Economic Theory and OPEC - Part 2

Posted on July 20, 2007
Posted By: Ferdinand E. Banks
 
GENIUS SPEAKS: A NOTE FOR THE CONFERENCE ‘OIL AND MONEY’

An unsolicited and perhaps undesired note is perhaps the correct term here. Every year a distinguished conference is held in Paris or London with the title ‘Oil and Money’, and for well over a decade, when I saw a notice of this conference in the New York Herald Tribune, I immediately begin writing and circulating articles and notes in the hope that my work would be detected by the sponsors of that conference, and perhaps sufficiently appreciated to gain me an all-expenses-paid invitation to e.g. give a ‘keynote’ speech in the ‘City of Light’ – a metropolis that I first visited not too long after being unexpectedly expelled from infantry leadership school in the United States Army.

In any event, in December, 2005, on the Swedish TV program ‘Genius Speaks’, a group of new Nobel Prize laureates spent a relaxed hour speculating on the human condition in the light of existing and possible scientific advances. As usual, the two economics laureates revealed themselves to be hopelessly naïve about what is happening in the real world, as compared to the fantasy worlds in the papers and lectures with which they provoke or bore their students and colleagues. As compared to the other laureates, they displayed an almost bizarre lack of poise or imagination, and one of them was barely unable to conceal his disgust at having his ineptitude paraded before the television audience.

Although macroeconomists, they were luckily not requested to explain or try to explain what might take place in the event of an oil price escalation which resulted in a barrel of oil trading for something around 75 $/b, as was the case several years ago. Had they been asked however, they would almost certainly have responded that such a high price, if sustained, would speed up the production of large quantities of synthetic oil from gas and coal, and in addition more effort would be put into exploiting the huge deposits of tar sands and heavy oil discussed above. What would not have been mentioned is the time factor, because in mainstream economics textbooks, the huge amount of unconventional oil that would be required to offset a ‘run-up’ in the oil price can virtually appear over night. They would also ignore the fact that when the initial millions of barrels of new non-conventional oil and/or motor fuel appeared, they would probably sell at or near the same price as the real thing, especially if their producers preferred more money to less.

Another gentleman – this one a professor of financial economics at Harvard, and writing in one of the leading natural science journals – went on record as believing that high oil prices were not of themselves a clear and present danger to the international macro-economy because of the ease with which derivatives – e.g. options and especially futures – could be used to hedge both short and long term price risk. As it happens, futures contracts with a maturity over 6 months have hardly any liquidity, and occasionally this is true for contracts that have a maturity in excess of 3 months.

Incidentally, the new chairman of the US Federal Reserve System, Professor Ben Bernanke (of Princeton University), remarked shortly after assuming office that on the basis of prices in the futures market he could not detect any danger of a spectacular oil price escalation. He had somehow come to the conclusion, or been informed, that long-term futures contracts – if indeed such assets exist – can provide valid information about long-term oil prices. This is not even wrong, because it is a statistical fact that severe oil price escalations have never been indicated by movements in futures prices, but instead tend to be the result of anomalous events (such as rifle-play in certain sensitive regions of the world). Of course, in terms of financial theory, futures prices are not ‘efficient’ estimators of physical oil prices in the future.

Having mentioned two former economics winners of the Nobel Prize – which probably should be called the ersatz Nobel Prize, because at no time in his highly productive life or for that matter his nightmares did Alfred Nobel contemplate founding an award that would be granted to some of the recent economics laureates – we can consider a likely future laureate. This is Professor Robert Schiller of Yale University, whose specialty is finance, and if I were on the Committee he would definitely be on my Very Short List for an award, particularly when I consider some of the other future candidates. His knowledge of oil however contains the usual defects, which to my way of thinking is always the problem when energy topics are broached in ‘academia’.

Schiller points out that using futures may be a problem for low-rollers, but he neglects to mention that the oil futures market has occasionally been labelled ‘The best game in town’ by ladies and gentlemen that the novelist Tom Wolfe identified as “masters of the universe”. Mr Wolfe is referring to people who not only possess the smarts required to earn a few million dollars a year well before they are thirty, but also have the intelligence and taste to spend it in an enlightened manner. In the United States these individuals attract a certain amount of attention in the business press, but while they undoubtedly outnumber successful rappers and hip-shakers on video clips, it is unlikely that there are more than a few thousand of them.

The future laureate believes that at current usage rates, proved reserves of oil will be exhausted in a few decades. A hundred decades is probably closer to the truth where exhaustion is concerned, because the bad news for those of us on the buy side of this market will come with the peaking of oil production. He also thinks that the price surge of oil “has the look and feel of a speculative bubble”. In his opinion the six-fold price increase for oil between l998 and 2004 does not jibe with the change in “economic indicators”. I have some problem sympathizing with this approach because of my familiarity with the work of Professor Alfred Marshall about a century ago. Marshall made it clear that price is determined by demand and supply. Demand now includes the voracious requirements of China and India, while the situation with supply is perhaps best characterized by the failure of most of the largest oil firms to replace their reserves of oil. Those two things do not add up to a “speculative bubble”.

