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With oil at $140 a barrel, can you still love Julian Simon?
Remember Julian Simon, the guy who argued that resource prices would fall, fall, fall in real terms? I loved spending time with him and to this day he remains an underrated economist. (By the way, the very first piece I ever wrote was a guide to using Julian Simon for high school debaters.) But can we still advocate his major thesis?
The possible belief space includes the following:
1. There is still a good chance that future resource and oil prices will fall dramatically, so Simon should not be dismissed. Still, the single best estimate today can be inferred from the current market price, which implies a good chance that resources will get more expensive.
2. Simon is right and futures markets currently indicate that the price of oil is expected to fall dramatically.
3. Simon is still right, the rest of the world is wrong, and betting on this is how I will get rich.
4. Simon is right but current markets don't allow us to bet on his major claims. Futures markets extend for only a few years' time, not for say the twenty years or so that are needed to validate his prediction.
4b. The deliverance of plenty is truly far away and no one is willing to take those margin calls for the next 187 years; in this scenario the present expected value of the future improvement is pretty low.
5. Simon is right but nominal interest rates will soon fall so low that successive short selling of oil in the futures market won't yield supernormal returns. (This can mean, for instance, that you'd rather lock up all your money today at the higher rates, rather than short selling.)
No way does #2 work, though there is often slight backwardation in the futures price. I've never heard anyone argue #5 and indeed most people haven't even thought of it as an escape hatch. My belief is closest to #1. Bryan Caplan argues for #4 but Arnold Kling shows that doesn't fly. If you're always rolling over a successively renewed short position in the futures market, sooner or later the price decline for oil will yield you supernormal profits; in the meantime your margin deposit is earning the rate of return on T-Bills, noting that you must buy into the new contract cycle before your old contract expires so as not to miss the window of opportunity. OK there is margin call risk, etc. but if Simon is right that is small relative to your potential gains.
(Alternatively you might argue that if you are in contract cycle #3, the good news will arrive to affect the pricing of cycle #4 before you can buy in, adding on that even after the future good news is announced the MC curve is so steep that you don't gain much on contract cycle #3. That's possible but a) ex ante you still have supernormal returns since it may not work out that way, and b) the reality is that huge good supply news, whether for oil or some other energy source, would lead to lots of pumping today and a plummeting oil price right away.)
I invite Alex to accept #1 or otherwise indicate his stance.
It's amazing how much, on this issue, some people resort to what can only be called technical analysis -- inferring future price movements from past trends -- when they would scoff at that approach in almost any other context. It's OK to argue that belief #3 held for most of world history --before we all read Simon and perhaps before there were futures markets in oil -- but I want to know if you are betting on #3 today and if not why not and also what other ways there are to get very rich that you can tell me about (does only the oil market malfunction so?).
I'll also note that current oil prices hardly suggest (do click on that link) a level of bone-crunching, civilization-ending scarcity, so you can believe in #1 and still be an optimist overall, as indeed I am. I'm just not nearly as much of an optimist as I was when oil was $10-$20 a barrel, wasn't it even $8 a barrel for domestic oil less than ten years ago?
Also on belief #4 note that: forward contracts allow for longer bets than do futures contracts, contract length is endogenous to important events (though synthetic contract positions mean we don't need all of the possible longer term contracts), and it is odd for libertarians -- combinatorial prediction market fans at that -- to suddenly cite missing markets to defend their broader position.
Addendum: Oh, yes, there is one more option. I call it "#3 is correct but my wife won't let us get rich." I'll say this in response: for all the virtues marriage has for men, when you look around and study it more closely, you'll find the institution has even more virtues than you had thought.
Second addendum: Here is Jeffrey Sachs on this topic.
Posted by Tyler Cowen on June 30, 2008 at 06:18 AM in Economics | Permalink
Comments
The amount of energy available is nearly limitless. The amount of energy a person can use is also nearly limitless. We are figuring out technology to promote the latter faster than the technology to extract former. We used to not use as much energy (before we developed capitalism and stumbled on fossil fuels). We know how to go back, we just don't know how to maintain trend growth with it.
Buffett became satisfactorily wealthy partly by practicing "time horizon arbitrage." Markets are short-term oriented. Prices have to come down. Will they come down due to technological progress or due to growth grinding to a halt? I think high energy prices are just the victory lap for globalization.
