Market Pricing

I keep seeing further reactions to last week's Senate hearing on the oil industry. While some commentators seem satisfied by explanations of hurricane-induced gasoline shortfalls and comparisons to profit margins in other industries, others continue to pursue oil company profits as if they were the next Enron scandal. While stipulating that the industry has done a dismal job of explaining how it works--not just at times of exceptional profits but throughout the boom-and-bust cycles that have typified most of its century-plus existence--I find the economic ignorance on display by journalists and elected officials simply breathtaking. In the process, the public is being misled into a conspiracy-theory mindset, hardly a tough sell in 2005 America.

For example, Friday's Washington Post business section included an article entitled, "Oil's Bigwigs Enjoy a Rigged Market." It's author, Mr. Pearlstein, offered some "simple truths", including his observation that the oil market is rigged by Middle East producers and thus doesn't justify being called a market. Perhaps he paid too much attention to Exxon Chairman Lee Raymond's muddled explanation of how oil prices are set, which should have mentioned that the Saudis and other producers do not set their prices in a vacuum, but instead pay a great deal of attention to oil markets around the world, and particularly to the futures markets in London, New York and Singapore. While it's true that the major oil companies don't set the price of the commodity, neither does OPEC, when all its members are producing flat out in a global market with essentially no spare capacity. Who sets the price, then? Buyers do, including those in Shanghai and Mumbai, by bidding it up.

Monday's Post featured an op-ed by William Raspberry, "An Oily Flavor." He correctly observed that the five industry execs couldn't adequately explain why record profits and record prices happened to coincide with the hurricane aftermath, and thus weren't the direct result of gouging consumers. (Try my posting of last Thursday for an explanation.) Where Mr. Raspberry and the CEOs went awry was in linking prices with costs. Street prices for gasoline may have gone up because suppliers raised their prices to dealers, but the prices charged by suppliers went up because a market with a voracious appetite was suddenly short about a quarter of its normal supplies, not because the cost of making gasoline had suddenly shot up. The laws of economics may not function with quite the remorseless rigor of those of physics, but in a situation like that there's only one way prices can go: up, with a vengeance. If companies had "sacrificed" by keeping prices low, as Mr. Raspberry and Senator Boxer suggested they should have, then half the gas stations in the country would have run out, and the ensuing hearings would have focused on oil company incompetence and shareholder injury, not profits.

While I could single out many other comments for similar treatment, the basic problem is that we live in a market economy in which only a small fraction of the population actually seems to understand markets or be comfortable with their adverse outcomes. And those few who do are either incapable of explaining market behavior in simple English, or are afraid that providing such an explanation would result in a populist backlash and further regulation.

If I told you that the price of oil is set in the same way as the price of a share of stock or a bushel of corn, would it make more sense than what you heard last Wednesday? Buyers buy because they have a need or think the price is going up. Sellers sell because they have more than they need or think the price is going down. Some have a bit more information about future supply or demand than others--or think they do--and some have a longer-term perspective than others. The level at which as many buyers are willing to buy as sellers are to sell is the price, for that moment. You can add as much complexity to that story as you wish, for oil, stocks or corn. You can talk about OPEC, its efforts to restrict current and future supply, and how effective it has been at different times. You can talk about the futures markets and the various forces that drive them, along with the leverage they generate when most other transactions around the world are settled based on their closing prices--something that was not true when I traded oil in the 1980s and early 90s. In other words, you can make this picture as detailed as you like, without changing its essence.

The point is that however complicated these markets are, they aren't incomprehensible, particularly to someone with a reasonable education. The failure here is not of oil markets, but of our past efforts to explain them simply and understandably. We pay for that failure every time the conversation about pricing becomes so confused and convoluted that it looks like someone is hiding something, as so many seem to have concluded from last week's panel in D.C.