Why does the price of oil change so much?

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. It was 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 marketplace. 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 Sea. Tar 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 use 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 in China and India. The price was 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, it appears that there 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 to the US actually talking 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.