Of the ‘majors’ the failure of Shell (the third largest of the Non-OPEC majors) is the most flagrant, which is perhaps why the director of that enterprise implied that the blame for high oil (and gasoline) prices should be placed on the financial markets. Of course, when he expands on this hypothesis, he gets just about everything wrong. He says “So if inventories are normal, why should the price be so high?” He answered his own question by saying “I know various pension funds that had money in bonds, in shares. Now they went into commodities.” I don’t think so, Mr van der Veer. Actually, most of the money that you are talking about went into paper commodities (i.e. futures and options on oil). Another expert on this topic is the Fox News story teller, Mr Bill O’Reilly. His genius led him to provide the following reason for high oil and gas prices: “those Vegas type people who sit in front of their computers and bid on futures contracts” (Fortune, May 29, 2006, page 28). The following diagram shows inventories as explicit, while “Vegas type people” are implicit – i.e. contributing to the formation of the expected price ( pe). (As Geoffrey Styles points out though (2007), the arrow connecting flow and inventory should go both ways.)

Hedge funds and futures markets (i.e. “Vegas types”) influence to some extent the expected price, and as a result desired stocks (i.e. inventories). If for example DI > AI because it is expected that price will increase, then price will increase as an attempt is made to increase stocks. But the key items in this price formation model are stocks (i.e. inventories), which are more important than the supply (s) and demand (d) flows. The mechanics of this market (and also futures and options markets) are explained in detail in my energy economics textbooks. I can reveal though that the word “normal” – as used by Mr van der Veer – carries very little scientific weight. Another way of looking at all this is considering the possible ‘abnormalities’ that could arise if there was a sudden shift in e.g. DI. If you enjoy manipulating differential equations this is a comparatively simple exercise, but for the present exposition it might be useful to make a few remarks about the importance of inventories, and what changing DI could mean.

Average inventories of oil for the US, Europe and Japan from January 1991 through March 2005 came to about 775 million barrels. These were fixed inventories, and an additional 830 million barrels (called floating inventories) were in transit at sea. More commercial stocks were held in the rest of the world, but there are no figures on the exact amounts. (There might also have been a billion barrels in official inventories – e.g. the US Strategic Petroleum Reserve (SPR) probably has about 800 million.) Now suppose that for one reason or another there is an increase in DI, and this is accompanied by an intention to raise AI by some fraction of one percent (1%), and in addition to do so in a short time.

In terms of the diagram above this puts a pressure on supply (s) that it cannot easily support, given the absence of reserve production capacity in the real world market. As a result the price (p) will immediately increase, and perhaps by a large amount. Yes, the people in front of computers may have contributed to this situation by misjudging the developing situation in the oil market, and thus playing a small or large part in causing pe to become something that it should not be, but the big problem was the failure of Mr van der Veer and his colleagues to locate sufficient new reserves and to invest in new capacity. Just as serious, the knowledge of these deficiencies is widespread, and so when market actors decide e.g. that they need larger inventories, their behaviour is vigorous.

Professor Shiller also says that the futures market expects oil prices to keep rising because it displays a condition called ‘contango’, with futures prices greater than the present spot price. This is interesting, because oil futures markets generally tend to be in ‘backwardation’ – with the spot price higher than the future price. Perhaps the main reason for this is given in the last sentence of the previous paragraph.

I think that by way of summation we can say that while Professor Shiller deserves his Nobel, his knowledge of the economics of energy markets would be much more sophisticated if he had taken a front row seat in the course on oil and gas that I recently gave in Bangkok. As for the excellent Bill O’Reilly and Mr van der Veer, they possess defective judgements of the role played by “Vegas types” or “Masters of the Universe” (or for that matter hedge fund hustlers) in the formation of oil prices. One of the masters, Mr John Brynjolfsson, says that he and his happy band deserve a pat on the back for bringing capital into the “commodities” markets, because that “helps these markets to work better”. I believe that the gentleman means bringing it into the futures and options markets where it increases liquidity, because as far as I can tell, the strictly physical side of the oil market (and gas and coal markets) can function very well without the assistance of young millionaires.

