Free Markets and the Price of Oil

B-Daddy here. I am boldly predicting a large drop in the price of oil within the next three years, unless our government intervenes to make a mess of things. How can I be so sure? History and logic are on my side.

First, the logic. The high cost of petroleum energy induces all sorts of changes in behavior. First, on the demand side, consumers make billions of tiny changes in behavior to compensate for the higher costs. Some examples: Many people drive more gently, accelerating more slowly, driving a little slower. Nissan has found that putting a fuel efficiency gauge on cars increases efficiency by as much as 10% (source here). Car pooling increases. Another small example, our family has started to plan out little errands, grouping trips together that were previously separate. Also, we ditched the 8-cylinder gas guzzler, even though it was a good starter car for our sixteen year old.

On the supply side, two things happen. First, there tends to be an increase in production in those nations not under despotism. (I realize that Iran and Venezuela, for example, will probably not be increasing production, but others will.) Oil that was not profitable to extract at $60 per barrel is very attractive at $140. Maintenance and repairs on old equipment suddenly makes more sense. Second, alternative forms of energy become relatively more competitive and can be brought on line, increasing the overall supply of energy.

Free markets are efficient, but not perfectly efficient. It will take a while for these changes to work their way through the markets, but when the trend is obvious, those speculators now vilified for allegedly driving the price of oil up, will be betting against future oil prices, driving them down.

As for the history, the following chart speaks for itself:

Source: Zfacts.

The other joker in this deck (besides Hugo and Mahmoud) is inflation. The price of oil vs. the price of oil makes a very steady ratio, as noted here. (Scroll to the bottom for the chart.) I theorize that inflationary pressure has been building for some time, popping up first in share prices, then in real estate and now in commodities. I am not sure the Fed has a good model for how inflation is now operating in a global economy, so part of the run up in oil prices may be due to inflationary pressure. Perhaps more on that another day.