The visible hand in economics

Why has the price of oil fallen so sharply?

Posted on: July 18, 2008

Over the last three days the price of oil has fallen by nearly 10%. Given the sudden nature of this change it seems impractical to state that it is fundamental supply and demand factors driving the shift in prices.

Tyler Cowen at Marginal Revolution states two reasons why we might get such significant changes to the current price, even if contemporaneous supply and demand conditions have not changed – both explanations avoid implying that there has been a “speculative bubble” in oil (where a speculative bubble would occur when traders have been holding inventories, which they have not been – however this does not rule out a general bubble, where future price expectations are out of whack). These reasons are:

  1. Future price expectations decline: Producers have been drilling less than they could based on future price expectations – production today and production tomorrow are substitutes. With the longer term oil demand outlook deteriorating (as petrol consumption has been found to be more elastic in the developed world) future prices are expected to be lower leading to higher production now. Note that this also applies when future supply is likely to be greater – so the more likely it is that the US will start drilling, the lower prices will be now.
  2. Small shifts reveal information in the market: New information leads to a transition from the current equilibrium. This movement provides information on the elasticities of supply and demand, which in turn leads to further downward adjustments – so one piece of new information can lead to the discovery of a whole bunch of other information. This will lead to a rejig in peoples expectations and substantial shifts in price.

Also don’t forget about the multiple equilibrium argument which would also explain a sharp drop in prices on the basis of expectations rather than fundamentals.

It will be interesting to see what happens to oil prices over the coming months.

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