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Oil and the Future
On oil I will make one point adding and one point detracting from Tyler's analysis. First, on speculation remember that demand and supply are both very inelastic so relatively small changes in either can make a big differrence. That means that speculation, if that is what you want to call it, can shift prices a lot without being very significant in total demand. Because of this point Krugman's analysis is quite right for iron ore but a little off for oil - indeed Krugman's analysis of oil is difficult to square with his analysis of the California electricity crisis.
My disagreement with Tyler is an agreement with Caplan.
Bryan Caplan notes that commodity prices always have fallen back down in the past and argues that is likely to happen again in the future. I say no, the current price is your best (rough) estimate of scarcity (adjusting for storage costs), don't expect mean-reversion, future returns (but not prices) are a random walk, and extrapolation is a dangerous method to apply to financial time series.
No, two points. First, commodities are not stocks and nothing need be a random walk. Imagine, for example, that you can produce 10 units of commodity X but no more (fixed production). Thus you produce 10, 10, 10.... Now you know that a big technological innovation is about to increase production possibilities to 20, 20. 20..... Does the price today necessarily fall? No. Price today is determined by supply and demand, supply is fixed and if substitution across time isn't very easy (you still have to get to work today, right?) then demand doesn't have to fall much with expectations of future supply. Thus the price is high until it drops, even if everyone expects the drop.
Finally, on oil - who really cares what the price is? The issue is energy, not oil. I am confident that the long run price of energy will fall.
Posted by Alex Tabarrok on June 27, 2008 at 08:54 AM in Economics | Permalink
Comments
"Finally, on oil - who really cares what the price is?"
Short term (next few years), you're kidding, right? Long term (when we have cars capable of returning >40 mpg), I might agree with you. There aren't many that do right now though - in the US, anyway.
Also, isn't this statement:
First, on speculation remember that demand and supply are both very inelastic so relatively small changes in either can make a big differrence.
completely at odds with this:
Imagine, for example, that you can produce 10 units of commodity X but no more (fixed production). Thus you produce 10, 10, 10.... Now you know that a big technological innovation is about to increase production possibilities to 20, 20. 20..... Does the price today necessarily fall? No. Price today is determined by supply and demand, supply is fixed and if substitution across time isn't very easy (you still have to get to work today, right?) then demand doesn't have to fall much with expectations of future supply.
Doubling oil output (per your example) wouldn't drop prices?
Posted by: meter at Jun 27, 2008 9:04:04 AM
Alex, your detracting point is wrong! You're responding to the view that prices are a random walk and that is the view that Bryan (incorrectly) describes. I wrote very carefully: "future returns (but not prices) are a random walk". Your counterexample thus does not detract. And empirically speaking, changes in commodity prices are on average permanent.
Posted by: Tyler Cowen at Jun 27, 2008 9:05:16 AM
The problem with this quote is physics:
Finally, on oil - who really cares what the price is? The issue is energy, not oil. I am confident that the long run price of energy will fall.
In most cases, when economists look for falling "commodity" prices they are looking at substitutable goods. Energy is a fundamental category, and there is no reason, after consuming the low-hanging fruit in the category (oil gushers) that we should suddenly find something else hanging even lower.
I mean, it's possible, it would be nice, but it is not guaranteed by the laws of nature.
Posted by: odograph at Jun 27, 2008 9:08:59 AM
meter,
Reread that paragraph again and take especial note that the word "today" was used three times for a reason.
Posted by: at Jun 27, 2008 9:10:57 AM
Reminder: The 1927 Ford Model-A got between 25 and 30 mpg (wikipedia). Why do so many cars to day get basically the same mileage? Physics.
Posted by: odograph at Jun 27, 2008 9:12:24 AM
OK, get the point now.
Posted by: meter at Jun 27, 2008 9:36:03 AM
The first thing to remember when one considers petroleum prices is that we are really buying a certain amount of travel at certain level of comfort and prestige. So there are many possible substitutes and even a change in attitudes toward prestige can reduce the amount used. If saving petrol becomes cool no telling what can happen. (see the BMW c1 200)
So my bet is that though petroleum prices may not return to the mean what we really buy most likely will (this is a 60%/40% for me).
Posted by: Floccina at Jun 27, 2008 9:41:35 AM
Oil will stay at the +$100 level for the near future simply because demand is growing and supply is not. Around 90% of the world's oil production is now owned by foreign governments, not big oil, who are in no rush to expand capacity. Even if they wanted to expand aggressively it would be a few years for anything to come on stream as they have under invested for so long and as a state owned enterprises are a pit sluggish to do anything. The only thing that will drive down prices is demand destruction. Yet there has been around 1mn bbl demand destruction in the US. But unfortunately this "extra" supply is being taken up outside the US. Between China and India you have 40% of the world's population that now want to live like the US and Europe. From this 70% of the demand growth is for transportation. Thank goodness you can't get auto financing in China otherwise we would be in worse shape.
