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Oil production is driven by real oil prices

I offer this chart to illustrate just how much the dollar value of commodities can affect the commodities market. What it shows is that the real price of crude oil (in dollars) has a significant impact on oil production via changes in the number of oil and gas rigs that are operating around the world. There is a long lag involved, of course, between increased oil drilling and actual production (several years I believe), but the response from oil producers to changes in the real price of oil is strong and quite obvious.

For example, note that real prices fell sharply from late 1996 through early 1999. In response, the active rig count started falling in late 1997, dropping fully 52% by mid-1999. Real prices then shot up, and that was followed by an eventual tripling in the number of active drilling rigs by 2008.

There's good news and bad news here. On the one hand it's good to know that the price signal does play an important role in the oil market. With real prices relatively high these days, producers are ramping up the exploration and production efforts and this should keep prices from climbing too high. But on the other hand, erratic monetary policy, to the extent it influences oil and other commodity prices, can result in a real roller-coaster ride for the industry over time. First, prices rise, which then encourages more exploration, which eventually results in increased supply, which then helps prices decline. Lower prices then discourage production, which then results in less supply, which eventually helps prices rise.

We would all be far better off without this tremendous price volatility. This is one reason why the Fed should pay more attention to commodity prices, since I do believe they are quite sensitive to changes in monetary policy, as I tried to point out in yesterday's post. If commodity prices were an important input to monetary policy decision-making, we might have not only less volatile commodity prices, but also lower and more stable inflation.

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