Elephantstrunk

Oil prices aren’t determined by supply of oil. That’s one of the conclusions Dave Cohen reaches in his extensive essay on oil prices. James Hamilton seems convinced:

Econbrowser: Is peak oil irrelevant?
Is peak oil irrelevant?

Does the market price of oil reflect a recognition that the resource is fundamentally limited?

Dave Cohen, writing at the Oil Drum, has been doggedly wading through the writings of economists on resource scarcity, going the extra mile (and then some) trying to understand how those on the other side of the river from him have thought about the issue of resource scarcity.

As Dave nicely explains, the traditional Hotelling model reasons that market forces will cause there to be a “scarcity rent” incorporated in the price of an exhaustible resource. The observation is that someone who sells a disappearing resource today is thereby surrendering the opportunity to sell that commodity in a future market in which it might be more highly valued. As a consequence of owners bringing more or less of the product to the market at each date on the basis of such calculations, the theory predicts that the scarcity rent should rise over time at the rate of interest.

Dave then runs into the same stumbling block as anyone else who has tried to apply this elegant theory to reality– if you look at the inflation-adjusted price of what should be exhaustible commodities over the last century, there’s no hint at all of an upward trend:

If a tragedy of the commons is being avoided by Coase-style property based price rationing then the kind of behaviour predicted by the Hotelling model is what you would expect. There’s a load of wiggle room — rates of discovery change, interest rates change, growth forecasts change — but the burden of proof should be on those who claim that oil use is being efficiently regulated by price. It is hard to think that there has been enough news about long term demand for oil to justify a four of five fold rise in the oil price in 4 years or even the size of drops.

The obvious response is that it isn’t availability of resources but of refinery capacity and the like that is the binding constraint. In the short term that is clearly sometimes true but the long period of static prices and significant political interference on all sides suggests that isn’t the whole story. Short political time horizons, trade imbalances and the empirical results suggest that the rules of the game are not those dictated by oil availability. Why would coffee or cocoa growers be exempt?