Behind the Bouncing Ball of Oil Prices

You wouldn’t expect to walk into a drugstore and find regular toothpaste selling for as much as $6 a tube. You might be equally surprised if the price dropped to $1.50. But in the market for oil, where forecasts for prices now vary by a factor of four, that kind of range may soon become a reality.
The future price of oil is a topic on which very intelligent, well-informed people can have completely different views. Michael J. Economides, a professor of chemical engineering at the University of Houston who has advised Russian oil companies, predicted this week that oil would soon sell for more than $100 a barrel. Frederick P. Leuffer, a senior managing director and senior energy analyst for Bear Stearns, forecast that oil would average just $25 a barrel in 2005.

The peculiar thing is, each could be correct at some point this year. Oil prices, now at about $45 a barrel, can be extremely volatile, spiking and plunging within weeks. If they were not, the current level of uncertainty might seem much less rational. Where does the volatility come from, though, and is it likely to persist?

The first question has some obvious answers. The market for oil carries more risk of huge shocks to supply and demand than most markets for commodities.

Sure, it is possible that scientists will someday discover that orange juice causes cancer, but that thought probably doesn’t keep many traders up at night.

The demand for oil, however, could be hurt in an instant – for example, if someone invented a portable cold fusion generator that could safely power a car or heat a house. It would take time for countries to switch to the new power source, and oil would still be needed for producing plastics and other products, but the writing would be on the wall.

On the supply side, conflicts and cartels haven’t been able to cut off or control the world’s coffee or cocoa. But every time a butterfly flaps its wings in the Persian Gulf, a hurricane hits London and New York.

There is clearly plenty of room for unexpected turns in the price of oil, and perhaps that justifies the huge range in predictions. Yet according to Stephen Figlewski, a professor of finance at New York University, uncertainty can actually increase volatility.

It can happen in two ways. The first occurs when uncertainty is perceived as risk, Professor Figlewski said, as in the case of shares in a company. If the shares are seen as risky, fewer people might trade them. As a result, the market would be less liquid, and prices would be likely to move in fits and starts rather than in smooth, continuous trends.

“A little bit of new information, or buying or selling demand pressure, will push the price a lot,” he said.

The second occurs when there are many buyers and sellers but poor information, as in the market for illegal drugs. If someone decides to sell drugs above the market price, buyers may assume that the correct price has changed, even if they don’t know why the price is rising. With better information, no one would buy, and the price would stay at its old level. But the lack of information means that the price might hover at an inefficient level – either higher or lower than the competitive price – without the knowledge of the buyers and sellers. This case, Professor Figlewski said, may be more applicable to the market for oil.

The explanation fits with Professor Economides’s view, too. With colleagues at the University of Houston, he has created a model for the market price of oil based only on demand and available supply, putting aside the political hiccups that affect prices in reality. If oil were to trade on a free market with buyers and sellers acting like profit-seeking businesses, he said, the average price would be $29 or $30 a barrel.

What keeps prices high and may push them higher, Professor Economides said, is fear.

“People are worried about supply more than anything,” he said. “That’s really what creates a lot of the volatility in the market. It’s human psychology. It’s not really an economic fundamental.”

NYT