Wednesday, September 29, 2004

Oil, free markets, and guinea hens

The price of oil topped $50 a barrel yesterday, an all-time high in dollar amount. Adjusting for inflation, though, it is still less than half the price after the Iranian Revolution.

Of course, that is trivia. No one cares what the relative cost was 25 years ago. Oil is 30% higher than last year, and that is what people notice. And that translates to an increased cost to the American economy of roughly $68 billion per year - about 6% of our GDP. It is fair to say that our economic growth rate would be at least 2% higher if oil had remained at pre-Iraq levels.

Still, industry analysts say there is still a 1% excess capacity on the production side. That is historically low, so while there is no immediate shortage, the markets fear that possible disruptions of supply in Iraq or Nigeria {where BP has had to shut down production of several facilities due to security concerns} or Venezuela could create a sudden shortfall in supply. Even so, the "fair market" price should be in the $28 - $35 per barrel range, say the experts.

For the markets, perception is reality. The free market does a wonderful job of allocating goods, services, and resources to their most efficient use, but the process by which it accomplishes that end is chaotic.

Fearing supply disruptions, investors began buying up oil futures contracts to lock in prices at current levels even before the Iraq War commenced. They profited by this defensive buying, so they did it again. And again. And again. And . . . well, you get the idea.

There are two primary motivators for investors in a free market. The first is desire for gain {or, as the left would call it, greed}. The second is fear of loss. The tech/internet stock bubble of 1999 - 2000 was fueled by the first. Investors saw these stocks going up and up, and bought into them. That most of the high-flying companies, savvy though their technologies were, had not yet figured out how to actually make money was lost in the stampede to buy.

With oil, it is the second and stronger motivator, fear of loss, which rules.

Always anticipating disaster has a way of feeding on itself, especially when such speculation also brings large profits. That the price of oil is inflated beyond reasonable supply and demand formulae is as irrelevant to the speculators in oil today as were simple business fundamentals to the speculators in NASDAQ five years ago.

When I was a boy, my family kept guinea hens for a while. These creatures were usually inobstrusive and stayed out of trouble on their own. But they were better than watchdogs, because whenever anything unusual came near, they began a cacophonous cackling which would wake the dead, and fled for their very lives. Anything would set them off, day or night, which is why we eventually got rid of them.

The markets are behaving like guinea hens on oil prices right now. Sooner or later reality will set in, and the price will fall, perhaps preciptiously, back to "normal" levels.

I'll never be able to get ten gallons of gas for $3 again, like I was in 1971. But then again, no one is able to get the amount of work out of me for $3 they could back then, either.


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