Friday, June 27, 2008

Required Reading for Politicians

Steve Hanke explains how the oil market functions and why prices are high. He also provides a way for politicians to do something useful about high prices rather than just hold hearings. First, he explains the role of the dollar:

For example, if the greenback had held its January 2001 value against the euro, oil would have traded at about $76 a barrel in May 2008. This is almost $50 below the price that crude oil was trading at in May 2008. Accordingly, the decline of the dollar’s value accounted for a whopping 51% of the $97 a barrel increase in the price of oil from May 2003-2008.

That's why a rate hike by the Fed to shore up the dollar would have also gone a long way toward puncturing the oil bubble.

Hanke then goes through an explanation of contango and backwardation and the resulting commodity interest rate:

If the price of a commodity for future delivery exceeds the spot (or cash) price, the market is in contango, and the commodity interest rate is negative. A lender of a commodity has no incentive to lend to the spot market because he would be in effect selling low and buying high. The reverse occurs when the spot price exceeds the futures price and the market is in backwardation. Commodity interest rates are positive. In this case, it pays those who hold commodities to loan them to the spot market.

Finally, Hanke gives some advice on how to bring prices down:

Instead of hoarding the SPR, the government should sell outof- the-money (at strike prices that exceed the current spot price) call options on the SPR. This would allow the purchasers to buy oil at the strike price until the option contracts expired. It would transform what is in effect a dead resource into a live one. It would provide the country with a huge inventory of oil, generate revenue to defray some of the government’s stockpiling costs, smooth out crude oil price fluctuations, and push down spot prices relative to prices for the oil to be delivered in the future. In consequence, commodity interest rates would become very negative as inventories would be abundant.

A stronger dollar and market-based release rules for SPR would provide relief from sky-high crude oil prices.

The solution is elegantly simple and has the advantage of being correct. Every politician should be required to read this article.

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