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Thu Apr 24 22:06:59 2008
High Oil and Gas Prices
More dubious questions about high oil prices.

In my April 1 post I talked about how the US Congress was grilling oil executives about their profits. Now it's local!

Historic supply and demand.
Image courtesy of User: Noroton (wiki)

Two Washington congresspeople, Senator Cantwell and Representative Inslee, have asked President Bush to set up a special task force to investigate the high prices. They claim "the price of oil and gas can no longer be explained or predicted by normal market dynamics or their historic understanding of supply and demand fundamentals."

Oh really?

I've given links (April 1, April 15, March 26) to multiple indications that world oil demand is climbing while supply (oil production) is staying flat or falling. On top of that, the US dollar is very weak, which doesn't help us in the global market for oil.

High demand + falling supply + weak dollar = high prices.

I'm guessing Cantwell and Inslee are frustrated because the price of oil is unrelated to the cost to produce it. But that's not unusual either: any time that you have high demand and limited supply, the price (value) of an item is only slightly related to the cost to produce it.

One recent example (for water prices, not oil) was when China poisoned the Songhua river and the spill was carried by the river through multiple large cities and into Russia. Almost 4 million citizens of the provincial capital Harbin had their water supplies shut off when the authorities realized that the 100 tons of leukemia-causing benzene might be dangerous.

Without water supplies, people started buying bottled water, which led prices to skyrocket. Obviously, bottled water isn't very expensive to produce, so the fact that prices shot up led to charges of "overpricing" and "price gouging." (See the USA Today story and the IHT story.) Also see this link for many on-the-ground anecdotes of people that went through it.

The idea is that greedy store owners started charging more for bottled water when it was announced that tap water was poisonous. Therefore, they were profiteers and price-gougers.

I only have one problem with that: the value of their water did go up!

How much would you pay for a bottle of water right now? Probably not much if, like me, you are sitting only steps away from a perfectly good water tap. Suppose you were told that the tap was shut off or poisoned, and the entire city's water supply would be shut down for a week. Now how much would you pay for that bottle of water? I'm guessing you'd pay more. You'd probably pay a lot more.

Suppose a citizen of Harbin wanted to celebrate someone's birthday with a monster slip-n-slide like these guys. Before the disaster, great. But after it was announced that the city's water supply had been poisoned, wouldn't it be irresponsible to hoard hundreds of gallons of water for your slide? I think it would be irresponsible. And isn't that an indication that water is worth more?

[Scary aside: the government knew about the crisis for days before it told anyone! At first, it shut off the water supply without telling people why. Government officials also apparently told local bottled water producers to prepare days ahead of any official announcements while the benzene was drifting downstream. So the "price gouging" could have been far worse if the government hadn't acted--somewhat immorally--to jack up supply ahead of time.]

Anytime there is a scarcity of a needed item (water during a drought, food during starvation), the value of the item--and therefore its price--goes up.

And the effect can be nonlinear! Just slight imbalances in supply and demand can result in large price changes (especially for inelastic supply such as oil).

So I have to believe that the current high prices are explained pretty well by classic supply and demand curves. And the prices will just get worse as demand increases (or stays high) while supply continues to fall.

Senator Cantwell and Representative Inslee will remain confused and frustrated for many years to come. Hopefully other members of Congress will do something productive to reduce the demand side of the equation.

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