Btw, price trends do contain information, just not the type a lot of technicians try to impute to it. I'm surprised that some people are using TODAY's volatile spot price to impute profound information. ;)
Posted by: Andrew at Jun 30, 2008 7:30:24 AM
Kling's response to Caplan is wrong-- the first commentor, JPC, points out why.
Posted by: mpkomara at Jun 30, 2008 7:51:24 AM
How to get rich:
A la Julian Simon, issue a challenge for a wager to Al Gore. The money is in the terms, not the outcome. He's a politician, you will own him on the fundamentals and he'll overcommit in order to signal his dogma. He won't even care.
Posted by: Andrew at Jun 30, 2008 7:52:14 AM
There's another option.
I'm not emotionally strong enough to be able to withstand the cost of taking small losses for several years in a row in hope for a big win later. Losing is emotionally too costly for me that I would start in such a business.
Read more about this approach in the Black Swan, if you're interested.
Posted by: Mikko at Jun 30, 2008 7:57:41 AM
Tyler, you obviously know a lot more about Simon than I, but I always dismiss any theory that feels permanent and inflexible regarding changes in preferences, technology, resources and markets. Thus, I have always lumped Simon in with Karl Marx (permanent instability of capitalism), free banking backed by gold is best people (von Mises thought it was a good idea, so it always will be, and other related theories. Essentially, any idea that people must take on faith feels more like religion to me than economics. I sympathize with #1.
Posted by: liberalarts at Jun 30, 2008 8:10:34 AM
I'm curious: Would the current market price in 1980 have correctly predicted the outcome of Simon's wager with Paul Ehrlich?
Incidentally, isn't this the same type of environment in which Simon made his original bet? Gas prices at inflation-adjusted records, commodity prices booming...This would be a great opportunity to make a series of new bets. In 2005, John Tierney bet Matthew Simmons that the price of oil would not average over $200 (in 2005 dollars) by 2010. www.nytimes.com/2005/08/23/opinion/23tierney.html
Posted by: Patrick McMenamin at Jun 30, 2008 8:17:40 AM
Since the oil supply is largely controlled by a cartel, are other commodity models applicable? I wonder if a large amount of the price increase in oil is due to the cartel's desire to affect politics in the United States. Of course we also know that much of the cost of oil is due to the dollar's devaluation.
Posted by: Neil West at Jun 30, 2008 8:28:03 AM
Snake oil gets no cheaper.
Posted by: dearieme at Jun 30, 2008 8:33:42 AM
you are missing an important option:
*Julian Simon was right and resource prices are falling in real terms, but the dollar is falling in value.
(anyone naive enough to believe that adjusting for official CPI transforms data into "real" terms can go to bed while the adults talk)
Posted by: Julian at Jun 30, 2008 8:42:39 AM
A few thoughts/questions on this ...
1. Must Simon be proven correct on each and every item for his views/points to be considered legitimate?
2. Is it possible that the market for oil is so horribly distorted by governments, politicians, and environmentalists that this is all an unreasonable comparison?
3. Is it possible that we need to look at long-term trends, not the last 12 months? How do we define 'long-term?'
I'm very interested in everyone's thoughts,
Chris
Posted by: Chris Meisenzahl at Jun 30, 2008 8:44:36 AM
Why am I not surprised!
Imperialism and mercantilism ruin the economy of the US, triggering a worldwide economic crisis and the closet socialists bring out the old malthusian arguments to attack consumerism/capitalism/whatever.
Guess what their recipees will be? that's right: more imperialism, mercantilism and authoritarianism. Damn you Tyler! You've sold your soul long ago and you're not even subtle.
Posted by: andrewlehman at Jun 30, 2008 8:51:47 AM
Your data is on oil today, but Simon talked about resources overall across time. Why not just accept high future oil prices, but low overall resource prices?
Posted by: Robin Hanson at Jun 30, 2008 8:54:58 AM
I am absolutely amazed. How can people talk about information contained in prices without even mentioning monetary factors?
Isn't supply and demand of money half the story behind every price?
I guess you americans just take the dollar for granted.
Posted by: confused at Jun 30, 2008 9:04:28 AM
I largely agree with "Julian" above, as well as Robin Hanson here. You've left out one option, the measurement/dollar issue.
