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August 12, 2008

Oil Prices are Falling, and that is a Good Thing

Category: Economics,News,Observations,Political – Tom Harrison – 8:50 am

Oil Prices as of August 12, 2008, from WRTG EconomicsThis Spring and Summer, oil prices spiked. They got our attention. Boy did they get our attention!

But prices are falling again, and are now down. This is good.

So why are lower prices good? The recent oil price spike has done what it can to wake us up. We need a respite; a chance to calm down, and a chance to see that the oil market is doing what markets do. They go up, they go down. When things are clear and investors are confident, markets respond calmly. When there’s a surprise, markets over-react, then settle. When there’s general nervousness, they become volatile and hard to predict.

Look at this one-year graph of various oil- and gas-related prices. What do you see? (A link to this WRTG Economics has been on the on the right under “Spot Oil, Gas Prices Daily”.)

In the price run-up over the last year, I see a little surprise, and an equal amount of volatility. High prices have been blamed on various bad actors. But in my simple world, price is based upon supply, or to put a fine point on it, the expectation of supply. This expectation element is where risk is added in — uncertainty, fear, unclear market signals increase the perception of risk such that small disruptions in supply can create apparently excessive price increases.

Of course I still believe that oil prices would and should probably be more than double even their recent high prices if the total cost of oil (and other carbon-based fuels) were included. Others may have different prices for this unrecognized cost of carbon. There are significant, external costs not accounted for in current oil (externalities), gas and coal prices.

If nothing terribly bad happens in the world in the next few months (wars, pipeline sabotage, hurricanes, etc.) we should expect current prices to continue to fall. For one, we have done what good consumers do and responded by reducing our consumption as gas prices rose. Still, prices are higher than last year, but only by 50%, thank goodness. Perhaps the people most affected by high prices will be able to heat their houses this winter.

That prices continue to fall is far from certain. But I think even with a few minor perturbations, we might get lucky.

And that’s good. Because we have been reacting (over-reacting), instead of responding to oil prices lately.

We need continued spikes, mitigated by retreats in price to help keep our attention focused on the problem without suddenly responding as though $4/gallon gas will end the world as we know it. As gas prices back off, and the world looks like it is retreating to normalcy, the real issues the presidential candidates should be focusing on might get some attention.

I predict that, as we tend to do, we’ll get complacent as oil prices less than $100/barrel return. But prices will come back up again. Whether it’s this year, or next, this “oil crisis” isn’t like the one in 1973. We have even less market power over oil, and other factors won’t let this one just go away as it was allowed to do when Regan was elected in 1980.

But any world event could change this apparent restoration of normalcy overnight.

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