CONCLUSION

“.......never underestimate the power of oil”
– The Economist, 13 April 2002

The expression that we often hear now is that OPEC is back in the driver’s seat. I think that this more or less sums up the situation, if by being in the driver’s seat you mean that they have decided to function at the top of their game. Here I am thinking of a recent article in Fortune Magazine (March l9, 2007) in which Abu Dhabi (in the UAE) is called “The Richest City in the World”, which means that the author of that article considered it richer than nearby Dubai. In point of truth neither of these cities is richer than Geneva and Zurich when everything is taken into consideration, but Abu Dhabi and Dubai have made remarkable progress. The most interesting thing for me in that article was someone saying that “They know that they have to diversify their economy away from just oil”. This kind of logic permeated my book on oil, and it has also taken hold in Saudi Arabia, where six industrial “clusters” are apparently being planned.

Murray Duffin notes that “the supply of light sweet crude has surely peaked already, and about 70% of world refining capacity is geared to light sweet crude (2007). He adds that upgrading refineries to handle heavier crude is going to be an expensive proposition, but I suspect that this is exactly the sort of challenge that the oil producers of the Middle East are in position to accept.

During the last 20 years there has been a concentrated effort to convince obtuse or lazy students of the oil market of the lack of importance of OPEC in the oil producing world. One of the persons helping to sponsor this loony judgement was the Director of the Energy Research Centre at Columbia’s Lamont-Doherty Earth Conservatory, and according to that gentleman the oil problem is not worth losing any sleep over because “if you pay smart people enough money, they will figure out all sorts of ways to get the oil that you need.”

Putting himself in the shoes of one of the smart people that he has so much confidence in, he claimed that the total expense of producing a barrel of oil from natural gas has been reduced to $20. He then proclaims “That will effectively put a ceiling on the price that anyone can charge for a barrel of oil – which is something that has never existed in history. The moment anyone tries to charge above this amount, people will switch to fuels derived from natural gas” (Discover, June 1999, pg 85).

The very moment this scholar claimed! Well, goodbye to my plans to publish a long article in Discover, because I doubt whether the logic in a paper such as the present one is publishable in that prestigious journal. I am aware however that I should have informed the President of Columbia University that I was available for a director of energy research job, because when someone makes a goofy statement like the one above about replacing oil, it gives smart people a bad name. Regardless of what conclusions are arrived at in the laboratories or investment banks, oil is not going to be put on the block for $20/b. What has happened is that the OPEC countries have finally learned to work together, and so they do not have to accept the kind of oil price that would be in effect if the price setting mechanism were e.g. a Nash-type arrangement in which ‘cheating’ made more sense than cooperation. ( Instead, it can be shown with a little algebra that a Pareto Optimum might now apply for a producer association like OPEC.)

Having mentioned a “little algebra” I will close this paper by slightly reformulating some important work of Alhajji and Huettner (2000). Take Q0 = QM – QN, where Q0 is the demand for OPEC oil, QM is the market demand, and QN is non-OPEC supply. Differentiation gives dQ0 = dQM – dQN and dividing both sides by Q0 we get:

Elasticities can be formed if we divide both sides by dP/P. On the left hand side of (1) this would give us E0, or the elasticity of derived demand for OPEC’S oil. On the right hand side we will have ß, the market elasticity of demand for oil, and d, the elasticity of supply of non-OPEC sellers. Another simplification is to define as positive the elasticity of demand – which is naturally negative – and to work with market shares instead of quantities: i.e. to deflate the Q’s with QM. This turns the above expression into:

The first term, ß/Q0 shows why the demand for OPEC’s oil could be very elastic (i.e. price sensitive), although the overall demand for oil might be fairly inelastic. If, for example, OPEC has 25 percent of the market for oil, then just considering that term, the elasticity of demand for its output would be four times that existing on the overall market. Assuming that OPEC decided that it wanted a higher price, then (ceteris paribus) it could find itself absorbing virtually the entire reduction in export output needed to support the higher price, and the smaller its share the greater the burden.

As for (1 – Q0)d/Q0, this can reinforce the first component in the expression. If OPEC’s market share is small, and the non-OPEC supply elasticity was large, then an even greater reduction in OPEC export volume is necessary to maintain the target price. What (2) and its interpretation indicates is that, to make itself highly effective, OPEC requires a sizable market share and, in addition must face fairly low non-OPEC supply elasticities. Since I make a practice of ignoring most of the elasticities that one finds in the econometric literature, I will confine myself to reminding readers that OPEC’s market share is increasing all the time, just as the supply elasticities of non-OPEC producers are very likely falling.

Before finishing this discussion, and the paper, readers should be aware that a peculiar variety of irrationality has characterized the ‘debate’ about what OPEC should and should not do, and how it should be confronted. Several years ago at the Rome meeting of the IAEE, I was grandly informed by a so-called expert on the world oil market that without foreign investment the OPEC countries were riding for a fall. I can understand – though not sympathize – with this kind of warped thinking because there is an enormous amount of money on the table. If the OPEC countries open their energy sectors to the major oil companies, and give them the return on investment that these enterprises feel that they are entitled to, then it would amount to a major triumph for various tender-hearted guardians of human rights that are pouring billions of dollars into marginal business ventures in corrupt countries, when they would like to see those billions go into the Middle East, where genuine oil prizes are still located. As it happens however, given the technical skill available to the OPEC countries, either domestically or on hire from abroad, they seem to be reluctant to roll out the welcome mat for the wrong kind of guests where oil and gas are concerned, as is President Putin of Russia. (John Irish (2007), however, seems to think that this might be changing.)

