The role of speculation in the oil price ratchet process

Abstract

The world price of oil could be as low as extraction costs or so high that alternative energy resources would displace oil on a massive scale. The actual price depends on the interactive policies of exporting and importing countries. In fact, the world oil price has increased sharply three times since 1970 and exhibited relative stability between the sharp upward movements; this is what is meant by the upward price ratchet. This paper emphasizes the role of inventory speculation in driving oil prices upward. Inventory speculation is also responsible for much of the variability in OPEC production. The oil importing countries could hold oil prices down by invoking stand-by measures to temporarily increase production, reduce consumption and mitigate the procyclical effects of inventory speculation. The timing of intervention into the market mechanism is critical. Elimination of stand-by measures after the market has stabilized is also important. Policies designed to reduce consumption in the long-run may cause the price to be ratcheted to even higher levels in the near future and should be rethought in light of the ratchet process.