Thursday, May 26, 2011

Are speculators causing higher oil prices?

My colleague, Srini Krishnamurthy and I have an op-ed piece in today's News and Observer that answers this question.  The bottom line is that global supply and demand is a more likely explanation for the price you pay at the pump than speculation in the futures markets.  Furthermore, manipulating oil prices by trading futures contracts is very difficult because for every buyer of a contract there has to be a seller.  In effect, the futures market is just a bet on the level future oil prices.

The N&O also published an excellent editorial from the LA Times next to our Op-Ed piece.  The gist of the editorial was that increasing oil production in the US is unlikely to have any effect on short term oil prices - despite the claims of numerous politicians.  This is due to two reasons.  First, bringing new oil production online takes years - so any new drilling is only going to impact future oil prices at best.  Second, and I think this is the point often not well understood, the US buys oil in a global market.  It doesn't really matter if we increase domestic production 10% because that increase will be a drop in the proverbial global bucket.  We could only hope to lower oil prices by increasing supply to such an extent that it impacts the global supply of oil.   Even then, OPEC could just as easily cut production to offset the new supply increase.
The best way to deal with higher oil prices would seem to be to focus on the demand side and use less oil.

This all ties back to basic finance.  When should an oil company drill for oil?   The answer is when doing so is a positive NPV project after taking account of all the real options involved.  MBA students will study real options in MBA 521 - Advanced Corporate Finance.