Oil Markets and the 21st Century War

Why are prices staying so low?

When four hijacked commercial airliner crashed into the World Trade Center, the Pentagon, and a remote field in Pennsylvania on September 11, shockwaves rapidly spread across the world economy. Not immune to these ripple effects, energy prices were also affected. Fortunately, a financial mechanism that helps stabilize commodity prices limited the effects of the attacks-a true lesson in the way markets cope with unexpected shocks and how we all benefit from such market instruments.

The day of the attacks, oil and gasoline prices initially spiked. Reports indicated that some stations increased gasoline prices to $4.00 a gallon. Many people feared disruption of the oil supply from the Middle East, especially if the U.S. pursued a military response similar to the Gulf War in 1991. Recalling the high oil and gas prices associated with that campaign, energy market participants expected that supplies would tighten and prices would go up. Even consumers, rushing to fill their tanks, magnified these short-term effects. Oil futures prices also went up initially, because these expectations and the response of the public created an incentive for energy firms to lock in supplies for the future, in anticipation of supply constraints.

Yet, two weeks later, oil prices and oil futures prices are the lowest they’ve been since 1991, and last week gasoline prices dropped 4.4 cents on average. Why? The answer to that question illustrates the complex interaction of supply and demand, time, and politics.

Oil and gas futures prices tell us a lot about what people in the industry think prospects are for higher prices in these uncertain times. After September 17 oil futures prices started to fall, and Monday, September 24 saw a 15 percent decrease in oil futures prices.

Prices for commodities like oil and gasoline are based on expectations of future supply and demand, and these prices move in response to unexpected events. Soon after the attacks, market observers thought that the future demand for oil and gasoline would more likely increase, because of possible military action. As it became more apparent that any military response would not be traditional or petroleum-intensive, these expectations changed. Traders also faced probable decreases in the demand for jet fuel because of reduced travel, as well as increased expectations of actual recession, perhaps even global recession. Even before September 11 consumer spending was in decline, which would lead to decreased production. Because petroleum products are fundamental to so many industrial and commercial processes, a recession could decrease demand. On top of that, long-term weather forecasts suggest fewer cold days than average in the next three months, lessening the expected demand for home heating. These expectations of lower demand drove current and future oil prices down.

What about supply effects? OPEC is known as an oil cartel that tries to manage the production in its member states, targeting prices in the $22-28 per barrel range. If they cut production to raise prices, that move could counter the expectations of falling demand and possibly lead to higher oil prices. OPEC, though, is under serious political pressure to support the U.S. in its efforts against terrorism, and a cut in oil production would not be seen as supportive. Most analysts believe that OPEC member states could lose a lot politically in return for a small gain if they curtailed production. In particular, Saudi Arabia, OPEC’s largest member state, has pledged to support the U.S. At its planned meeting on September 26, OPEC announced that it would not change production plans, thus meeting traders’ expectations for future supply. In addition to OPEC’s effects, the recent high oil, gasoline and natural gas prices in the U.S. have led suppliers to increase their inventories, particularly of products with high winter demand such as home heating oil. Expected lower demand and stable supplies also contributed to falling oil futures prices.

Behind all these machinations lies the usefulness of futures markets at reducing price volatility, even in the wake of such a catastrophic event. They help buyers and sellers manage risk in potentially volatile markets, like oil and gas, by creating the ability to buy and sell today the rights to a commodity in the future. Consumers (individual and business) benefit from these instruments, through stable energy prices and the resulting predictability and ability to plan their own energy budgets.

Buyers and sellers acting on their expectations convey a lot of information about market conditions. From the current futures prices, market participants expect an economic downturn to last into early 2002, but not much beyond that. Of course, if something unanticipated happens or some new information arises, those expectations will change and be reflected in changes in futures prices. But incorporating expectations of future prices into current production and consumption decisions reduces volatility and contributes to more stable and certain markets, for energy and for other goods and services.

No doubt, we owe a debt of gratitude to many different people and institutions in the wake of these attacks-the workers and volunteers that risk their lives to save others, the entrepreneurs that keep the wheels of the economy turning, the government response that is helping manage the crisis, and a financial mechanism that helped keep the economy from choking on sky-high energy prices.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.