As far as "speculation" in the fiancial markets is concerned, yes financial investors are there but it is misslabeled. It is not speculation it is hedging. Being in the industry I can tell you all that the common thought right now is that the performance of every investment is becoming tied to oil. If you look through periods of high commodity price growth the only industries that perform are materials and energy. So knowing this as a money manager why would I not have significant exposure to oil? (Warning, gratuitous bragging to follow) My investors may be spending more at the pump but at least the are benefiting in their retirement accounts as I am outperforming the S&P by 6% this year so far and 10% last year. But the fact is that I and others are not going to pull out until we no longer feel that rising oil prices are a threat to the economy.
On a personal note however I hope that oil stays at this level. Longer term it will slow urban sprawl. And at $100 a bbl the economics of all these green alternative energy options actually work now. If all the wind farms that are being planned in the US right now come to fruition by 2020 or so we will have 20% of our generating capacity from this source. T. Boone Pickens is planning a 4,000 MW wind farm in West Texas. It is literally a gold rush right now in alternative energy. All the billions of dollars that was made in the tech bubble of the '90s is now rushing into the alternative energy industry.
This massive investment in energy substitution will have a result of eventually bringing oil prices back down. But this will probably take at least 5 years for a lot of this stuff to come online in a big way. So in the mean time we either have to live with oil at this level or higher, or we will see a sizable global recession to0 bring down global demand.
Posted by: asiequana at Jun 27, 2008 9:45:48 AM
f all the wind farms that are being planned in the US right now come to fruition by 2020 or so we will have 20% of our generating capacity from this source.
How many windmills can I put on the roof of my car/truck?
Hehe.....
Posted by: J at Jun 27, 2008 9:52:31 AM
If oil prices stay at this level in about 5 years, maybe less, you will be able to buy a truck that is a PHEV and pay around $1.00 a gallon equivalent at least for the first 40 miles. And that electricity could come from a windmill. In the meantime your screwed unless you can carpool, walk, take public trasportation, ride a bike or buy a more fuel efficient vehicle.
Posted by: asiequana at Jun 27, 2008 9:59:43 AM
Battery technology is another category we have hopes for ... but we have been making electric cars for more than a hundred years now ... and we are a little stuck. Low cost electric cars resemble golf carts, and heavier, more conventional electric cars carry a $40K+ premium over the gasoline equivalent.
We may have a breakthrough, and I am cautiously optimistic, but I'm not going to count these chickens before they hatch (any more than I would for hydrogen cars).
Note: The physics batteries have to overcome is "energy density." Cars require a lot of energy to push, which is why we've used as explosive and dangerous a fuel as gasoline. Pack in as much stored electric energy and you face similar problems ... well, see exploding laptops and cell phones.
Posted by: odograph at Jun 27, 2008 10:07:54 AM
Supposedly iron phosphate chemistry significantly reduces the risk of explosion. My understanding is that with the next generation of technology currently being commercialized a lot of the issues with energy density and cost are significantly improved (see A123systems). Up until the last few years, how much money and serious effort have gone in to developing a workable lithium ion battery for transportation applications? There certainly are some interesting lab proven advances right now that have the potential to be commercialized in the coming few years too push the efficiencies up even further.
Also the conventional lithium ion battery used in the Tesla Motors roadster, which is an all electric car, is supposed to cost about $20k and give you a range of about 220 miles. But we don't necessarily need to go to full electrification. Most trips people take are less than 40 miles so a PHEV would suffice for this. Therefore the battery cost wouldn't have to be as significant.
Posted by: asiequana at Jun 27, 2008 10:31:57 AM
Alex,
You neglect to add that the forward market for oil should, however, reflect this increased supply with a lower forward price - that's if the market, on average, believe's that an increase in supply will occur. With no ability to sunstitute demand across time, a buyer of oil must still pay the higher price for current demand, but they can benefit from the current BELIEF in higher supplies by locking in cheaper forward oil.
Further, one of the key misunderstandings which I believe is common to much commentary on this subject is in the nexus between speculation and fundamental supply/demand. Speculation by buying spot delivery oil, storing it, and hoping to sell it at a higher price (or locking in sales at a higher price on the forward market) IS part of the fundamental supply-demand balance for oil, but this kind of speculative activity is very limited as it requires a level of interaction with physical oil markets (and storage markets) which most financial institutions don't have.
