We Can Lower Oil Prices Now

By MARTIN FELDSTEIN

July 1, 2008

Although
most experts agree that financial speculation was not responsible for
the surge in the global prices of food and energy, many people remain
puzzled about the source of these remarkable price rises. Economics
offers a simple supply-and-demand explanation and reason for optimism
about the future of commodity prices. In the case of oil, economics
also suggests how policy changes today that affect the future could
quickly lower the current price of oil.

We all know that rising
incomes in China, India and the Gulf states have increased the demand
for oil and many other commodities. But how could the modest, one-year
rise of these demands lead to 100% increases in the prices of oil and
other commodities? Let's take a look first at perishable agricultural
commodities.

Corbis

In
the short run, there is little scope for increasing the supply of corn
in response to a global increase in demand. For demand and supply to
balance – for the market to clear – the price of corn must rise.

If
the demand for corn were very price-sensitive, a relatively small
increase in price would reduce global demand by enough to offset the
initial rise in demand. However, since demand is actually quite
insensitive to price in the short run, it takes a very large price rise
to bring global demand into line with supply.

Here is a
simplified picture of what happened in the past year. The quantity of
corn demanded by high-growth countries rose gradually, increasing
eventually by an amount equal to, say, 10% of the previous total global
level of corn consumption. Since the supply of corn did not increase,
the price had to increase enough to reduce corn consumption in other
countries by 10%. If it takes a 10% increase in the price to reduce the
quantity of corn demanded in the first year by just 1%, it would take a
100% increase in the price of corn to offset the initial 10% rise in
the quantity of corn demanded.

In reality, the picture is
complicated by the substitution in both supply and demand among
different agricultural commodities, and by the role of the corn ethanol
program. But the basic explanation holds: With a very low short-run
price sensitivity of demand and little scope to raise supply in the
short run, even a relatively small increase in corn demand by the
high-growth economies can lead to a very large short-run rise in the
price of corn.

Fortunately, the price sensitivity of both demand
and supply will increase with time. This implies that the rising demand
from China and other countries may eventually be accommodated with a
price lower than today's level.

The situation for oil is more complex, but the outcome for prices is potentially more favorable.

Unlike
perishable agricultural products, oil can be stored in the ground. So
when will an owner of oil reduce production or increase inventories
instead of selling his oil and converting the proceeds into investible
cash? A simplified answer is that he will keep the oil in the ground if
its price is expected to rise faster than the interest rate that could be earned on the money obtained from selling the oil. The actual
price of oil may rise faster or slower than is expected, but the
decision to sell (or hold) the oil depends on the expected price rise.

There
are of course considerations of risk, and of the impact of price
changes on long-term consumer behavior, that complicate the oil owner's
decision – and therefore the behavior of prices. The Organization of
Petroleum Exporting Countries (the OPEC cartel), with its strong
pricing power, still plays a role. But the fundamental insight is that
owners of oil will adjust their production and inventories until the
price of oil is expected to rise at the rate of interest, appropriately
adjusted for risk. If the price of oil is expected to rise faster,
they'll keep the oil in the ground. In contrast, if the price of oil is
not expected to rise as fast as the rate of interest, the owners will
extract more and invest the proceeds.

The relationship between
future and current oil prices implies that an expected change in the
future price of oil will have an immediate impact on the current price
of oil.

Thus, when oil producers concluded that the demand for
oil in China and some other countries will grow more rapidly in future
years than they had previously expected, they inferred that the future
price of oil would be higher than they had previously believed. They
responded by reducing supply and raising the spot price enough to bring
the expected price rise back to its initial rate.

Hence, with no
change in the current demand for oil, the expectation of a greater
future demand and a higher future price caused the current price to
rise. Similarly, credible reports about the future decline of oil
production in Russia and in Mexico implied a higher future global price
of oil – and that also required an increase in the current oil price to
maintain the initial expected rate of increase in the price of oil.

Once
this relation is understood, it is easy to see how news stories, rumors
and industry reports can cause substantial fluctuations in current
prices – all without anything happening to current demand or supply.

Of
course, a rise in the spot price of oil triggered by a change in
expectations about future prices will cause a decline in the current
quantity of oil that consumers demand. If current supply and demand
were initially in balance, the OPEC countries and other oil producers
would respond by reducing sales to bring supply into line with the
temporary reduction in demand. A rise in the expected future demand for
oil thus causes a current decline in the amount of oil being supplied.
This is what happened as the Saudis and others cut supply in 2007.

Now
here is the good news. Any policy that causes the expected future oil
price to fall can cause the current price to fall, or to rise less than
it would otherwise do. In other words, it is possible to bring down
today's price of oil with policies that will have their physical impact
on oil demand or supply only in the future.

For example,
increases in government subsidies to develop technology that will make
future cars more efficient, or tighter standards that gradually improve
the gas mileage of the stock of cars, would lower the future demand for
oil and therefore the price of oil today.

Similarly, increasing
the expected future supply of oil would also reduce today's price. That
fall in the current price would induce an immediate rise in oil
consumption that would be matched by an increase in supply from the
OPEC producers and others with some current excess capacity or
available inventories.

Any steps that can be taken now to
increase the future supply of oil, or reduce the future demand for oil
in the U.S. or elsewhere, can therefore lead both to lower prices and
increased consumption today.

Mr. Feldstein, chairman of
the Council of Economic Advisers under President Reagan, is a professor
at Harvard and a member of The Wall Street Journal's board of
contributors.