Using Monetary Policy to Get Away from Oil

Basil Oberholzer discusses how monetary policy could move us away from oil.

The world economy of the past fifteen years has featured numerous outstanding and most often not very pleasant events. Besides the financial and economic crisis, the euro crisis, private and public indebtedness, stagnation as well as ultra-expansive monetary policy, we have observed a very particular pattern of commodity prices. Among the latter, the price of crude oil is to be mentioned as the most important commodity in global trade as well as in its role as the driving fuel of the world economy. The oil price exhibited a strong rise in the noughties until its all-time peak in 2008 when it dropped down sharply. It rose again in 2009 and remained on a high level of around USD 100 until 2014. Since then, we have featured record low prices and not much seems to be changing in this respect. How is the crude oil price linked to the above mentioned macroeconomic developments? What are the problems arising from this and how should they be treated?

First of all, crude oil has a dual character. On the one hand, it is a conventional physical good that is traded in the spot market. On the other hand, it is the basis of futures contracts – and as such a financial asset – which is traded in the futures market. Hence, the same item is traded in two different but nevertheless closely connected markets. In the futures market, as in any other financial market, speculation is likely to take place. Unlike what the efficient market hypothesis tells us, uncertainty can give rise to bubbles and allows speculation to become profitable and effective. In the course of expansive monetary policy, financial investors want to escape from the low interest environment and are looking for different kinds of financial assets. Speculative demand drives up prices of crude oil futures. This has specifically been the case during the phase of quantitative easing in the US. Due to the dual nature of crude oil, the high futures price transmits to the oil price in the spot market. A higher oil price implies increasing profits for oil producers. As a natural reaction, they start investing in production capacities. The oil price increase caused by financial investment cannot be upheld forever in the face of dramatically enlarged production capacities. The oil price falls and we end up with a new price level lower than the one prior to the speculative bubble since there are now overcapacities in the oil industry. Once production capacity is in place, it does not disappear again for years.

Why should this be a problem? First, speculation means increased price volatility. This is a risk for speculators themselves, but mainly for oil producers and the rest of the producing economy. The second problem is an environmental one: overcapacities and a low oil price imply more oil consumption, which is a threat to our climate.

There exist different policy approaches to deal with these problems. Futures market regulation or a tax on fossil energies to reduce oil consumption are among them. All the policy propositions have advantages and disadvantages. Overall, none of them is able to deal with both the stability and the environmental problem at the same time. However, there is an approach, which makes it possible to solve both problems jointly. It is a combination of existing approaches. Moreover, it is effective and efficient.

Imagine that from now on, the oil price is exogenously determined. Thereby, speculative attacks and price bubbles are ruled out. Imagine further that the oil price is not just fixed on a certain level but is set such that it increases on a stable, continuous and transparent path. This establishes stability in the oil market. And since an increasing price implies lower consumption, the ecological challenge is taken into account, too. How can this price pattern be realized? We can mandate monetary policy to do this. By intervening in the oil futures market in the form of futures purchases and sales, the central bank can basically realize any oil price. Since the monetary authority has unlimited means in creating purchasing power, speculative attacks become powerless. However, an exogenously rising oil price gives rise to another challenge: since producers enjoy growing profits and since they realize that the price is going to increase further, they start investing and enlarge production. We thus end up with overproduction which puts downward pressure on the oil price such that it becomes increasingly difficult for the central bank to defend the price target. As a solution to this, oil production is charged with a tax. This raises production costs and diminishes producers’ profits such that they reduce investment. The oil market thus remains balanced while oil production and consumption continuously decrease.

The oil price targeting system described here is a combination of monetary and fiscal policy. It establishes transparency and stability for producers, consumers and investors. All market agents become aware that investment in oil is a losing deal in the long run. Investment in renewable energy and energy efficiency shoot up.

Basil Oberholzer, Global Infrastructure Basel Foundation, Switzerland

Monetary Policy and Crude Oil by Basil Oberholzer is available now.

Read chapter one free on elgaronline.