Nothing to smile about

Aug 5th 2008 From The Economist

The oil price is dropping. Reasons not to cheer.

CUSHING is a small town and a trading hub in Oklahoma, home to about 8,400 people and a latticework of oil pipelines. On Monday August 4th, someone agreed to deliver 1,000 barrels of light, sweet crude at Cushing next month for less than $120 a barrel. Only last month, the same deal was made for over $147. This steep drop in the oil price will raise many people’s hopes for the world economy. But, inasmuch as the falling price of oil (and that of other commodities) is a symptom of worsening economic troubles in America and beyond, it may be merely a confirmation of their fears.

Optimists will argue that the extortionate oil prices of July were an aberration, the result of unwholesome speculation divorced from the reality of supply and demand. Traders, after all, now hold over 286,000 contracts for delivery of oil next month in Cushing, but only a tiny fraction of them, about 2%, have any intention of getting their hands on any crude. Most would struggle to locate Cushing on a map. The aim of many of them is simply to sell their contract, before it expires, at a higher price than they paid for it.

Those looking on the bright side will also hope that a fall in the oil price will untie the hands of central bankers, allowing them to postpone the rate rises they may be contemplating to fight inflation. In his testimony to Congress last month, the Federal Reserve's chairman, Ben Bernanke, said it was the central bank’s “critical responsibility” to stop high energy costs triggering a ruinous race between prices and wages. Similar warnings were voiced by the president of the European Central Bank when it raised interest rates in July.

But the problem with the optimists’ case is that these two arguments are in tension with each other. If speculation is to blame for the high oil price, then higher interest rates, not lower ones, may be warranted, at least in the medium term. Cheap money, after all, results in expensive assets, as the bubble in stocks then houses showed. In a research note published last month, Marco Annunziata of UniCredit argued that once the current crisis is over, central banks may return to the “unfinished job” of restoring interest rates to a less bubble-blowing level.

That the oil price may be so high because interest rates are so low is also an argument long pursued by Jeffrey Frankel of Harvard University. He points out that rates now fail to compensate savers for inflation: real interest rates are negative. As a result, the return to pumping a barrel of oil, selling it and investing the proceeds is often less than can be gained by leaving the oil in the ground and waiting for its price to rise further. Although there is no sign that producers are actually sitting on their hands, the theory suggests that they might do so until the oil price is so high—so far above its long-run value—that they begin to suspect it might fall.

Then, and only then, will they feel motivated to pump, preventing the price rising any further. Rather than paving the way for lower interest rates, the oil price may have dropped in anticipation of higher ones. The same day as the price breached $120 a barrel, America’s Department of Commerce showed that inflation, as measured by the price index for personal consumption expenditures, rose by 4.1% in the year to June and by 0.8% compared with just a month ago. Only in the aftermath of Hurricane Katrina have prices jumped so much in a single month.

These price pressures may prevent the Federal Reserve doing much more to stimulate the slowing American economy. And it is that slowdown, echoed in the euro area, that surely underlies the fall in the price of oil in recent weeks. According to one recent study a 10% increase in the price of oil reduces American demand for the stuff by only about 0.3-0.8%. But a decline in American income has a bigger effect. The United States will guzzle 430,000 fewer barrels a day this year, according to analysts at Lehman Brothers.

Signs of this new temperance are already visible. Luxury pick-up trucks and SUVs now account for 12-13% of car sales (seasonally adjusted) compared with 18% last year, they point out. And on July 28th, the Department of Transportation reported that Americans drove 9.6 billion fewer miles (15.5 billion km) in May than they had a year before.

Speculation does not drive the oil price. Driving does.