As I have found out over the past few years, the above kind of reasoning on my part has caused quite a few persons to question my competence and perhaps my sanity. “Fruitcake” was one of the delicious appellations directed toward my good self by a young lady. I don’t worry at all about this, because I know that in order to win the energy wars a large amount of publishable and applicable research is going to be essential, and this is one leadership school in which my approach is likely to be tolerated. Of course, I might someday have a reason to reflect on how decision makers like a Former Deputy Assistant Secretary of Energy for Policy in the US would react to the way that I express myself. As he says in the latest IAEE Newsletter, ”oil policy is too important to be left to politicians”. In his candid opinion “Governments are the source and not the consequence of the energy security dilemma; their withdrawal from the marketplace would provide the condition precedent for rational use of oil”. He does not say in this article however that the peak oil hypothesis is hogwash, because although he believes it with all his heart and soul, saying it would cast an ugly shadow over the remainder of his precious thoughts. For this and a few other reasons, it might be possible that we are gradually getting closer to a debate or something like a systematic debate on the future of oil that is free of its long-standing and gratuitous irrationality.

REFERENCES

Adelman, Morris A. and Martin B. Zimmerman (1974). ‘Prices and profits in Petrochemicals’. The Journal of Industrial Economics (June).

Alhajii, A. F and David Huettner (2000). “OPEC and other commodity cartels: a comparison. Energy Policy (1151-1164).

Banks, Ferdinand E. (2007). The Political Economy of Energy: An Introductory Textbook. London, New York and Singapore: World Scientific.

______ (2007). ‘An applicable update on the world oil market’. (Working paper).

______ (2004). ‘A new world oil market’. Geopolitics of Energy. (December).

______ (2001). Global Finance and Financial Markets: A Modern Approach. London, New York and Singapore: World Scientific.

______ (2000). Energy Economics: A Modern Introduction. Boston and Dordrecht: Kluwer Academic.

______ (1994). ‘Oil stocks and oil prices’. The OPEC Review (Summer).

______ (1991). ‘Paper oil, real oil, and the price of oil’. Energy Policy (July/August).

______ (1987). ‘The reserve-production ratio’. The Energy Journal (April)

______ (1980). The Political Economy of Oil. Lexington and Toronto: D.C. Heath.

Crandall, Maureen S. (2006). Energy Economics and Politics in the Caspian Region. Connecticut and London: Praeger Security International.

Davies, Peter and Neelesh Nerurkar (2006). ‘Global energy market trends’. IAEE Newsletter (Autumn).

Duffin, Murray (2007). Comment on Banks, F.E. ‘An applicable update on the world oil market’. EnergyPulse (www.energypulse.net).

Flower, Andrew (1978). ‘World oil production’. Scientific American. 283(3): 41-49.

Friedemann, Alice (2007). ‘Peak Soil: Why cellulosic ethanol and other biofuels are Not sustainable and a threat to America’s national security’. (Parts I, II, and III) EnergyPulse (www.energypulse.com).

Irish, John (2007). ‘SAGIA opens doors’. The Middle East. (May).

Parra, Francisco (2004). Oil Politics – A modern history of Petroleum. London: Tauris

Salomeh, Mamdouh G. (2002). ‘The quest for Middle East oil’. Energy Policy.

Shiller, Robert J. (2007). ‘A shield against the next oil shock’. Forbes (June 4).

Styles, Geoffrey (2007). Comment on Banks, F.E. ‘An applicable update on the world oil market’. EnergyPulse (www.energypulse.net).

Teitelbaum, R. (1995). ‘Your last big play in oil’. Fortune, 30 October.

Yamaguchi, Nancy (2007). Middle East petroleum sector growing in all directions. Petromin (March).

 
 
Authored By:
Ferdinand E. Banks (Uppsala University, Sweden), performed his undergraduate studies at Illinois Institute of Technology (electrical engineering) and Roosevelt University (Chicago), graduating with honors in economics. He also attended the University of Maryland and UCLA. He has the MSc from Stockholm University and the PhD from Uppsala University. He has been visiting professor at 5 universities in Australia, 2 universities in France, The Czech University (Prague), Stockholm University, Nanyang Technical
 

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Comments

July, 20 2007

Len Gould says

Well done. Just when I start to think I can understand some things about macroeconomics, I read a brilliant article like this. Perhaps you might consider an opinion from a lowly generalist, that being that whomever can come up with formulae such as you provide above is likely just as worthy of a Nobel as someone who postulates that elementary particles are comprised of strings. Perhaps the only fault with the formulae is the misssing measure of how much the world economy does not react rationally, eg. are not true markets. My estimation is that in this respect things are getting better and in future economics will/may gain enough precision to take it's place gracefully alongside the hard sciences, writing or peacemaking. Had I a ballot, you'd have my vote.

