Thursday, May 29, 2008

I Got Your Oil Inventories Right Here

Jeff Frankel defends his argument that the high oil prices are primarily attributable to low interest rates. According to Frankel's theory, low interest rates lead to an expectation of rising oil prices, which provides an incentive to build up oil inventories (because the stored oil can be sold later at a higher price). Frankel admits that inventory levels haven't risen enough support his theory, but notes that storing oil isn't the only way oil producers respond to interest rates:

Stocks of oil held in deposits underground dwarf those held in inventories aboveground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation that apply to inventories. (The classic reference is Hotelling’s Rule.) Apparently the Saudis have decided to leave theirs in the ground. "King Abdullah, the country’s ruler, put it more bluntly: 'I keep no secret from you that, when there were some new finds, I told them, 'No, leave it in the ground, with grace from God, our children need it'.'" (Financial Times 19 May).
In other words, instead of extracting oil and storing it in inventories, oil producers are just keeping the oil in the ground. This is certainly a plausible explanation for the case of the missing oil inventories. Paul Krugman has challenged the people who believe there's an oil bubble: "Tell me where you think the excess supply of crude is going." If Frankel is right, the answer would be: Nowhere—it's staying in the ground. Now, I'm not sure if Frankel actually is right, but it's certainly possible that oil producers are leaving oil in the ground instead of storing it in inventories. As a recent research note from the Dallas Fed notes: "So far, new supplies haven’t materialized quickly enough to keep up with growth in world demand." The most popular explanation for the high oil prices is that world demand is rising while supply is stagnating. But suppose that Frankel is right, and that oil producers really are leaving oil in the ground because of the low interest rates. That would mean that some of the apparent stagnation in the supply of oil is just an illusion: oil producers could be keeping up with the rising demand, but the low interest rates are inducing them to keep more oil in the ground, thereby creating the appearance of stagnating oil supply. I'm still not ready to fully buy into Frankel's argument, but it's definitely the explanation I'm rooting for!


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