Everyone knows that oil prices are $60/barrel, right? But where does that price come from? And where is it headed?
If you've ever taken a course in environmental and/or resource economics you've heard the Hotelling's Rule story. Energy is an asset and with competitive markets (lots of firms, entry into and exit out of the market is easy, similar products) the asset price will rise at the rate of interest (as a proxy for the rate of return on alternative investments) over the long run (not the day to day fluctuations that we read about in the WSJ's Commodities Column). If the price rises above the rate of interest, firms will enter the market, supply will increase and prices will fall back to the long term trend. If the price rises more slowly than the rate of interest then firms will exit, supply will decrease and the price will rise back to the long term trend.
There are lots of academic studies that test Hotelling's Rule. Some find that it holds and others find otherwise. Here is a recent example.
These days everyone knows that the current price of oil shouldn't be $60 but much lower based on current consumption (demand) and supply. Today's price incorporates expectations about the future. One factor driving today's prices upwards is that market participants expect that demand in China and India will continue to grow leading to future prices higher than what today's price actually should be. If you want to make money, you buy oil today at today's low price and sell it in the future at a higher price (i.e., buy low, sell high). Well, if a lot of people are smart like you (or follow the herd), then the big profit-seeking increase in demand today will lead to an increase in price ... today! So, we hear that OPEC (wait, what was that about plenty of firms? and free entry?) is pumping as much oil as they can and $60/barrel prices don't make sense. But they do make sense because future demand plays such an important role.
How does all of this happen? Back on June 9, James Hamilton, at Econbrowser, describes the mechanics of the futures market ("Oil futures and the future of oil"). This week he discusses the speculation about future oil prices and the options market ($100 a barrel-- what are the odds?). Good reads.