July, 23 2007

Jeff Presley says

Ferdinand, there is an EPRI conference this summer, stateside, that I tried to finagle you an invitation for, but apparently your reputation precedes you...

I largely agree with some points in your two part article, but believe you've made an error concerning heavy oil's energy content. It is considerably higher, not lower than WTI, which is another kind of error in your discussion. Talking about "the price" of oil when what is REALLY being discussed is the price of a particular type of oil, specifically West Texas Intermediate (WTI).

In point of fact, until they got caught, NYMEX was as guilty as a couple of Chicago commodities exchanges were when the silver market was supposedly being manipulated by the Hunt brothers. Their gyrations aside, the REAL fact is that the commodities exchanges (who shall go unnamed here) sold over 3 million ounces of silver to the Hunts, but could produce only 1 million. The price went so high because they were busy trying to cover their... However, they figured out it would be easier to cry foul. Legally they were more guilty than the Hunts, but history is written by the victors. Silver is different from oil because like gold, in that it is largely traded, not consumed. The Hunts upset the applecart because they were actually hoarding silver against some imagined catastrophe of the American economic system. The fact that it hasn't happened yet, doesn't make them wrong for trying.

Some of the lack of volatility and ready market that you're seeing in those oil futures has more to do with REAL supply issues than whether those 3,000 millionaires wouldn't like to play junior Hunt games. But even if you had every ounce of WTI produced in the world for the next 10 years, you'd have an insignificant portion of the oil production CONSUMED daily. That's why WTI and Brent are useful only as a starting point for contracted negotiations of oil. And those "benchmarks" are well on their way down the production graph, so they specifically will always go higher in price until they are replaced.

That Saudi oil, not being as light and sweet as WTI gets penalized so in point of fact OPEC can't actually cash checks for 30 million bbls / day at today's WTI SPOT price. MOST of the oil they sell is still going for around $40/bbl, and that's why they are intelligently trying to step up the food chain towards higher value products. Whether they can pull it off using imported expertise, given their xenophobia and worse towards outsiders remains to be seen. The home grown talent can't pull it off alone, especially in Saudi because, frankly, they don't like to get their hands dirty. I like their engineers however, they're fine in the clean, air-conditioned office.

And you were hoping I was on vacation ;)

July, 24 2007

Jim Beyer says

Jeff,

Dr. Banks said that heavy oil has a much smaller net energy output. I think this is true, because the processing steps (even after the expensive extraction) require a lot of added energy. I've heard that the Canadians are faced with a tough choice of whether to sell their nat. gas to the Americans or use it to refine their tar sands. Another problem with the tar sands, obviously, is their larger overall carbon footprint, due to their more involved production steps.

July, 24 2007

Jeff Presley says

Jim,

You have a point. Of course in real estate there is a concept called highest and best use. Unfortunately in the economics of energy there isn't an equivalent notion. Some of the extraction methods for heavy oil are third world certainly, and wasting all those heavy oil long chain molecule BTU's to turn that pig's ear into a silk purse (gasoline or lighter) is an unfortunate marketing aberration.

Tar sands bring a whole new element to the table. Suffice to say that the method the Canadians are using is not the only viable method. As far as upgrading is concerned a wise man once said something like, "Using natural gas to upgrade bitumen [heavy oil] is like using gold to make lead".

In all these energy discussions, it pays to have a cheat sheet handy for the conversion factors. Here's one from my bookmarks:

Unit Conversions Page

July, 24 2007

larry vance says

please note that there is a recently patented insitu gasification process for the extraction of kerogen from marlstone that does not require water and is published in the department of energy ( secure fuels from domestic resources) report office of petrolium reserves larry vance ceo earth search sciences

July, 25 2007

Len Gould says

Jeff: You might note that the process Larry refers to, if that's the "Shell" process, involves trading huge quantities of electricity for crude oil. If natural gas to oil is "gold to lead", then what's the shell process.

July, 25 2007

Jim Beyer says

Len,

That seems to be the case. Insitu retorting of marlstone (oil shale) by insertiing electric heaters in drill holes.

FWIW, tar sands seems pretty bad too - 2 tons of sand is processed to get a barrel of oil? Is this what its coming down to, ladies and gentlemen? Plucking drops of oil out of grains of sand?

