Kenneth D. Gartrell

By: Kenneth D. Gartrell

On Greta Vansustern’s FOX News evening show on the 24th of June, the Speaker of the House, Nancy Pelosi, said that on June 30th, just 6 days hence, the price of oil would fall because that was the day that the US Government would cease to purchase oil for the strategic petroleum reserve under emergency legislation. Today is June 30th and the Associated Press is reporting a new record price for oil of $143 per barrel. Speaker Pelosi’s forecast proved incorrect. During the period of her forecast, the price of oil rose from $139 per bbl on June 26th to close today at $142 per bbl, a 2.1% increase in just 6 days.

The speaker made a mistake in economic reasoning that is all too common among politicians and pundits who have become de jure economists and who declare boldly that future events have no impact on today’s price of oil.

The Speaker is not the only prominent politician who exhibits remarkable limitations in her understanding of oil markets and prices. In response to John McCain’s changing position on US oil drilling and discovery policies, Barack Obama unequivocally asserts that increases in drilling ten years away have “absolutely no impact on the price of oil today.” And, a short while back, Senators John Warner, Barbara Boxer and Joe Lieberman were feverishly trying to railroad a bill to create cap-and-trade markets in the US. On Face the Nation when confronted by Tim Russert with the objection of possible negative effects of passage on today’s price of oil, the Senators proudly asserted they had made provisions for this contingency by setting the effective date of the law to 2012. In the minds of these anxious leaders there would be no effect on the price of oil today from what many experts believe could be as much as a 40% increase in the price of oil due to the cap-and-trade system.

The Pelosi Faux Pas

Speaker Pelosi’s error reflects a genuine, but all too common, ignorance of how oil prices are determined in an efficient market. What she neglected is the fact that any commodity, including oil, is priced at the present value of all expected future cash flows pertaining to projected supply and demand. Speaker Pelosi failed to recognize that everyone in the market for oil already knew that the US would cease buying for the strategic reserves on June 30th, 2008 — long before she made her statement on June 26th.

To the extent that the decision by the United States to cease purchases in the strategic reserve was material to the price of oil, informed investors had either knowledge of the decision or reason to believe such a move was likely. The expectation would have shown in the price as soon as a consensus about future supply and demand was reached.

This is not the first time that the US has ceased purchases for the strategic reserve. Such decisions were taken at the time of Hurricane Katrina and at other times of crisis. Accordingly, the expected impact on supply and demand at some uncertain future date was included in the price on the day there was perceived change in the probability of US action. Let’s say, for the sake of illustration and with some exaggeration as to the amount, the US decision would have a certain effect of one percent on the price of oil, but the chance of such a decision was as low as one in ten. On that day the price of oil would fall one tenth of one percent or 1 basis point (the expectation times the probability). Subsequently, as the President and Congress moved to seek suspension, the probability would have risen. Let’s say the decision had been made by leadership and the final action depended only on a 50% chance of success in the Congress. On that day the price would have fallen further to one half of one percent or by 49 basis points. Finally, on the day the legislation was certain to pass (which might not be until the day it did pass) the price would have declined another one half of one percent or 50 basis points.

This explains why the Speaker was wrong. Future expectations do influence the price today. By the time Speaker Pelosi made her statement, the June 30th suspension on strategic reserve purchases was a certainty and already completely in the price. The rise that took place between June 24th and June 30th was entirely independent of any consideration of the strategic reserve purchases.

Pelosi Part Duex

A second astonishing thing the Speaker did in her interview with Greta Van Susterrn was wage yet another routine political attack on “speculators” in the oil market who she claims are manipulating the price of oil intentionally and irrationally.

The Speaker makes clear that she has no idea how oil is priced. She is remarkably oblivious to the fact that 90% plus of the trades that fall under the regulatory definition of “speculation” are purchases by those who are making a rational decision to hedge the exposure they have to oil price fluctuations elsewhere in their businesses and portfolios. A hedged position is not only rational but it is riskless. The Speaker needs an introductory course in economics to help her understand that that the amount of uniformed risk taking in oil futures is limited and likely to have no impact on the price of oil.

A glaring irony in the Speaker’s view of all this is that the policy she extols to suspend purchases in the strategic reserve is nothing more or less than the hedging activity she assertively defames as ‘speculation.” In suspending the purchase of oil from the strategic reserves she and her political colleagues expose the United States to a risk of higher oil prices to meet the reserve requirement in the future. Likewise they are taking a gamble that in future the strategic reserve can be filled at the same or lower prices than today. It is only logical to wonder why the Speaker believes the great unnamed “speculators” are doing anything more irrational or manipulative to the price of oil than she and the Congress. When said and done, the US Government is likely as of today June 30th, 2008 to be the single largest “speculator” in the US domestic oil markets by way of its actions pertaining to the US Strategic Oil Reserve.