A) Simon didn't say (if I recall) that any given commodity would *never* have spikes above real term increases; B) measurement (CPI, dollar-terms, etc., etc) is key and taking short term measures of these will get it wrong - frequently; and C) oil or any one commodity is not what Simon was referring to, but a basket of all meaningful commodities.
In truth, I think the likelihood is that energy will be (and probably still is, and will probably remain so even if it goes up in price substantially) the one commodity most likely to remain below real term prices over the long term. Energy is one of the few commodities where there is continual input (solar energy to earth).
This isn't necessarily at odds with parts of Malthusian theory, or at least somewhat adjusted Malthusianism. Like natural population predator/prey fluctuations, if there was serious scarcity, some large-scale death event would probably take place, massively reducing demand again, but leaving most of the productivity/technological gains.
Posted by: Greg at Jun 30, 2008 9:09:17 AM
Tyler, in Caplan's assumptions, rolling over a short position in a futures contract would earn you no profits once the other participants "catch on" in one year's time.
Posted by: mpkomara at Jun 30, 2008 9:10:47 AM
People, people, people! Not many of you are stating a number from my list of beliefs or admitting that you will get rich. On the money side, the low dollar is one factor but it doesn't account for the leap from $10 a barrel to $142 or so a barrel. Robin's point is correct but of course most other resource prices are very high now as well. My parenthetical remarks covers JPC's criticism of Arnold as well as mpkomara's point. And I'm totally against mercantilism and write frequently as such, I simply don't want to stretch the facts to make mercantilism look bad.
Posted by: Tyler Cowen at Jun 30, 2008 9:15:00 AM
I would love to build a coal-to-oil plant and get rich selling oil at a huge profit, but the EPA won't let me.
Posted by: Alex J. at Jun 30, 2008 9:27:36 AM
I am told by the Fed that oil prices are so volatile in the short run that changes in oil prices should be excluded from inflation statistics when determining macroeconomic policy. If I accept the Fed's reasoning, why would I take a one-period market-implied prediction of future oil prices (derived from the current period as opposed to last year's) as proof-positive that resource prices (not just oil) will be higher in ten years than they are now? Tyler, please add
#6, Short-term volatility in energy prices will make Simon look wrong for some periods over the ten-year span of a new bet, just as the same volatility will make a new bet look correct for some periods. As it happens, Simon was correct for the ten-year span of his bet. Only time will tell how a new ten year bet would play out, but you get better odds if you bet that the real price of oil will be lower ten years from now.
Posted by: evm at Jun 30, 2008 9:41:51 AM
Oil has bee going up in euros as well. Not quite as steeply, but oil prices are still higher.
One could point out that oil bottomed when they had "Oil $5/barrel?" on their cover. My guess is the peak will be when they have "Oil $200/barrel?" on their cover.
Posted by: Mo at Jun 30, 2008 9:45:22 AM
Here's how to get rich:
1) Convince someone who is jinxed (like me) to go long on oil.
2) Go short on oil.
The jinx will cause oil's price to collapse and you get rich.
Anyone want to make informal promises about what you'll give me if oil's price goes down? That *might* cause me to go long...
Posted by: Person at Jun 30, 2008 9:53:12 AM
I don't think Simon ever suggested that this would apply for every single commodity all the time. If the commodity is "energy", not oil specifically, there is no doubt what so ever in my mind that it will be *a lot* cheaper in a hundred years compared to today. But what will happen with the oil price specifically? No idea, don't care, don't think anyone else should care much either, as long as energy prices decline. So put me down as 1, but note the long time horizon. (If Simon ever said anything about short time spans, put me in the "well, he is wrong" category. I don't think he said that, however.
3 & 4 are possibly right in theory, but definitely wrong in practice. The market can stay irrational longer than you can stay solvent.
Posted by: Joe T at Jun 30, 2008 9:53:24 AM
Using the CPI-U, the price of WTI is currently around $157 per barrel in December 2005 dollars. It averaged $64.97 per barrel during August 2005, when Tierney and Simmons made that bet. There's still a lot of time between now and 2010 - I wouldn't count Simmons out yet.
Posted by: Kyle S at Jun 30, 2008 9:55:33 AM
Bah.
Oil is still the same price as 10 years ago in gold. Just this fact should make you rethink your premises.
Posted by: HUMBUG at Jun 30, 2008 10:09:37 AM
Lets see: War in Afghanistan, War in Iraq, looming war in Iran.. these wouldn't be factors on a commodity with 60% of the world's supply in the middle east?
sometimes it doesn't have to be so complicated...
