Sharpest Analysis on Oil

From Bloomberg, Caroline Baum writes: World Is `Drowning in Oil' (Again) After Drought.

She is the smartest economic reporter the EE knows, and the only one he takes seriously (even if we differ which is rare.)

Three months ago, the world was running out of oil.

Seriously. I kid you not. Everywhere you turned, you heard whispers that the day of petroleum reckoning was at hand.

Now there's too much oil, prodding OPEC to cut production targets for the first time in two years. Last week, the Organization of Petroleum Exporting Countries, confronted with the halving of oil prices since July, announced a 1.5 million barrel-a-day cut in output.

All speculative bubbles have a kernel of truth behind them to justify their existence. This time around it was China and India. These emerging Asian giants were gobbling up all the commodities the world could produce to fuel their rapid industrialization.

It wasn't that the story was untrue; it was old. Growing global demand probably was the reason for the gradual rise in oil prices from $20 a barrel to $40 earlier in the decade, and even to $60 by mid-2005.

It was the moon shot to $147 that took on a life, and a litany, of its own. Emerging nations didn't start gobbling up crude, coal and copper all of a sudden in the middle of 2007.

Yet analysts on TV and in print told us with a straight face that the doubling in oil prices from July 2007 to July 2008 was a result of fundamental demand, not speculative buying or investors, including pension funds, ``diversifying'' into ``alternative investments'' in search of ``uncorrelated returns.'' (It sounds a lot better than admitting you got suckered into buying what was going up and are now stuck with a pile of stuff that no one wants.)

``It happens in every market,'' says Michael Aronstein, president of Marketfield Asset Management in New York. ``Once it goes up an enormous amount, creating unfathomable wealth for the fortunate participants, someone makes an ex-post case as to why we are only at a beginning and it's not too late to get in.''

This advice is ``generally formulated by someone who has a vested interest in selling the stuff,'' he says.

Like the world of fashion, trends in markets come and go. Oil is a limited, albeit vast, resource. At some point in the future, we probably will run out of petroleum, at least as we know it.

Man's ingenuity is equally vast. When the time comes, given all the tax incentives that will be thrown in the direction of alternative energy, I have full confidence the world will not return to travel by horse and buggy.

The silliness that accompanies speculative bubbles isn't to be outdone by what passes for economic analysis. It's just over three months since commodities began their sharp, swift descent, and already the nonsense is starting: Lower oil prices are going to boost consumer demand.

Whoa! The price of oil (and other raw materials) is falling because of a cutback in demand, both actual and expected. Expressed as a graph, the demand curve for oil has shifted back, to the left. Consumers demand less energy (gasoline, heating oil) at any given price than they did before.

To say that lower prices will stimulate demand, a widely held misconception, confuses a movement along the demand curve (lower price, higher quantity) with a shift back in the curve (lower price, lower quantity).

Why this is such a hard concept to understand, I'm not sure. People imbue oil prices with all kinds of mystical powers. They see a falling price and treat it as a cause, not an effect.

Brilliant, simply brilliant!