(I can't help but think of the scene from "The Seven Samurai" where the impoverished farmer spills a bag of rice, and is seen slowly and methodically picking up each grain of rice from the floor).

We gotta get off oil. We gotta.

July, 25 2007

Jim Beyer says

$500,000,000 in electricity per year to produce 100,000 barrels per day. But it's gotta "bake" for 3 years first. I dunno.....

If we ignore the 1.5 Billion dollars in "baking", then that would be 1.37 Million dollars per day (in electricity) to get 100,000 barrels of oil (per day) or about $14 per barrel.

I dunno...... A total non-starter without nuclear power, that's for sure.

If we assume $0.10 per kW-hr, then we are talking 140 kWe-hr per barrel (which is 40x35 = 1400 kW-hrs of raw energy content). I dunno.....

July, 25 2007

Jeff Presley says

The Shell process isn't the only in-situ process. In situ is the way to go, and once my company is out of stealth mode we can tell you more about our method. Shell suffers from a not-invented-here syndrome like a lot of big companies and that is why they are taking the approach they have and filed the largest patents ever filed. The net energy ratio on their process isn't great, but then again you have to heat to ~400C to pyrolyze the kerogen, and that heat ain't cheap. Of course if we were in Russia or many other countries we'd just emplace a nuclear power plant underground there in the Mahogony Basin and cook it "for free", similar to Len's suggestion of how to do nuclear awhile back (with the added benefit of free oil). The plants produce vast amounts of excess heat anyway, why not utilize it? But this is the US, and that oil shale is in Colorado so we know that ain't a gonna happen anytime soon.

Of course there will have to be major economic and political disasters in this country before we do something. Long before then, all those commuters who vote on the left will continue to drive their SUV's 500 miles a week and complain that the government isn't doing what it should. The politicians will continue to utilize armies on misadventures to control oil supplies and, well we've all seen this movie before.

July, 25 2007

Malcolm Rawlingson says

Just a note to Jeff Presley,

This has nothing to do with Mr Banks wonderfully written article but rather to set the record straight on silver.

Not sure where you got the notion that silver was traded rather than consumed? did I read what you wrote incorrectly.

"Silver is different from oil because like gold, in that it is largely traded, not consumed."

As a silver and gold investor of many years now exactly the opposite is true. It is gold that is traded and not consumed. Most of the gold ever mined remains in vaults somewhere on the planet. Most of the silver ever mined has been consumed. Due to its relatively high value significant recycling takes place but large amounts are not recoverd or recoverable at present prices.

For the correct facts about silver consumption and supply I refer all readers to the web site of the Silver Institute. There you will find the rates of consumption for the metal.

For the readers enlightenment and future reference silver is a heavily utilised industrial metal used (in quantities not economically recoverable) in electronics - every cell phone in the entire world has a small amount of silver in it, electrical switchgear, mirror surfaces,photographic papers and emulsions (a declining use), a fungicide and recently in superconducting wire. For the latter use see the web site of American Superconductor Inc.

So, although it is a precious metal it has multitudes of industrial uses and it is very much a consumed metal not a traded metal. In that respect it is much more akin to copper than gold.

Because it IS an industrial metal is one reason why the price has shot up in the last few years to my great happiness and delight. And of course why Mr Warren Buffet bought many tons of it ........China and India need it for their industrial expansion and supply has not kept pace with demand.

Which brings us back to oil and the fundamentals of its price being just like any other commodity.

Knowing the facts about things really does assist in the bank balance department.

Malcolm

July, 25 2007

Jeff Presley says

Malcolm,

Just to clarify your clarification. I didn't go into great depth because it was an aside to make another point. At the time in question, the US refused to allow American citizens to own gold, in fact Hunt Sr. had already had his gold confiscated, as did my grandfather and many others. There were also things called silver certificates in rather large denominations, but that selfsame US government stopped issuing them or honoring them. The government was also accumulating vast quantities of silver at the time for "strategic" reasons. So in fact there was a numismatic use for silver and it was as they say, the only game in town. That was then, this is now.

The key question is when you are trading silver futures are you REALLY expecting delivery of those 20,000 ounces at the end of the term? If not, you and everyone like you is merely a trader, and the exchanges are counting on that behavior when they shortchange the deck.

And by the way, I once worked at the Sunshine Mine, the largest silver mine in the world, so I'm passingly familiar with the subject.

July, 26 2007

Len Gould says

re: "confiscated" - was it really transfered to the treasury without compensation? Or simply requisitioned, eg paid for. Every common useage of confiscate I know of means "without payment".

TheFreeDictionary.com definition of confiscated - Latin confiscatio 'joining to the fiscus, i.e. transfer to the treasury' is a legal seizure without compensation by a government or other public authority.

