[R-G] Martin Feldstein: "We Can Lower Oil Prices Now"

[Yoshie Furuhashi]

<http://online.wsj.com/public/article_print/SB121486800837317581.html>
July 1, 2008

We Can Lower Oil Prices Now
By MARTIN FELDSTEIN
July 1, 2008; Page A17

Although most experts agree that financial speculation was not
responsible for the surge in the global prices of food and energy,
many people remain puzzled about the source of these remarkable price
rises. Economics offers a simple supply-and-demand explanation and
reason for optimism about the future of commodity prices. In the case
of oil, economics also suggests how policy changes today that affect
the future could quickly lower the current price of oil.

We all know that rising incomes in China, India and the Gulf states
have increased the demand for oil and many other commodities. But how
could the modest, one-year rise of these demands lead to 100%
increases in the prices of oil and other commodities? Let's take a
look first at perishable agricultural commodities.

In the short run, there is little scope for increasing the supply of
corn in response to a global increase in demand. For demand and supply
to balance – for the market to clear – the price of corn must rise.

If the demand for corn were very price-sensitive, a relatively small
increase in price would reduce global demand by enough to offset the
initial rise in demand. However, since demand is actually quite
insensitive to price in the short run, it takes a very large price
rise to bring global demand into line with supply.

Here is a simplified picture of what happened in the past year. The
quantity of corn demanded by high-growth countries rose gradually,
increasing eventually by an amount equal to, say, 10% of the previous
total global level of corn consumption. Since the supply of corn did
not increase, the price had to increase enough to reduce corn
consumption in other countries by 10%. If it takes a 10% increase in
the price to reduce the quantity of corn demanded in the first year by
just 1%, it would take a 100% increase in the price of corn to offset
the initial 10% rise in the quantity of corn demanded.

In reality, the picture is complicated by the substitution in both
supply and demand among different agricultural commodities, and by the
role of the corn ethanol program. But the basic explanation holds:
With a very low short-run price sensitivity of demand and little scope
to raise supply in the short run, even a relatively small increase in
corn demand by the high-growth economies can lead to a very large
short-run rise in the price of corn.

Fortunately, the price sensitivity of both demand and supply will
increase with time. This implies that the rising demand from China and
other countries may eventually be accommodated with a price lower than
today's level.

The situation for oil is more complex, but the outcome for prices is
potentially more favorable.

Unlike perishable agricultural products, oil can be stored in the
ground. So when will an owner of oil reduce production or increase
inventories instead of selling his oil and converting the proceeds
into investible cash? A simplified answer is that he will keep the oil
in the ground if its price is _expected_ to rise faster than the
interest rate that could be earned on the money obtained from selling
the oil. The _actual_ price of oil may rise faster or slower than is
expected, but the decision to sell (or hold) the oil depends on the
expected price rise.

There are of course considerations of risk, and of the impact of price
changes on long-term consumer behavior, that complicate the oil
owner's decision – and therefore the behavior of prices. The
Organization of Petroleum Exporting Countries (the OPEC cartel), with
its strong pricing power, still plays a role. But the fundamental
insight is that owners of oil will adjust their production and
inventories until the price of oil is expected to rise at the rate of
interest, appropriately adjusted for risk. If the price of oil is
expected to rise faster, they'll keep the oil in the ground. In
contrast, if the price of oil is not expected to rise as fast as the
rate of interest, the owners will extract more and invest the
proceeds.

The relationship between future and current oil prices implies that an
expected change in the future price of oil will have an immediate
impact on the current price of oil.

Thus, when oil producers concluded that the demand for oil in China
and some other countries will grow more rapidly in future years than
they had previously expected, they inferred that the future price of
oil would be higher than they had previously believed. They responded
by reducing supply and raising the spot price enough to bring the
expected price rise back to its initial rate.

Hence, with no change in the current demand for oil, the expectation
of a greater future demand and a higher future price caused the
current price to rise. Similarly, credible reports about the future
decline of oil production in Russia and in Mexico implied a higher
future global price of oil – and that also required an increase in the
current oil price to maintain the initial expected rate of increase in
the price of oil.

Once this relation is understood, it is easy to see how news stories,
rumors and industry reports can cause substantial fluctuations in
current prices – all without anything happening to current demand or
supply.

Of course, a rise in the spot price of oil triggered by a change in
expectations about future prices will cause a decline in the current
quantity of oil that consumers demand. If current supply and demand
were initially in balance, the OPEC countries and other oil producers
would respond by reducing sales to bring supply into line with the
temporary reduction in demand. A rise in the expected future demand
for oil thus causes a current decline in the amount of oil being
supplied. This is what happened as the Saudis and others cut supply in
2007.

Now here is the good news. Any policy that causes the expected future
oil price to fall can cause the current price to fall, or to rise less
than it would otherwise do. In other words, it is possible to bring
down today's price of oil with policies that will have their physical
impact on oil demand or supply only in the future.

For example, increases in government subsidies to develop technology
that will make future cars more efficient, or tighter standards that
gradually improve the gas mileage of the stock of cars, would lower
the future demand for oil and therefore the price of oil today.

Similarly, increasing the expected future supply of oil would also
reduce today's price. That fall in the current price would induce an
immediate rise in oil consumption that would be matched by an increase
in supply from the OPEC producers and others with some current excess
capacity or available inventories.

Any steps that can be taken now to increase the future supply of oil,
or reduce the future demand for oil in the U.S. or elsewhere, can
therefore lead both to lower prices and increased consumption today.

Mr. Feldstein, chairman of the Council of Economic Advisers under
President Reagan, is a professor at Harvard and a member of The Wall
Street Journal's board of contributors.