I still think Julian is mostly right.
Posted by: pointobvious at Jun 30, 2008 10:21:31 AM
I'm not sure where Simon would come down on this, but what I really dislike is the blithe optimist who (referencing Simon) says we have no need to shepherd resources.
Resources are not equal, and some of the substitutes are inferior.
(I think oil is something we should be conservative with, but we've also obviously wreaked havoc on our wild fish stocks. Would Simon himself consider battery chicken a substitute for wild Cod or Salmon?)
Posted by: odograph at Jun 30, 2008 11:01:54 AM
To answer Tyler's historical fact question, I recall that the price of oil went below $10 in nominal terms in about December 1985 or December 1986. I don't think it ever hit $8. It was always $9 or above.
Best,
David
Posted by: David R. Henderson at Jun 30, 2008 11:08:02 AM
1. My reading Simon he really only says that life will improve. As for as resources he uses the word effective meaning the amount of the resources that is used effectively will increase. In this case miles driven a given level of comfort will get more affordable. Thus in his model more efficient use is an increase in the effective resource.
2. Is it not true that petroleum is getting more affordable to more people despite the rise in price (see China and India).
3. It is a principle and not a guarantee, in general in the long run things will get more affordable to more people. For example the fact that lobster used to be cheap does not mean that Simon was wrong and by extention he is not wrong now.
Posted by: Floccina at Jun 30, 2008 11:08:59 AM
BTW A cheap battery that performs as well as an NMH battery could allow for much more driving.
Posted by: Floccina at Jun 30, 2008 11:30:15 AM
"I don't think Simon ever suggested that this would apply for every single commodity all the time. If the commodity is "energy", not oil specifically, there is no doubt what so ever in my mind that it will be *a lot* cheaper in a hundred years compared to today."
Well-stated! Exactly what I was poorly trying to get at with my earlier comment.
Posted by: Chris Meisenzahl at Jun 30, 2008 11:44:51 AM
Oil price may never come down, but that's not relevant. Energy cost and transportation costs are the important things, and they will continue to decline over the long term. How much would it cost to buy a bbl. of authentic whale oil nowadays?
To make your fortune, invest in industries that will benefit* from low energy and transportation costs: shipping, travel, tourism, etc.
*Don't forget most profits from innovation seem to be captured by the consumers and not the innovators.
Posted by: J. Random American at Jun 30, 2008 11:53:58 AM
Tyler,
I actually wanted to buy puts on oil futures about a year ago, and my wife talked me out of it! Phew!
If you're still checking this thread, can you clarify this?
Still, the single best estimate today can be inferred from the current market price, which implies a good chance that resources will get more expensive.
I'm confused by this claim. If today's spot price is the best guess of the future price, then isn't there a 50/50 chance that oil will go up or down? Or is that all you mean by "good chance"?
(For what it's worth, I think the relation between a current market price and expected spot prices in the future is more subtle than many economists realize.)
Posted by: Bob Murphy at Jun 30, 2008 12:05:38 PM
J. Random has it right. Petroleum from the ground may never come down. It won't matter, energy will be cheaper.
If #1 is broadened just a touch--- to include substituting products--- it's not just right, it's slam dunk right. I can't tell you what will win, but at $140/bbl so many alternatives make sense, even with current technology. Coal liquid/gasification, solar->H2, biofuels, ge microbes eating trash. If we let the market sort it out it will- in short order.
Opec was strategically right to keep the price low to discourage competition. That ship ship has sailed, they better wisely invest some of the (substantial) money they are making now because their window is closing.
Now, how should I invest, to win on #3?
Posted by: Two Hands, One Mouth at Jun 30, 2008 12:52:14 PM
If it wasn't for the huge increase in demand generated by China and others, that did not exist in the 1970s, then the collapse of oil prices would be insured, even in China's demand remained constant. But it will only increase, so any offset caused by greater efficiency in US, Europe, and Japan and new fields will be temporary. Expect high prices to remain for the next 5 years and then probably a "reasonable? prices that would still be high compared to the '90s.
