President Obama recently told a crowd at a community college in Maryland: “there is no such thing as a quick fix when it comes to high gas prices. There’s no silver bullet.” He could have been referring to releasing oil from the strategic petroleum reserve or he could have been arguing against a policy of encouraging more domestic drilling or both. Contrary to the President’s statement, there is a silver bullet, which economists call rational expectations, but it does not always work in the direction the President would like.
The President’s comments are a reaction to rising gasoline prices, which have produced two conflicting positions. One is that increased domestic drilling for crude oil, which would increase the supply of oil, would not cause the price of oil and gasoline to go down. The other is that releases from the strategic petroleum reserve (SPR), which would also increase the supply of crude, would lower crude oil prices and gasoline prices. So which was is it? Either supply matters or it does not.
One of the arguments against domestic drilling says that more drilling and oil production will not push oil and gasoline prices down because the process takes too long. In 2008, President Obama’s Campaign for the Future said: “New drilling wouldn’t bring the first drop of oil to market for at least 10 years—and they know it. Normally, it takes years—to set up operations, dig test wells, and build a functioning oil rig—before any oil goes to market. So it would take 10 years before any oil is pumped out of new offshore wells, and about 20 years before those wells would reach peak capacity.”
A recent article in the Huffington Post reemphasized the mantra: “It’s not going to change the price of oil overnight, and it’s probably not going to have a huge impact on the price of oil ever,” said Mike Lynch of Strategic Energy and Economic Research, Inc., referring…to expanding all U.S. drilling.”
This line of reasoning ignores an important economic theory called rational expectations, an economic theory that “the expectations of individuals are rational if they take fully into account the available and relevant information.” Here is how it works. If the President announced tomorrow that he was signing an executive order opening up all federal lands and offshore areas for oil and gas drilling and expediting the permitting process and restraining the EPA from enacting new oil and gas regulations, the price of crude oil and gasoline would drop immediately due to rational expectations. In other words, the operation of rational expectations would provide the “silver bullet” that would immediately lower crude oil and gasoline prices.
As for releases from the strategic petroleum reserves, rational expectations work in the opposite direction. Many have argued that releases from the SPR will reduce crude and gasoline prices. For example, the Center for American Progress recently stated that “There is one proven tool for temporary reductions in oil and gasoline prices, and can lower prices to help middle-class families: selling oil from the Strategic Petroleum Reserve.
The problem is that rational expectations produce perverse results in the case of releases from the SPR, causing the price of crude to go up, not down. This results because the market knows that the United States will have to enter the crude oil market to replace what has been released which increases the demand for crude oil. Until the oil is replaced, the U. S. is also more vulnerable to supply disruptions, adding additional uncertainly to the market.
The importance of rational expectations to oil prices is seen when problems heat up in the Middle East or North Africa, as they have recently, and expectations shift toward a concern about the instability of future crude oil supplies coming out of those regions. Similarly, the mere forecast of a hurricane in the Gulf of Mexico causes crude oil prices to increase due to the expectations that offshore platforms will shut down and reduce the supply of crude oil on the market.
The bottom line is that opening up more federal lands and offshore areas and encouraging increased domestic drilling will lower world oil prices sooner than later. The mere announcement of this policy is all it takes. There is a silver bullet. Will the President use it?