July, 26 2007

Jeff Presley says

Len,

Let's put it this way. Gold is used as a hedge against inflation for obvious reasons, so if the country prints up a bunch of new value-less paper and forces you to turn in your gold at a valuation that THEY set for the gold versus their worthless paper, it is rather confiscatory. When Nixon went off Breton Woods and our gold standard, things started to go to hell in a hand basket pretty quickly for the dollar. But you were forced to sell your gold for $12.50 per ounce. Considering today's price, how happy would you be selling a few thousand ounces at that valuation? Does this meet your dictionary definition?

If I give you $5 / share for your Google stock, that's fair isn't it, because you're being "compensated"?

July, 26 2007

Arvid Hallén says

Talking about the Shell oil shale technology, wouldn't it be possible to heat the ground with steam pipes instead of electric heaters?

If it was possible the people at Shell should have thought of it, but then, does anyone know why it was discarded?

July, 26 2007

Jeff Presley says

Arvid,

Steam doesn't work because of the heat losses as it goes deeper / further. Also, it is difficult to get steam past 400C, which is what you need for pyrolysis. Some of these deposits are thousands of feet thick, at as much as 1 bbl per ton of rock. That's why there are over 2 trillion bbls of oil in the US, just in the shale. A lot of the statistics critics quote assume ancient methods to get the oil out including mining, crushing and surface retorting. Also, the reserves calculations assume so-called economic recovery but still count on using obsolete technology to recover. That's one of the reasons reserves numbers bounce around. As technology improves, and the price of oil goes up, enhanced oil recovery techniques become economically justified.

The output of oil shale is pretty sweet, the reason it is called kerogen is because it is so close to kerosene. In fact, kerosene was distilled from oil shale long before crude oil was discovered. If I have the time and the inclination I might put a paper up here on the subject. I worked on the oil shale project near Rifle, CO in the early 80's before it was shut down, back in my mining days before I had the bright idea of going into computers instead.

July, 26 2007

Len Gould says

Jeff: What would be the value today of an ounce of gold if every unit of fiscal exchange worldwide were backed by gold? Is it fair that some few who have sufficient reserve assets to afford to own many ounces of gold to double their investment every time the world GDP doubles?

July, 27 2007

Jeff Presley says

Len: An ounce of gold would be worth an ounce of gold.

Gold in vaults doesn't even get moved around anymore, they just change the sign that says who owns it. I don't have the time, nor the inclination to explain mercantilism to you, but here's a beginner writeup on it: Mercantilism

De Gaulle used the gold/dollar exchange rate against the US in the mid 60's, hoarding dollars he'd received because of the Marshall Plan and demanding that they be converted into gold, which he hoarded instead. His actions directly damaged the United State's economic system and he did it on purpose.

I believe it was around that time that De Gaulle famously said, "No nation has friends, only interests". So much for WWII allies

Corrections to my statements previously: it is spelled Bretton no Breton by the time in question gold was up to $35 /ounce, it had been $12.50 when my grandfather had his "appropriated". It was at $18 for a long time, and then $25.

An interesting exercise for the student is to go back 100 years to the present and reprice oil as if it were purchase with gold. In other words, instead of pricing a bbl of oil (WTI) in dollars, convert them to gold, which is what the Saudis liked to do with their dollars for a long time. And realize even today, all oil is bought and sold using dollars (petrodollars) even if for example, Russia is selling oil to France.

So if the price of oil goes up (in dollars) 40%, but the Euro appreciates 40% against the dollar, did oil go up (in Euros)? More generally, if you're making money (in dollars) but dollars everywhere else are worth less, are you really making money?

July, 28 2007

Len Gould says

"if you're making money (in dollars) but dollars everywhere else are worth less, are you really making money? " -- an issue mainl of interest to holders of US $

My point, which you haven't addressed, is "explain to me why should the quantiy in existence of some single precious, eg. scarce, commodity like gold define the sum total of all exchangeable currency in existence? ". Proponents of a gold-backed currency always seem to stop arguing at that point.

July, 29 2007

Jeff Presley says

Len, I'm not a proponent of gold-backed currency, therefore I won't carry their water for them.

I understand why people want to use gold, silver and other precious (ie scarce) commodities to hedge against inflation. If you're really interested in this subject, I recommend you follow the links I gave you and then think about it vis a vis the state of the world economies. I can guarantee if we were all mercantilists, the world GNP would be less than 1/10th what it is, and we'd have had dozens more wars between major powers to get to the gold in the vaults. As any student of history knows, ALL wars are over money/resources.

July, 31 2007

Ferdinand E. Banks says

After reading Jeff's comments, I knew that I shouldn't have taken a vacation, even a short one. Anyway, as William S. said, "the deed is done but not the thought".

