Arnold Kling poses a question for (economist and New York Times columnist) Paul Krugman.
Kling writes (http://econlog.econlib.org/archives/2008/06/a_question_for_1.html):
“Early in 2007, the price of oil was $60 a barrel. Recently, it has been above $130 a barrel. Which of the following does Paul Krugman believe:
(a) market fundamentals justified $60 a barrel then, and they justify $130 a barrel now; or
(b) market fundamentals justified a much higher price in 2007?
I believe that (b) is more likely to be true, meaning that we had what Tyler Cowen calls an “anti-bubble” in oil.
We know that Krugman does not believe that today’s oil price is out of line with fundamentals. Krugman’s view, in effect, is that if speculators artificially boost the price of oil, then supply will exceed demand, and the excess has to go somewhere. Where are the inventories? (I should clarify that “where are the inventories” is the question that Krugman is asking. It is not my question.)
This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet, they did not. So, is Krugman forced by his model to conclude that the price of oil of $60 also reflected fundamentals?
My view is that inventories are not a reliable indicator of supply-demand balance versus speculation. Inventories, and the futures-spot differential, also reflect interest rates and “convenience yield” (or option value).
Here’s how I would answer (Kling’s question to Krugman):
The “fundamentals” price of oil depends on a number of factors that cannot be perfectly foreseen. Among these are (1) will the world enter a deep and prolonged recession in 2007, and (2) will global oil production in 2007 be higher than it was in 2006?
Today, we know that the answer to both questions is no, and conditional on knowing that answer, we can see that $60 a barrel was too low a price. But a year ago, no one knew those answers.
Likewise, the price of oil today is very much dependent on the answer to questions such as (1) will the world enter a deep and prolonged recession in 2008, and (2) will global oil production in 2008 be higher than it was in 2007?
Today, we do not know the answer to these questions. If the answer is yes, the price of oil today is much too high. If the answer is no, the price could still be too low.
As for the specific question of “where are the inventories”, let’s be a little more precise about the question being asked.
The correct question is: Did the movement along the demand curve that resulted from the increased price show up as an increase in inventories?
The correct answer is, no, it was offset by a shift in the demand curve for newly industrialized countries and the oil producing countries. For example, China may have consumed half a million more barrels of oil per day in 2007 compared with 2006.
Where are the inventories? China already burned them.
This is a post from the blog www.econbrowser.com.
James Hamilton is professor of economics at the University of California, San Diego. Comment at firstname.lastname@example.org