Most speculation involves buying and selling forward or futures contracts for oil, and reversing the position before physical delivery takes place. Saying that speculative buying of forward contracts for oil ADDS to demand for oil is wrong. The price of forward oil contracts (collectively the oil curve) reflects the market's current best estimate or forecast of future physical supply/demand balances - the market is in contango between now and winter, reflecting expectations that supply will be reasonably static while demand will increase seasonally with colder temperatures etc. Buying and selling of forward contracts reflects the supply and demand of different FORECASTS of the future physical balance (It's probably more accurate to say supply and demand of CONVICTION in different forecasts, but this sounds a little esoteric). Some market participants act on a new forecast (or an increased likelihood of one forecast being correct) because they are buying or selling for future physical use and the risk to their wider business model of a particular forecast being correct makes the current forward price compelling to buy or sell. Speculators simply generate or believe a different forecast and act on it, expecting that forecast to gain wider market acceptance with time, thus moving the market in their favour.
Regardless, the forward curve at all times remains the best (or average) forecast of the price which will balance of future supply and demand.
Posted by: Patrick Gillett at Jun 27, 2008 11:11:31 AM
I've been watching those same developments asiequana, but for me the chicken is hatched when the product is on the market with a real price.
By that measure the Tesla is still iffy ... not yet in full production ...
Tesla Motors says its new powertrain, developed to meet the company’s original promise of 0 to 60 mph in about 4 seconds, will be ready around August.
http://www.greentechmedia.com/articles/tesla-powertrain-powers-forward-939.html
Posted by: odograph at Jun 27, 2008 11:42:56 AM
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Posted by: Steve at Jun 27, 2008 11:47:50 AM
Your opinion on whether speculation or fundamentals are driving the price boils down to whether you believe oil is running out or not. Those who think we can still find and extract sufficient oil for all our demands in the near and middle future believe the problem is speculation.
Those who think peak oil is here or past, believe it's fundamentals. The rest of the verbiage is just that - verbiage.
One thing is for sure - if you're in charge of SA or Russian oil production, and you know you're sitting on a finite resource, and you can sell it for $140/b, why would you pump faster to get a lower price? Why would you ever let the price drop below that?
If demand declines, pump slower to keep the price up. That way you maximize the revenue from your finite resource.
Anyone who forecasts a return to gas much cheaper than we have now (regardless of the reason why it's priced what it is) is dreaming.
Posted by: foo at Jun 27, 2008 12:19:25 PM
But the problem you mention odograph is developing a new two speed transmission that would deliver the 0-to-60 spec that was promised. The batteries are off-the-shelf and costs and performance are already a known quantity. Even so my understanding is the transmission issue was largely solved and they just need extra time to ramp up the production given the delay.
Posted by: asiequana at Jun 27, 2008 12:22:15 PM
Odograph and asiequana IMO the best hope of battery car right now is Firefly energy. They claim the performance of nickel metal hydride batteries at one fifth the cost. Nickel metal hydride batteries have just enough energy density for plug-in hybrids.
Asiequana even if all the current players in market see restricting supply as a benefit any new players will want to produce as much as soon as the can. New players could include coal to liquid and gas to liquid. BTW currently the coal interests claim regime uncertainty concerning AGW as the reason they are not building CTL plants.
From what I understand some people are converting their vehicles to run on natural gas. If enough people do this and price of natural gas rises we could also see coal to gas (gas from coal used to be called town gas).
Posted by: Floccina at Jun 27, 2008 12:34:32 PM
foo wrote:
If demand declines, pump slower to keep the price up. That way you maximize the revenue from your finite resource.
But you risk a new technology (like firefly's batteries and many other possibilities) that could kill the value of your asset.
Posted by: Floccina at Jun 27, 2008 12:38:13 PM
Floccina,
Who knows what technology will win in the end. But the number of potential new technologies and companies that are popping up all over the spectrum of energy generation and distribution is really unbelievable right now. This is why I am longer term bearish on energy prices. All the competing technologies mean that it will drive the industry to innovate very quickly and drive down prices. Also as we are holding out hopes for technological innovation to solve the energy problem we need lots of potential alternatives because developing new technologies is a bit of a crap shoot. The more chances we have to find a solution the more like it is that we will be able to solve the problem.
The Saudis are afraid of exactly such a scenario as technology collapsing the price of oil again and have made public statement to this effect. They would increase production if they could but the problem is that they can't. They are running out of oil and I would be surprised if they actually are able to deliver the 200k bbls they are promising. Unfortunately they are 10% of global production. They are also probably significantly exaggerating their reserves but there is no way of really knowing for sure.
Posted by: asiequana at Jun 27, 2008 1:01:41 PM
My first post here - be gentle.
