On Oil, Tulips, and Shark Attacks

$2.54.

That's how much regular unleaded gasoline costs (per gallon) at the Conoco on the corner. I don't enjoy paying that much. But I've always believed, generally speaking, that gas prices are rational. When others speak of vast oil-wing conspiracies that explain the rise in price around Memorial Day, Labor Day, etc., I counter with a supply and demand argument. I don't do so out of any great love for the oil industry (though it did indirectly pay for my graduate degree. Thanks Exxon!), but rather because it's a simpler explanation that better fits the data.

In this instance, however, I don't think there's a rational explanation for the rise in oil prices. Yes, demand is rising in India and China. Yes, there have been minor production disruptions at several American refineries (which wouldn't be an issue if a single formulation of gasoline could be used for the entire country). But these are not sufficient to explain the sharp rise in prices seen over the last several months.

Ultimately, I think a lot of the price increase is due to good, old fashioned hysteria. Hysteria that war & terrorism will stall production. Hysteria that China will buy U.S. oil companies and horde the output. Hysteria that the world is running out of oil.

But, slowly, economic opinion seems to be addressing some of these wilder perceptions. First, economist Steven Levitt likens the notion that we're running out of oil to the media-driven fear of shark attacks.

"Peak Oil:" Welcome to the media's new version of shark attacks

The idea behind 'peak oil' is that the world has been on a path of increasing oil production for many years, and now we are about to peak and go into a situation where there are dwindling reserves, leading to triple-digit prices for a barrel of oil, an unparalleled worldwide depression, and as one web page puts it, 'Civilization as we know it is coming to an end soon.'

One might think that doomsday proponents would be chastened by the long history of people of their ilk being wrong: Nostradamus, Malthus, Paul Ehrlich, etc. Clearly they are not.

[...]

High prices lead people to develop substitutes. Which is exactly why we don't need to panic over peak oil in the first place.So why do I compare peak oil to shark attacks? It is because shark attacks mostly stay about constant, but fear of them goes up sharply when the media decides to report on them. The same thing, I bet, will now happen with peak oil. I expect tons of copycat journalism stoking the fears of consumers about oil induced catastrophe, even though nothing fundamental has changed in the oil outlook in the last decade."

Meanwhile, Scott Cramer at Optionetics says the present situation is more like Holland's tulip mania.

The Black Bubble

Everyone from nobility to gardeners began to rationalize investing in the bulbs as a smart investment, and the continuously rising prices seemed to justify these as smart investments. Eventually things got so out of control with demand that a single bulb could command as much as $80,000 converted into today's U.S. Dollars. At the peak in January 1637 there was a twenty-fold increase in the price of bulbs.

Much like how people could rationalize taking equity out of their homes at 7% to invest in NASDAQ stocks in the late 1990s, many 17th century people in Holland sold their homes, thinking that a few bulbs would net them two homes in a few months’ time. Eventually the laws of gravity took affect and what was once a market with only buyers became a market with only sellers.

Realizing the potential catastrophic affect a crash would have on an economy focused on one product, the Dutch government stepped in made a public statement declaring that there was no reason why the price of tulips should fall. Not surprisingly, government reassurances didn't work as hoped, so the government stepped in and guaranteed the price of tulip bulbs at 10% of the high price. Not long after that tulips fell through the government's floor price, which nearly bankrupted Holland's government.

[...]

One reason why bubbles form is that many good arguments can be made for 'why this time things are different.' Generally speaking, as a whole, the public is not crazy. The media sells people on the best or worst case scenarios. For the last 70+ years people have heard reports from so-called specialists about how there is only so much oil in the world, and eventually it has to run out. Yet if you look at the predictions the specialists have made about when the last drop of oil will be pumped out of the ground, you notice that every couple of years the date gets extended out a few more years."

Regardless, my next car will still be a hybrid!