Only when the infrastructure of the world economy greatly changes so that it uses other sources of energy will the price of oil be driven down. And of course, someone will make tons of money by doing that. It won't be by speculating on oil though, but by making the right investments in energy R&D, engineering, and infrastructure. This will all take a long time and require some amount of expertise. It's like knowing the railroads will be big, but having no idea exactly which railroads to invest in. Not everyone is JP Morgan.
Posted by: Chris Durnell at Jun 30, 2008 1:30:06 PM
Today's futures price for, say, June 2014 WTI ($136.18 was the closing price on Friday) is not a prediction of what the price will be in June 2014. It is today's price for oil delivered at that time.
While it may theoretically be the midpoint of a probability distribution of the market's price expectations, that probability distribution has an insanely large standard deviation, which makes it pretty useless as a predictor not even factoring in the impact of posting margin now for a delivery that can't occur for almost six years. The seeming precision of that $136.18 figure masks the reality - "it'll be somewhere between $25 and $250" may be just as accurate, but isn't how the futures exchange figures their prices. In reality, they take the price of an actively-traded month and add or subtract time spreads, such as "August 2008 is $140.21, the 08/09 spread is -15 at 0 so we'll call it -8 cents, the 09/10 spread is -$2.55 at -$2.30 so we'll call it -$2.43, the 10/11 spread is -$1.70 at -$1.40 so we'll call it -$1.55, etc, etc". The bid/ask spreads, and thus the imprecision, grow as you get further from the current delivery month.
And for Mr. Henderson, the all-time low on the NYMEX was $9.75, in March or April of 1986. That's for a light, sweet crude, though - other crudes were selling for around $8.00 at the time.
Posted by: djc at Jun 30, 2008 1:35:48 PM
I don't think #5 works. You can put your money into fixed income assets locking in interest rates now and then use those assets as collateral for swaps to take short positions in oil. Taking a position on oil doesn't require you to forego investing in debt.
Posted by: FXKLM at Jun 30, 2008 1:59:38 PM
This discussion is fun, but it paints an inaccurate picture of Simon. Simon didn't think that natrual resource prices necessarily always decrease. He believed that, by and large and in the long run, the conditions of production will improve.
Ehrlich's first suggest bet was that England would not exist in 2000. Faced with a stark-raving "the end is nigh" type willing to countenance just about any pessemestic forecast, the commodity price bet was a good way to embarass him at the time. But when, having been burnt once, Ehrlich proposed a wager with a more finely tuned basket of metrics, Simon articulated his core belief:
Let me characterize their [Ehrlich and Schneider's] offer as follows. I predict, and this is for real, that the average performances in the next Olympics will be better than those in the last Olympics. On average, the performances have gotten better, Olympics to Olympics, for a variety of reasons. What Ehrlich and others says is that they don't want to bet on athletic performances, they want to bet on the conditions of the track, or the weather, or the officials, or any other such indirect measure.
Simon wouldn't say that oil prices must necessarily fall. He would say that perhaps oil prices will fall, or perhaps a cheaper energy-generation technology will take over, or perhaps we will figure out how to produce stuff with much less energy. We can't be sure exactly how it will play out, but we should be confident that, if we let people innovate, human welfare will improve. (I might add that human welfare is improving even right now -- the commodity price increases that are inconvenient to those of us in the rich world are a side-effect of the rapid, massive improvement in standards of living in much of the third world.)
Posted by: David Wright at Jun 30, 2008 3:00:45 PM
Isn't supply and demand of money half the story behind every price?
With unstable currencies it is far more than half of the story. Small changes in long-term inflation expectations cause large changes in commodity prices. If Tyler applies Lachmannian expectations to the currency side of a trade of currency for commodity I think he will discover why he was quite wrong to say:
On the money side, the low dollar is one factor but it doesn't account for the leap from $10 a barrel to $142 or so a barrel.
Increased expectations of inflation in future decades, from 1998 (near the end of a decade when deflation was the main worry) to today (even Alan Greenspan said in his recent book to expect 4.5%/year from here on out, and that was well before the Bear Stearns bailout), can easily account for a factor of 14 increase. For example, a Hotelling nonrenewable commodity for which there are no changes in expected consumption (assume the expectation covers the next 100 years), but there is a change in expected inflation from 1.75%/year over that time to 4.50%/year over that time, gives us a factor of 14.3 increase in the commodity price.
When floating currencies bob in the waves, price changes in commodities, especially less renewable or substitutable commodities like oil, easily swamp traditional fundamental factors.
