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.
“.......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.
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