oil: confusing correlation and causation

This is about the current state of the oil market.

The fact that two things occur together (correlation) does not always mean that one causes the other.

For example, every morning the rooster crows and the sun comes up.  But killing the rooster won’t plunge the world into eternal darkness.

Birds fly south and winter begins: birds fly north and winter ends.  Same story.


Some commentators are arguing that the sharp decline in the price of oil is a harbinger of recession, using the argument that low prices and recession are very often linked.  I don’t think this is correct.

The causal connection between lower demand and price works something like this:

When aggregate global demand begins to contract, sellers of end products see their businesses begin to slow down.  They may cut their prices to sell stuff they have on hand and they certainly begin to shrink their inventories to a level that matches the lower demand they are experiencing.  They do so by cutting back new orders sharply.  Middlemen do the same.  This process typically hits producers with a very sharp decrease in new orders.  Producers respond in the only way they can, by cutting prices.

In the case of oil today, none of this is true.  Yes, prices are only a third of what they were eighteen months ago.  But aggregate demand is steadily rising.  So too world inventories.  The majority of oil producers are increasing their output, as well.

What’s happening with oil is that years of very high prices established a pricing umbrella that encouraged new entrants (shale oil), previously uneconomical, to invest tons of money and enter the business.

Established producers, meaning OPEC, have started a massive price war to force the new guys into bankruptcy.  The producers are learning the basic, but bitter, lesson that it’s much easier to keep new entrants out (by keeping prices low) than it is to deal with them once they have invested in plant and equipment and have begun production.

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