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Friday, June 27, 2008

One reason for the increase in oil price?

Don't like the price of oil? It seems there are plenty of people to blame, from an inactive Congress, the oil companies, the President, the speculators, to the Man on the Moon. However, the (spot) price of oil is not too hard to figure out: it is the price that equates quantity supplied with quantity demanded. An increase in the demand for oil in the rest of the world is imposing a form of "negative externality" on the U.S. in as much as the rest of the world is bidding up the price of oil and we in the United States have to take the price as given.

However, what actually has been the increase in the demand for oil in the rest of the world? Alas, the media are not so quick to report these numbers. After all, nothing new seems to be happening in Morocco or Belize. However, demand in China is booming, as reported here:
China's oil imports posted double-digit growth in the first five months of 2008 as global crude prices more than doubled from a year earlier, the General Administration of Customs said Wednesday.

The country imported 75.97 million tons of crude oil, up 12.7 percent from a year earlier, with average prices rising 64.1 percent to 689.9 U.S. dollars per ton.
As world oil suppliers are at or near capacity, the increased imports by China would be expected to increase the price of crude oil.

Can we blame President Bush for China demanding more oil?

Here's a graph of China's oil consumption and production through 2006 from the Energy Information Agency:

It looks like China is acting much like the U.S.: not dramatically increasing domestic production while relying upon imports.

Here is a rather interesting thought. Many have expressed concern over China's large foreign reserves, generated mostly by having an artificially undervalued currency and large current account surplus. These reserves are often a starring role in conspiracies and cataclysmic stories about China dumping U.S. treasuries and/or currency on the world market, thereby destroying the U.S. economy. This might still happen, but it has always seemed a silly move by China.

Why else, then hold so many foreign reserves?

Perhaps a more compelling story is that China foresaw that their growth (and their increased demand for crude oil) was going to push up the price of oil dramatically. Without a reserve of foreign currency wth which to purchase crude oil, especially the U.S. dollars in which oil is traded, the Chinese economy would likely have faltered within a few months after the dramatic rise in oil price. Could it be that the economic planners in China foresaw what was going to happen and actually planned correctly? Economic theory sometimes assumes the "benevolent dictator" who makes wise decisions on the part of socierty, but I have always questioned such an assumption; have we ever seen a benevolent dictator in practice?

However, if China's strategy was to amass foreign currency to finance their continued growth during an increase in crude oil prices, rather than taxing their current production or going into debt to finance their growth, that might be clever by half. I am not sure if such a strategy is really socially efficient, as it requires the Chinese government to withhold foreign reserves rather than distributing them to the Chinese people in the form of higher wages or returns on investment.

I have long claimed that the U.S. is one of the few countries in the world that can "afford" $125 per barrel of oil (along with some of western Europe and maybe Japan). Perhaps that list should be expanded to include China as well.

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I am confused. Wouldn't holding so many US dollars over the years when its declining be a bad thing for China?

> Why else, then hold so many foreign reserves

Good question. Why does China hold 1.2t us$ in reserves while the US only holds app 50b? And europe does about as little?

I think it has to do with the fact that they are a communist country, at least in name.

They won't float the yuan, because that would mean the exports to the US and europe would shrink rapidly, creating a lot of (temporarily) unemployment. And they can't have that. Remember: China is a police state. Uprising of the working class because they are unemployed means the end of the communist dictators, as tienamin nearly showed in '89.

They choose stability over progress. Employment over prosperity.

There are 300m people in china living on less than a dollar per day, while at the same time china adds 1.5b-2b per day to its reserves.

Remember: These people are not really interested in the people: They want to stay in power as any dictator would.
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