Tyler's list (1)-(5) completely misses the problem with trying to go short commodities (which is of course to also go long a floating currency) in an era of changing expectations about long-term inflation. A bet to go short would be a bet that the Fed, ECB, etc. are going to get their act together and behave quite admirably in future decades, and thus that inflation expectations are too high. If you really know that inflation is only going to average 3.5%/year instead of 4.5%/year in the coming decades, and furthermore you know that everybody else is going to (magically!) realize this just a few years from now, you can indeed make a killing with this rollover short position. But predicting the future of central bank behavior is a far dicier proposition than predicting the future of geology or even of technology.
If you put Julian Simon's bet as the price of an industrial commodity basket in terms of gold, it has been, is now, and quite likely will be in the future, a winning bet.
Here is my overview explaining the recent dramatic runup in commodity prices.
Posted by: nick at Jun 30, 2008 3:14:18 PM
Nick –
Clicking through your links, I found what seems to me to be a set of incorrect underlying assumptions. In your Commodities, Currencies, and the St. Petersburg Paradox article, your model is stated as assuming that the commodity at issue is not renewable, cannot be substituted for, and has secure property rights. But substitution is not only possible but growing, with new production (like the Canadian oil sands) as well as other forms of energy. Also, property rights in oil reserves are far from secure, as events in places such as Venezuela and Russia have proven.
You also talk about producers stockpiling crude oil by leaving their oil in the ground rather than sell it for depreciating dollars. If that were the case, wouldn’t production be declining significantly? That doesn’t seem to be happening, based on the statistics I’ve seen.
I’m no professional economist, and I am not familiar with the sensitivity of the models to these issues. I understand that a jump in inflationary expectations can cause a huge increase in prices for delivery and payment in 100 years (the time period you mentioned in your posting), but I’m not sure how it has that kind of impact on prices for delivery and payment next month. To my eyes, it should only steepen the contango in the market (make prices for future delivery progressively higher). Could you help me with this?
Posted by: djc at Jun 30, 2008 3:53:25 PM
Incidentally, if you think Julian Simon is wrong, and you think we have reached "peak" for certain industrial commodities, due to geological and technological rather than monetary causes, and that substitutes for these commodities will be less efficient, due to which real prices for those commodities will rise, here is the bet for you:
(1) go short gold, or silver, or both.
(2) go long a basket of whatever industrial commodities you think have "peaked" and are not readily substituted for over the long term: oil, coal, iron, copper, etc.
This is a nice bet, as close as possible to being currency neutral(*), that commodities that are necessities for industry will be consumed faster, or supplied more sparingly, or both, in the future than commodities whose value comes almost entirely from their monetary and luxury value. If your long position is a broad commodities basket, it is a bet that the future will move us closer to Malthusian doom and farther away from a world of greater luxury.
(*) It's not completely currency neutral because gold and certain industrial commodities might react to future inflation expectations differently, e.g. based on the respective costs of "storing" them above or below ground, including costs from the insecurity of property rights. But this is about as close as one can come to being currency neutral for a long-term bet.
Posted by: nick at Jun 30, 2008 4:17:05 PM
dic: But substitution is not only possible but growing, with new production (like the Canadian oil sands) as well as other forms of energy.
The problem here is that higher inflation expectations must be built into cost estimates for them. It's no good to say that coal gasification cost only $80/barrel last year, for example, and so it must be cheaper than oil at $140/barrel. One has to figure out how much a coal gasification plant will cost over its future lifetime given the higher expected inflation. The cost ratio for coal gasification or extracting tar sands to the cost of extracting Saudi oil hasn't changed, it is still more than a factor of 10 higher. As inflation spreads from gold and oil (where it appears first) to other commodities, and then to wholesale prices, then to retail prices, then to labor costs, we will see the nominal costs of tar sands, coal gasification, nuclear power, wind power, and so on catch up to the nominal price of oil. The relative real costs of all these sources haven't changed much, and won't change much, unless there is some joker discovery like a great improvement to biofuels due to genetic engineering. (It is true that the nominal attractiveness of these alternatives to oil increases the R&D into alternatives and thus increases odds of such a joker occuring per year). Nevertheless, it's probably the case that only nominal relative costs, rather than real relative costs, have and will substantially change due to inflation expectations hitting gold and oil prices before they hit other kinds of prices.