About this silver thing, I only heard of Bunker Hunt trying to (foolishly) corner the silver market. Lamar busied himself with his football team. As for this business with heavy oil vs WTI, that's the kind of mistake for which I fail people. The key thing here is the energy obtained in relation to the dollar input. That moves heavy oil well out of the picture for the time being; and Jeff, I hope that you aren't trying to say that there is a left wing conspiracy working to prevent shale from being exploited in the US.

About the conference at EPRI to which I wasn't invited. I ran into some of the folks from that organization at another conference a few hundred years ago. They were singing a silly song about the beauties of electric deregulation, but I straightened them out employing language that was only marginally academic. I can mention that you are correct about General DeGaulle: he did hoard gold and he was not a friend of The Uncle. Incidentally, my favorite headline is one that I saw in Paris when the General left this vale of tears. "Bal tragique a Columby - un mort". (I probably misspelled Columby, which was the General's home town.) Some French scholar out there can provide a translation.

About this making money thing when the value of the dollar declines relative to the Euro, although the price of oil increase. I dont know about you but I would make money, because I would transfer my spending from the Euro to the dollar area, or for that matter to economies who priced their goods and services in dollars.

Fred

August, 03 2007

Jeff Presley says

Fred, I'd debate you, but you're so darn easy. :) My points all stand as stated, although I could have typed parts a bit better, was in a hurry. The BTU's in long chain molecules are substantially higher than short ones ergo heavy > light AND I provided a link. Yes, it is difficult (read expensive) to extract heavy oil because of its viscosity, but it is also difficult to extract light oil from 20,000 feet below the sea. Dollars are dollars and by the time you factor them ALL into the equation things aren't so different as you imagine. Give me a failing grade if you like, teachers like you were why I left college in the first place. Out here in the real world however, the only failing grade is failing to succeed, something you cannot accuse me of. Keep your letter grades, I'll keep my greenbacks (and equivalents) thank you very much. :)

The point about silver had to do with the machinations of the options market, you just regurgitated the "party line" about Bunker, I gave the back story.

Jeff, I hope that you aren't trying to say that there is a left wing conspiracy working to prevent shale from being exploited in the US Again my friend, you're all too easy. ;)

About this making money thing when the value of the dollar declines relative to the Euro, although the price of oil increase. I dont know about you but I would make money, because I would transfer my spending from the Euro to the dollar area, or for that matter to economies who priced their goods and services in dollars.

Um, this is why I don't trust economists with my money. Long Term Capital Management notwithstanding, this is NOT the way money works. If you could have invested your Euros at 5% for a year, but instead cash them in on dollars at a 40% discount, invest those dollars at 20% but the dollar depreciates another 20% against the Euro, have you made any money? I leave this as an exercise for those students passingly familiar with algebra.

Theory only gets you so far, then reality rears its ugly head.

August, 04 2007

Ferdinand E. Banks says

Jeff, you came to the wrong forum to make a statement like the following ":... it is difficult to extract heavy oil because of its viscosity, but it is also difficult to extract light oil from 20,000 feet below the sea." That's the kind of deep observation that you make at your local disco in order to get the attention of the airhead in the short dress at the next table

Of course, I know that you're trying to take advantage of me, talking about equations and other animals, while knowing that I failed college algebra not once but twice thank you, and the dean of engineering pronounced me completely and absolutely hopeless. As for not wanting to trust economists with your money, I think that you're very wrong there: every economist that I've met - and just about everybody else for that matter - has more money than I do.

I will give you credit for one thing though, by which I mean your talent an an arbitrageur. Unless I'm mistaken, there will be a shortage of arbitrageurs in Afghanistan after the next poppy crop comes in. Why don't you go over there and give thim a little help.

August, 05 2007

Jim Beyer says

Scenario 1: Eurodollars at 5%. After one year, your total is 1.05E (assuming simple interest)

Scenario 2:

1E => 1.667D (convert to dollars at 40% discount)

1.667D => 2.0D (invested at 20%, again assuming simple interest)

2.0D => 0.96E (converted back to Euros at 48% (60%x80%)

So, you are better off sticking with the Euros.

Don't worry Fred, I got your back.......

August, 05 2007

Jeff Presley says

Uh thanks Jim, you just backed ME up, so I guess you got MY back. Fred wanted to convert to dollars in a falling currency exchange situation, he was wrong as you so eloquently demonstrated. :)

Just cause I don't always agree with Fred, doesn't mean I don't like the guy, in fact I think he's a great writer and livens up any conversation with his witty asides. If we're ever in the same place at the same time, I'll even buy the drinks. I bet he's just a party animal. ;)

August, 05 2007

Ferdinand E. Banks says

Jeff, I think that I'll let you slide this time, but if you are really and truly curious as to what is happening in this oil price game, go to the nearest library and tell them I said that you should be allowed to look at the recent issue of Newsweek in which they discuss what those rapidly depreciating dollars are doing for the Middle East.

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