Behavioral finance and oil prices

I get to talk and write a lot about psychology and law, but the M.B.A. part of my training often gets left out of my media work, so allow me to take this opportunity to write about something a little different from the norm.  As you probably know, there’s a lot of unrest in the Middle East.  That’s no surprise, I know.  And what’s also no surprise is that the unrest in the region is going to have an impact at your local gas pump.

Purchasers of oil from the Middle East (e.g. oil companies that supply the U.S.) fear that the supply of oil getting out of the Middle East will be reduced by the unrest, making future purchases of oil more expensive for them.  Consequently, they’re scrambling to lock in enough supply to meet their customers’ needs in the coming weeks and months, and in a sense, creating a self-fulfilling prophecy — by trying to “outbid” one another today for access to tomorrow’s (and next week’s, next month’s, etc.) oil, they’re driving today’s price upward.

Now, so far, the supply of oil coming out of the Middle East has been disrupted only slightly, yet prices at the pump here in America are rising significantly.  Some, like my friend Bill O’Reilly, have opined that this suggests some kind of conspiracy by a group of shadowy “speculators” to exploit the American consumer.  I agree with O’Reilly often, but not on this.

If those who make money selling oil to consumers were getting it for the same price today that they were paying last week, yet telling consumers that the price at the pump had to be raised because of supply disruptions, at least O’Reilly would be accurate in claiming that consumers were being deceived.  But I’m not seeing that.  Even though supplies haven’t been disrupted much — yet — the price of a barrel of oil coming out of the Middle East has risen sharply, and a fairly proportional increase appears to be happening at the pump, so it looks to me like the increased cost of supply is pretty much just being passed on to consumers.

Yes, the price increases that we’re currently seeing are attributable more to fears of supply disruptions than to actual supply disruptions, but the fears appear to me to be real.  O’Reilly characterized such upward price movements as “artificial.”  I don’t know what he means by that.  Fears affect the prices that both companies and consumers are willing to pay for things.  Sometimes those fears are exaggerated, even irrational, yet they influence prices profoundly.  There’s a whole discipline called “behavioral finance” that’s dedicated to predicting such effects by combining the studies of psychology and economics.

Often, when fears elevate the price of a commodity and then turn out to have been overblown, there’s a reverse reaction whereby there’s excess supply of that commodity and a corresponding drop in its price.  That may very well happen here.  If supplies do get tight, and prices continue to rise, companies and consumers who bought at today’s prices might look like geniuses.  On the other hand, if supplies stabilize, and prices drop back to where they were a month ago, the same purchasers might lose their shirts.

That’s the nature of markets in which human beings do the purchasing, and that’s why behavioral finance is fascinating (at least to Ph.D./M.B.A. types like me).  Accurately assessing how much of an upward price swing is based on justified fear and how much of it is based on irrational fear can help one to predict who will be the “geniuses” and who will be the “shirtless” and to invest (or not) accordingly.  That’s “speculating,” and there’s nothing nefarious about it.

(Now, just for fun, let’s say that O’Reilly was right and that oil companies were taking advantage of the news coming out of the Middle East to raise prices at the pump without really paying any more for their supplies.  I hate to tell you this, but that’d be ok, too.  The oil companies’ supplies of oil are the private property of those companies’ shareholders — who probably include your pension fund, your neighbors, maybe even yourself — and it’s their management’s job to get the highest possible prices for those supplies at the pump.  They can try to sell their oil for whatever price they want, and they don’t owe you or me or O’Reilly a justification or even an explanation of why they’re charging what they’re charging.  Our immediate recourse as consumers — and what keeps the price down most of the time — is our right to drive a little farther down the street and buy gas at the next company’s station.  I know, some people would say that the major oil companies are all getting together and setting the same price.  Ok, maybe, but I don’t think so.  I think it’s more likely that they’re all paying very close to the same price for supply, and they all have very close to the same costs of getting that supply to your pump, so they all end up charging very close to the same price.  If one company built a substantially-larger profit margin into its price than its competitors did, everyone would just buy from the competitors.  But guess who can get together and manipulate oil prices?  Us.  That’s right, whenever someone complains about the price of oil, we consumers do have ways to bring it down over time.  One is to increase the supply of oil available to the oil companies, and ultimately to us, by telling our politicians to permit more oil to be extracted closer to home, which also reduces our energy dependence on Middle Eastern nations who aren’t interested in our economic well-being under normal circumstances, let alone now.  If our President even talked convincingly about energy independence, you might be amazed by the effects that it could have on the outputs of oil-exporting countries around the world — if they feared that we were going full-steam-ahead with massive exploration and drilling projects, specifically so that we could buy less from them starting a few years from now, they’d probably increase their output to keep the price at a point where it wouldn’t make sense for us to go through with our plans.  See?  Behavioral finance can work for us as well as against us.  Another thing we can do as consumers and voters is tell our politicians to cut the substantial taxes contained in the price of every gallon of gas that we buy.  Depending on where you live, 10% or more of what you pay for gas probably has nothing whatsoever to do with the Middle East or the oil companies and everything to do with federal and state taxes.  Another approach we can take is to decrease the demand for the oil companies’ product by actually using less of it — conserving, car-pooling, etc., etc., etc.  Think about it — if you sold oil for a living, wouldn’t you keep raising the price of it until your customers finally started buying significantly less of it?  And along those lines, there’s actually something else we can do — become oil company owners if we’re not owners already.  That’s right, by investing in their stocks.  That way, if their revenues truly are rising favorably-disproportionately to their costs, then while we’re helping to generate their revenues at the pump, we can also share in their profits.)

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