The Price of Oil

Oil is down to $32/barrel, from a high of something like $140/barrel. What happened?
I did some reading a few months ago on the price of oil, and came to the conclusion that nobody really knows exactly why the price of oil ends up where it does. Things that you think would change it don’t seem to change it, but sometimes what seem like small causes have huge effects on the price of oil.

Now, I’m not qualified to offer any expert advise, so this post is for entertainment purposes only. But here’s my theory.

A few months back, speculators were bidding on the price of oil futures. In September, they were buying December’s oil. There’s a fixed capacity for producing oil, which can be changed but only slowly, and there were far more speculators bidding on the price of oil than there was actually oil available to buy, so the price went up way beyond where it would have naturally settled if there were unlimited supply.

But the speculators bid on more oil than the world actually needed. The oil companies said “hey you want to buy a barrel of oil in December for $120? Sure!”. The speculators did this because they expected that the demand would be there and they’d be able to unload that barrel of oil for more than they paid for it.

But then demand destruction kicked in. Demand for oil dropped because it was so expensive that it started to cause people to changing their habits. It didn’t have to change much – only a few percent – for the pendulum to swing from not enough to excess.

An analogy: If there are 10 people, and 9 available doses of a drug that they all must have, each will bid higher until one drops out, and the rest will pay that high price. If there are 8 people who want the drug, it will sell for much less because there’s a surplus. Demand didn’t have to change much to effect a huge swing in the price.

It didn’t take much for the price of oil to go from $140 to $32, and in my opinion, it won’t take much for it to go back up. I wouldn’t trade the Prius in for a Hummer just yet.