The Economics of Oil Prices

David R Henderson. Excerpt:

"The World Market

While I was waiting to play pickleball a couple of weeks ago, a friend who knows I’m an economist asked me a question: “Given that we in America produce almost all the oil we use, why does a reduction in supply of other countries’ oil lead to a price increase here?”

I loved the question because I occasionally raised exactly this question when I taught at the Naval Postgraduate School.

Here’s how I answered.

Because of low transportation costs per barrel of oil, which are a small fraction of the price of a barrel of oil, the market for oil is global. A reduction in the supply of oil anywhere in the world reduces world supply. For a given world demand, therefore, the price oil will increase everywhere.

My friend thought for a minute. He seemed to get it.

Then the next question occurred to him. “What,” he asked, “if a domestic refiner is sitting on a large inventory of oil that it had bought weeks earlier for over $20 less than the current price? How can it justify pricing its refined products as if it had paid the current higher price of oil?”

I sensed a certain upset at gasoline companies and so I decided to take an indirect route to answer. I was pretty sure this guy, who is close to my age, had lived in the area a long time. I asked him if he owned a house. He said he did. I asked him if his house is worth a lot more than what he paid for it. He said it is. Then I asked, “If you decided to sell your house, would you price it at what you paid for it or would you price it according to current market conditions, which would imply a much higher price?” He answered that he would price to the market.

He got it.

By the way, when I wrote my Wall Street Journal piece in August 1990 arguing that you couldn’t justify war in the Middle East based on Saddam Hussein’s probable impact on the price of crude oil, I of course put no consideration on how much oil we got from Iraq or Kuwait—it was a small amount but the amount was irrelevant. Remember that it’s a world market."