Friday, March 4, 2011

Oil Prices, Oil Supply, & Financial Crisis

Over the last two or three weeks there has been a lot of speculation about the unusual spread between Brent Oil And West Texas Intermediate (WTI) oil, which usually track each other but Brent oil has been becoming more expensive since about November 2010.  Some analysts have tried to explain it as increased shipments from Canada to the Cushing, Oklahoma depository as well as the efficiencies and problems of the flow and delivery of oil in different parts of the United States, including pipelines and Midwest refinery capacity utilization.  Financial arbitrage in the buying and selling of WTI and Brent futures contracts do not seem to explain it.  Krugman and others have been pointing to commodity price increases as not exhibiting anything more than supply and demand with little impact on core inflation--- and for the most part they are correct.  However, headline, short term inflation does build expectation of longer term inflation and definitely impacts consumer and corporate spending.  I have long thought the supply and demand rationale for oil prices has not always held credence at times in the last 4 years, because oil future contracts extant can far exceed oil for delivery and most contracts are not held to delivery.  This may imply that prices are being driven by speculation, whether news driven or not, and the futures contract market is inelastic.  Futures contracts can set future prices which are inconsistent with current spot market prices, because, as Yves Smith as very aptly argued, futures contracts are price oil on a weighted average of futures prices.  Hoarding does not appear to be the problem, but the futures market itself may be the problem

Another possibility is oil shock from the Middle East or the expectation of oil shock  In our last post, we detailed the dependence of European countries on Libyan oil.  It is true that the United States has significant strategic oil reserves and the European countries have oil reserves which would mitigate any short term disruption of oil supply from Libya.  Conflict in Libya continues and one refinery may be on fire, while other Middle East countries are confronted with pro-democracy protesters; all of which could cause a more long term disruption in oil supply, stock markets, and financial transactions in the Middle East, causing another financial crisis.

How central banks react to the rise in oil prices and other commodities will determine how the worldwide economic recovery continues to slowly proceed or frailly falls back   Already the ECB under Trichet's leadership has indicated they will raise their interest rate 25 basis point to 1.25% in April.  This reaction to headline inflation will drive down nominal wages and increase unemployment which will not be compensated by an increased value of the euro to the dollar as a means to mitigate commodity price shock.  Given the damage of austerity in Europe and the refusal of the United States to deal with unemployment and the causes and perpetrators of financial fraud, financial stability is appears to be for those who have enough money and elite privileges to capitalize from crisis.

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