Incidentally, because this theory depends on price stickiness, which in turn depends on transaction costs, this theory could be shown wrong (or alternatively, you could turn a tiny pile of money into a very big pile of money) if you could find a low transaction cost way to construct the following arbitrage to last for several decades:
(1) go short oil or gold
(2) go long the CPI or PPI
That is, the theory predicts that gold and oil prices are leading indicators of inflation, reflecting changed inflation expectations immediately, and that the PPI, CPI, and wages only reflect such changed expectations after long delays, possibly decades. This arbitrage, if it could be done at low transaction costs, would profit from this price stickiness.
(There is a problem with this arbitrage, though: it's possible that inflation expectations may keep increasing faster than PPI and CPI for as long as one can hold the bet: I don't know what the maximum divergence between these might be).
Also, property rights in oil reserves are far from secure, as events in places such as Venezuela and Russia have proven.
But most governments have quite secure property rights over their oil. A Saudi oil minister was recently quoted saying that he's already rich enough himself and would prefer to save the oil for his children. Considering that governments own 70%+ of oil reserves, property rights in oil have grown more secure since the Cold War and its rough aftermath. The disruption of Russian oil property rights has now greatly diminished: Gasprom can now more confidently keep their oil off the market knowing it will still belong to Gasprom in the future. Indeed, some of the runup in oil prices might be due to increased security of property rights over oil over the last 2-3 years, as opposed to the extremely insecure rights during the Yeltsin and early Putin eras.
You also talk about producers stockpiling crude oil by leaving their oil in the ground rather than sell it for depreciating dollars. If that were the case, wouldn’t production be declining significantly?
First, they still want to use the capital equipment and labor force development they've already invested, since steel unlike the oil rusts and oil workers are hard to retrain. When inflation expectations rise faster than oil prices we expect to see fewer investments in near-future production and greater investments in discovery, and we have been seeing this. Second, this only holds true until the price of oil catches up with the increased inflation expectations. If the spot price of oil exceeded its expected value, we'd see a great increase in pumping. With modern markets there is not much of a gap between the inflation expectation and the spot price, so we don't see much change in production patterns one way or the other. (Except that the theory does predict that some lower-cost production from places with strong property rights will be replaced with some higher-cost production from places with less secure property rights).
BTW, don't take "commodity inventory" numbers too seriously. They only reflect certain official reporting warehouses. Indeed, when there is "hoarding" due to rising inflation expectations, official stockpiles are often depleted as commodity consumers build their own unreported stockpiles faster than the official warehouses care to replace them. Yet another example of where most economists take official numbers way too seriously.
I understand that a jump in inflationary expectations can cause a huge increase in prices for delivery and payment in 100 years (the time period you mentioned in your posting), but I’m not sure how it has that kind of impact on prices for delivery and payment next month. To my eyes, it should only steepen the contango
No, it's a myth that the futures price is a prediction of future prices and the spot price is not. They both roughly equally reflect expectations of future prices. If the cotango is steep there's an easy arbitrage: pump less oil. That will drive up today's spot price and drive down the futures price until they both reflect expectations of the future price. It's only in a few commodities that are expensive to store either above or below ground (e.g. orange juice) that one can say the futures price is predicting the future price much better than the spot price.
Posted by: nick at Jun 30, 2008 5:36:49 PM
"It won't matter, energy will be cheaper."
Survivorship bias.
Economics can't beat physics or chemistry. Battery tech is limited by the periodic table itself. Oil is effectively burning thousands of harvests of 'biofuels' all in one go. Etc.
Petroleum was around when we transitioned from whale oil; it was a known quantity - the EROEI was good even though the infrastructure hadn't been built. Nothing today comes remotely close to matching petroleum's EROEI, much less exceeding it.
Posted by: M1EK at Jun 30, 2008 5:42:05 PM
I thought his "major thesis" was that increased human population catalyzes growth.
Posted by: Paul N at Jun 30, 2008 10:10:42 PM
David Wright says it better than I would have, which would have been something like:
6. Oil may become cheaper, or simply irrelevant. Not a clear enough choice for me to bet the farm on.
Economics does not have to beat chemistry or physics: economics only helps *different* physics or chemistry beat physics (or chemistry). Examples: Video teleconferencing and Acrobat. Not to mention better genetic engineering (and not just of the "frankenfood" variety). And supply substitution (i.e. the bus for cars, better cities for the 'burbs). We forget that we have built an entire culture around having cheap oil and that we can change our minds about many of those choices once we accept that the fundamental assumption has obviously changed.