"T. Boone Pickens is planning a 4,000 MW wind farm in West Texas. It is literally a gold rush right now in alternative energy. All the billions of dollars that was made in the tech bubble of the '90s is now rushing into the alternative energy industry."
He has only ordered 1,000 MW of equipment so far, with the 4,000 MW figure planned for 2014. We need to remember two points when talking about this project - (1) it's economical only because of federal tax credits, and (2) the 4,000 MW figure is nameplate capacity only. Actual production is usually only 1/4 to 1/3 of the nameplate, as the wind doesn't always blow strongly enough much less 24/7.
I know several people trading oil on the NYMEX floor, having traded it myself in the past, and they universally agree that the investment money flowing into oil futures is pushing prices up. When you have a market with buyers and sellers in rough equilibrium, and then add a huge number of players who buy but never sell, there is only one way for prices to go. They tell me that speculators (including themselves) who might want to go short are afraid to do so, in fear that new orders to buy 50,000 contracts will hit the floor/screens and prevent any downward price movement. In the short term, traders are spooked and see massive demand destruction as the only way prices could fall even by relatively small amounts. In the long term, alternative energy technologies and new production (Brazil, Equatorial Guinea, etc) will help, but until then there will be huge wealth transfers to the oil-producing nations. Pumping existing reserves faster doesn't work, because once you hit the right production level, getting an extra million barrels out today means that you lose more than that in the future. Maintaining the right field pressures is a delicate thing, and getting it wrong cuts recovery totals.
Re the "10, 10, 10, 20, 20, 20" example, prices will not drop to fully take the production increase into account, as the new supply can't be used now. The only thing you can do is run down inventory levels ahead of the price drop, and stocks aren't so high that that can affect price to any great degree. But if demand were to go "10, 10, 10, 20, 20, 20", or supply were to go "20, 20, 20, 10, 10, 10", then you will see an immediate impact, as you can store supply now (thus reducing current supply) in anticipation of higher prices. Peak oil fears play to the supply side, and China and India fears play to the demand side of that.
Put all this together, and you have $140 oil.
Posted by: djc at Jun 27, 2008 1:07:42 PM
djc,
What you say about NYMEX traders is interesting because the data I see is that short interest is close to long positions so that it's mostly a wash.
One the windmill stuff I have a close relative who is a senior manager at a firm building wind farms. The information I am getting is that they don't need subsidies anymore to get the projects to work but it depends on the price of electricity in the state. I think Texas rates are lower than national average of something like c10/Kwh. Also the land grab for the most productive sites is about done and the projection of 20% of total generating capacity is based on the assumption that most of these projects get done, which may or may not actually be the case. Regardless the ramp up in generating capacity via wind is certainly accelerating rapidly for now and who knows what else we will get from the various other alternatives.
Posted by: asiequana at Jun 27, 2008 1:20:36 PM
Tyler,
I wrote carefully also, vis "commodities are not stocks and nothing need be a random walk," that includes returns. In the example I gave, return are not a random walk.
Alex
Posted by: Alex Tabarrok at Jun 27, 2008 2:37:09 PM
"I am confident that the long run price of energy will fall."
um, what was that saying by keynes again?
Posted by: glory at Jun 27, 2008 4:37:59 PM
Alex,
I am confused about what investment you are making in your example - for which the return is not random. Is it buying oil now, storing it until after supply (almost certainly, as per the example) increases, and then selling it? This strategy does return a non-random, negative, return. If there is a forward market whose participants are also aware of and believe in the future supply increase, the strategy's negative return can be made 100% certain by selling the oil in the forward market at the lower forward curve price.
In this case the speculator has made a risk free investment in oil (albeit one in which they are locking ina negative return). Their risky, rather more random-return investment has occurred earlier - when they invested in buying storage capacity and then waited for an opportunity to invest in spot oil for future sale.
Or is it an investment in a forward oil contract - buying or selling a contract for delivery of oil at a time after the supply increase? If this supply increase (and it's price effects) are absolutely certain, then yes there will be a non-random return from this strategy. However in a more realistic scenario, in which the prediction of a supply increase is just that - a prediction - the return will be more random. Believing the prediction, you may sell the forward oil contract today. Tomorrow, new information may become available affecting your belief in this prediction, and your and other market participant's view of the future price. The continual change in information and forecast prices, until the contract delivers, generates volatility in the price walk.
Btw I say "more" random as I don't believe that all financial instruments follow completely random walks. There is almost always an element of uncertainty but sometimes clear probabilities of a move in a certain direction.
Posted by: Pat Gillett at Jun 27, 2008 5:01:56 PM
