I got an interesting question in class on Friday. We were talking about the
recent economic news, and one of the items was that oil had traded below $70.
over twice that a few months ago so the quite obvious question was,
"Why does the
price of oil change so much?"
The simple, but unsatisfying answer is that it's all speculation. And truth
be told, it is all speculation, but as an economist, we like to call it something
else. What we like to call it is the Marginal User Cost.
Oil is a mineral. It is a non-renewable natural resource. There appears to
be a fixed amount of it in the earth's crust which means that if we produce
some today, we won't have it to produce tomorrow. Because of that, we break
the cost of a non-renewable natural resource into two parts - the Marginal
Extraction Cost and the Marginal User Cost.
The Marginal Extraction Cost is fairly straightforward. It is the incremental
cost of extracting (producing) the next unit of the resource. For oil today,
my guess is that it's around $40 a barrel. Said another way, it's the
incremental cost of producing the most expensive barrel of oil we currently
provide to the
Oil from some fields in the middle east come in at about $2 a barrel. The
expensive stuff is deep offshore and from rather nasty places like the North
sands are in this range, and oil from shale is a bit out of this range.
As the Marginal Extraction Cost increases, so does the cost (price) of the
resource. (Remember that prices are set at the margin.)
The Marginal User Cost is different. Since using the resource today means
that we don't have it to use tomorrow, we pay a cost for that. The marginal
user cost is the incremental cost of not having that unit of the resource to
in the future. That also means that the Marginal User Cost is dependent upon
how people view the future.
If people believe that we will have substantially less of the resource available
in the future, then the Marginal User Cost goes up. If they
think we will have somewhat more, the Marginal User Cost decreases.
In addition, how much people discount future
values changes the Marginal User Cost. If you heavily discount future values
(a higher interest rate) the Marginal User Cost decreases. A lower discount
rate (you value the future more
highly) results in a higher Marginal User Cost. (BTW if you don't discount
future values then I want
to talk to you. You're going to be willing to lend me a lot of money at a
really low interest rate, perhaps zero.)
So now we can talk about changes in the price of oil (or copper or any other
non-renewable natural resource.) The question splits into two - what's happening
to the Marginal Extraction Cost and what's happening to the Marginal User Cost.
In the short run, the Marginal Extraction Cost doesn't change much. Over long
periods of time (decades or more) in real terms, this tends to go down. It
seems that it ought to be
increasing since we're always producing from more difficult circumstances (deeper,
lower grade, further out...) However, we are an inventive lot, and we keep
getting smarter about how to find and produce non-renewable natural resources
and this more than offsets the other effect. (Hence I like to tell my students
that as long as they keep getting smarter than we ever were, we're going to
be OK.) But again, in the short run, the Marginal Extraction Cost doesn't change much.
That leaves the Marginal User Cost. When demand is increasing faster than
supply it appears that there will be less of the resource available in the
future so the Marginal User Cost increases. Up through the first half of 2008
this was happening with oil, copper and other commodities as demand had increased
increasing faster than the Marginal Extraction Cost so it must have been Marginal
User Cost. Similarly, when demand decreases, as it is today with a slowdown
in the world economy,
will be ample supplies in the future and Marginal User Cost decreases. (That
also implies that the Marginal User Cost is the incremental price consumers
are willing to pay over the
Marginal Extraction Cost
so that they can consume it today and not have to wait
until tomorrow. Using it in the present is more valuable than having it in
the future. Some consumers will compete for the available resource today since
their use is so valuable.)
Another thing that affects Marginal User Cost is the expectation of future
production. If production will be restricted, as it is with oil offshore in
the US, then Marginal User Cost
will increase. If it appears that production will be opened up, then Marginal
User Cost decreases. OPEC production quotas will affect Marginal User Cost
in a similar manner if people believe
that they will be enforced in the long run. (Note that if ample supplies appear
to be available for the foreseeable future, the Marginal User Cost may go to
zero. I think that is what happened
to copper in the late 1990's. The Marginal Extraction Cost and the price in the
market were essentially the same.)
So back to the original question,"Why does the price of oil change so
much?" As best I can tell, the Marginal User Cost has decreased sustantially.
In part I think this is due to reduced demand and in part I think this is due
about producing offshore resources.
Having answered that question, the obvious followup was, "Isn't that all
really just speculation?" To which I reply yes, in truth it is. But as economists,
we like to act like we're very precise about our guesses about the future so
we call it changes in Marginal User Cost. Now you can too.
Labels: environment, macroeconomics, microeconomics