is buying massive amounts of oil and physically storing it somewhere, but this is highly unlikely. What is more likely is that the price is maintained high because it is being "stored" in the ground rather than making it to market; that is some oil companies are cutting production.

Step 4 in the chain is the crucial one. Unless the oil is being stored by the speculators (or somebody the speculators are selling their futures to), they cannot permanently drive the price up. All else being equal, oil prices must fall as the speculators sell their futures prior to maturity. But since the price of futures are not going down (on average), then all else must not be equal - it must be that production is being cut from what it would have been. We can think of the current situation as being akin to oil companies buying the futures from the speculators and delivering the oil to themselves.

Due to this, it is not clear that getting rid of the speculators would drop oil prices one cent. The high prices appear to be largely supply-side issue. How much of the lower supply is due to oil companies cutting production and how much is due to "natural" factors is open to debate.