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Oil’s Well With Price Volatility
Companies Can Take Advantage of Fluctuations
Oil prices have fluctuated radically over the past 20 months. To understand why this is a good thing for companies that use or produce oil, pretend you eat only steak and lobster. If the price of steak were always $20, which would you prefer to be true about the price of lobster: (a) it’s always $20, or (b) half the time it’s $10, and the other half it’s $30.
Under the first option you always pay $20 a meal. But with the second you could buy lobster when its price is $10 and steak when the price of lobster is $30. So under the latter choice you’d sometimes pay $20 for dinner but sometimes only $10. Consequently, that choice leaves you better off.
True, your situation would be further improved if the price of lobster were always $10. But given that lobster has an average price of $20, you should prefer a fluctuating price.
When most people think about volatility, they usually only consider the chance of something getting worse and so falsely believe volatility is bad. But we can often benefit from volatility by taking advantage of times when fluctuations move in our favor.
You can use more of a good when its price decreases. And when the price rises, you can buy less of it, thus diminishing the harm of the increase. Using this strategy, the benefits of a decrease outweigh the damages of an increase, causing price fluctuations to put you in a better situation.
Airlines, for example, can add routes if the price of oil falls but cut routes when it rises, causing them to pay less on average for crude than if its price didn’t fluctuate. Airlines that don’t want to deal with short-run price variations can use futures markets to lock in prices by paying for the oil today but taking delivery of it later. But there are some transaction costs of using futures markets, and companies that do use them to lock in prices have consequently been harmed by price volatility.
The greatest beneficiaries from price volatility are perhaps oil-producing companies. To see this, let’s say the price of oil is $60 a barrel and an oil company has land on which it would cost $70 a barrel to extract crude. If the price of oil were always $60, the land would always be worthless to the oil producer. But if the company expects the price of oil to fluctuate greatly, it will expect the price to sometimes go to about $70. So the oil producer will believe it will someday be profitable to extract oil from the land.
Oil companies have drilling rights to vast tracks of land for which the price of oil isn’t yet high enough to justify extraction. The best situation for these producers would be if the price of oil continually rose. But given a choice between having the price of oil never change or having the price of oil sometimes going up and sometimes down, they’d pick volatility because their extraction rights would often have value.
James D. Miller is an associate professor of economics at Smith College in Northampton, Mass. His latest book is Singularity Rising: Surviving and Thriving in a Smarter, Richer and More Dangerous World (BenBella Books), on sale in October.