Thursday, June 14, 2007

"Overshoot" Theory

This is my theory about oil prices principally, but it works equally well for prices for a range of other stuff. My theory is to do with pricing as a tool for matching supply and demand, coupled with profits being used to invest in increased capacity, coupled with the long-term average price being a fairly simple function of the cost of extraction. Thus the long term average price is fairly independent of demand and supply. Thus as it runs out, it is the increased cost of extraction of a depleted resource that will determine higher average prices, rather than the discrepancy between supply and demand. That particular increase in cost doesn't appear to exist in the places which have the most oil left.

Thus the supply curve is still behind the demand curve. Capacity is increasing financed with the profits. The Supply will catch up with demand because the profits have nowhere else useful to go other than increased capacity. The (long) delay is because the profits have to build up, the capacity needs time to ramp up. But the march is unstoppable. When the supply and demand curves intersect, prices will undershoot their long term average.

2 comments:

Dr. Clam said...

This is why all the Club of Rome predictions about rising costs of materials have failed so badly, i guess- technological advances improving extraction have triumphed over supply and demand...

Marco said...

Of course the 6 Trillion dollar question is when these (theoretical) supply/demand curves are going to intersect. Most of the snippets of data that I see indicate the only supply side constraint now, is time, and downside vs upside risks on demand seem to have levelled out. The affordability of new (in the future - excess) capacity is at an all time high. My prediction of a pre-Olympic downward correction in prices still seems likely.