Posted by: Eric H at Jul 1, 2008 12:11:59 AM
Saying we will video conference, as a way to avoid physical travel, is very different than saying energy will get cheaper.
The "energy will get cheaper" folks are basically saying "electric SUVs for everybody."
Maybe, but certainly not yet. And the "show me" folks are only asking that we be conservative. Let's base current policy on what we know, with a prudent eye on what we risk.
We know we use oil, we risk falling production before we have a gee-whiz future lined up.
... I notice that Andrew Leonard is in the show me camp:
The great, unanswerable question in "Electro-Shock Therapy," Jonathan Rauch's long and interesting look in the Atlantic at GM's efforts to transform the automobile industry with the über-hybrid Chevy Volt, is whether GM will pull it off. Americans have learned not to expect much from their car companies, and no amount of hype from GM executives, or "failure is not an option" assertions from GM engineers, will convince us differently.Only the real thing -- a stylish, high-mileage automobile charging up from an ordinary electric socket -- will do the trick. If Volts start battling Priuses for Berkeley parking spots, then we can talk. But we won't get a glimmer of that reality until at least 2010. So while stories such as Rauch's make for good reading, they are ultimately a little unsatisfying -- something Rauch knows as well as anybody. His most telling line, near the end of the piece, "I was looking at the Barack Obama of automobiles -- everyone's hope for change," acknowledges as much. We can invest as much optimism as we want in the prospect of the truly revolutionary electric car -- but we're still forced to wait and see.
Posted by: odograph at Jul 1, 2008 7:46:23 AM
Uh... The only possible belief spaces are all variations on Simon being right? How open-minded! Especially on a planet with many non-renewable and difficult to renew (old growth forests, fish stocks, soil) resources during a period of EXPONENTIAL population growth. From an reality based ecologists point-of-view how about broadening the discussion to #6; Simon is WRONG. Humans ability to innovate can surpass ecological and enconomic constraints for a period and drive down costs of resources, but at the point at which the resource returns on energy invested become marginal, the ability to drive those costs down collapses, as the production of that product peaks. We MAY replace oil with another energy source and keep energy cheap, but we WILL run out of oil this century. In the next 2-3 decades oil will be volitile, but it will go UP in price.
Posted by: Bill R at Jul 1, 2008 11:55:28 AM
M1EK:
One word: Uranium.
Posted by: jimbo at Jul 1, 2008 1:38:32 PM
M1EK
No, of course not. However, economics can provide incentives to get very imaginative with both physics and chemistry. Personally, someone is going to find a way to make a very nice WTI equivalent crude. Actually, someone already figured it out, all that remains is to scale it up. I'm just waiting to see who will roll it out first.
Beyond that, there's high temp GaAs PV's. Again, you'll need good batteries but that may not be as far away as you think.
Posted by: McBlogger at Jul 1, 2008 4:03:06 PM
M1EK,
Physics is on the side of cheap energy, because we conveniently have a little fusion reactor floating 8 light minutes away.
According to the wiki, incoming solar radiation is 3,850 ZJ/y (ZettaJoules/year). Human consumption--- at the sorce, counting all inefficencies--- is 0.487 KJ/y. Thats a little over on ten-thousanth of incoming energy. There are (large) practical problems gathering that enery, but physics is on the side of cheap energy.
Posted by: Two Hands, One Mouth at Jul 1, 2008 4:41:20 PM
Agree completely with the comments on solar and nuclear energy. Add in wind, wave, biomass, etc. Then consider the population bust that seems awfully likely in the next 50 years or so. How can the price of oil not go down? Really, it seems inconceivable.
As for getting rich on it, that's harder. Between the time value of money and the risk of making a mistake and losing my shirt, I'm wary of it. But I am talking myself into it a bit. Anyone want to go into further detail on how one would construct a long-term short on oil? I'm a little ignorant of how rolling over a short would work. Should probably call some of my trading friends...
Posted by: Greg at Jul 1, 2008 5:18:16 PM
I think, Two Hands, that those "(large) practical problems" make theoretical cheapness somewhat moot.
Posted by: odograph at Jul 1, 2008 5:20:35 PM
