ECONOMIC THEORY AND OIL: A MODERN SURVEY

On the second of January, 2008, at approximately the same time that I was skimming an offbeat article by Christopher Helman with the title ‘Really, really cheap oil’, (Forbes, October 2, 2006), the price of oil on the New York Mercantile Exchange (NYMEX) touched one hundred dollars per barrel (=$100/b) for the first time in modern history. That price continued up until it reached slightly over $147/b, and in the wake of the recession now touching most of the world, it has declined to about $45/b. There are simple but not widely circulated explanations of this rise and drastic decline, and they will be presented in the next section, but it needs to be emphasized that a statement has been made: a fundamentally different oil era is still in the offing, and this state-of-affairs is unlikely to be responsive to the bogus wisdom of a self-appointed denial lobby with barely a minimal comprehension of energy economics.

A great deal of Mr Helman’s composition provided false impressions. “New” oil may be “coming from everywhere”, but even so it will not be sufficient to change supply and demand realities on world markets after the present macroeconomic doldrums, and the same is true of “new” technology. His work contained an ill-advised attempt to discount the growing energy demand of China, while Saudi Arabia was bizarrely pictured as reducing its production in order to make room for non-OPEC output. The resources of the Caspian and offshore Africa are in all liklihood overestimated, and there was a drastic mistake in the conjectured spare capacity of the global oil production system: it is at least three million barrels per day (= 3 mb/d) less than the 5 mb/d that one of Helman’s gurus believed would prevail at the present time. Financial speculation (in the oil futures market) was basically misinterpreted, and in certain respects was theoretically incorrect. These and similar issues have been examined in my new energy economics textbook (2008), where I attempt to outline in non-technical language the departure from mainstream economic logic that still characterizes much of the commentary on petroleum markets.

It is generally believed that the main explanatory factor for the 59% oil price rise in 2007 was the escalation in Chinese (and Indian) demand, which can only be supplied by greater imports. For instance, China now has about 30 million vehicles, but there are estimates that by the year 2020, this figure may reach 120 million. However even if it does not, the difference will be more than covered by the increased sales of cars, vans and trucks in India. Readers should also be aware of the growing oil consumption in leading exporters, of which Russia is an excellent example. CNN recently called attention to a growing demand in the Middle East, where the largest fraction of OPEC oil is produced, and in addition where all governments evidently agree that an excessive reliance on the export of crude oil is both economically and politically imprudent. “Resource nationalism” is an expression that has been introduced to describe the likely behaviour of many OPEC countries and Russia.

Underlying the present contribution is the belief that the supply of (conventional and unconventional) oil will be unable to expand at a fast enough rate to satisfy future global demand without substantial price increases, and perhaps sooner rather than later there could be a traumatic piece of bad news in the form of a peaking of the global oil supply, regardless of price dynamics. Note the expression “substantial price increases”, which refers to price increases from wherever the oil price happens to be when the recessionary impulses and trends that now characterize the global macro-economy are terminated. As a result, an unhealthy freight of ill-tidings could be featured on the oil price scene well before global production turns down.

Really bad news though would appear if the annual growth in global demand for crude oil again reached and continued for a few years at about 3 mb/d, which was the average for a 12 month period in 2003-2004. The hypothesis I often circulate is that the only way for decision makers to confront this prospect without the risk of overdosing on aspirin is to ensure that a portion of this kind of growth can be ‘satisfied’ with some brand of conventional or non-conventional fuel that can be substituted for crude oil or an oil product, to include ethanol, bio-diesel, natural gas, electricity or something similar. I generally advise students that an annual increase of 1-1.5 mb/d is appropriate when they ponder the global future oil output, which implies that we may have less than 10 years before we reach what Monsieur de Margarie – the CEO of Total (France) – regards as the maximum global output , which he estimate will be 100 mb/d.

ALBERT EINSTEIN AND SCIENTIFIC COMPLEXITY

Albert Einstein, considered the premier scientist of the 20^th century, once remarked that even children were capable of understanding complex physical concepts. If this is true, then we can certainly hope that they help their parents to comprehend the key idea in the book ‘Hubbert’s Peak’, by Kenneth Deffeyes (2003). (As a background to this book, readers should be aware that in l962, Dr. M. King Hubbert delivered a report to the (U.S.) National Academy of Sciences in which he said that U.S. oil production would peak between 1966 and 1971. This important event actually came about, and I invested a great deal of time and gusto in clarifying for my class on oil and gas economics at the Asian Institute of Technology (Bangkok, Thailand) that if it could happen in the U.S., it could happen anywhere, by which I meant globally as well as a particular region).

Deffeyes’ work is about a peak in the output of what George Monbiot called “the resource on which our lives are built”. It’s about being faced with the possibility that the global oil production in some year in the not too distant future will, unexpectedly, be unambiguously smaller than production in the previous year (as compared to being only slightly smaller, as may have been the case in 2007), and when this dilemma is carefully analysed with respect to future prospects, and a conclusion is drawn by a consensus of reputable observers that the oil wolf is at the door, the global macroeconomy and the financial markets could react in a manner analogous to crowd behaviour in your favourite vampire movie when sold-out signs are posted in the windows of garlic shops. Furthermore, there are commentators who claim that if we stick to ‘conventional’ oil, a genuine peak has already taken place, while other observers speak of a ‘geopolitical peak’, which could result if major exporters elected to limit production. Although not inclined toward optimism in these matters, I prefer to wait for a lifting of the present macroeconomic malaise before rendering a final judgement.

There are two very simple things that everyone who reads this paper should make every effort to understand perfectly. The first is how easy it was for Dr. Hubbert to arrive at such a provocative conclusion about the output of oil, although the consensus opinion in the U.S. was that there would be an oil glut for the remainder of the 20^th century, and probably most of the 21^st. The second is that we are dealing with economics and not geology. It may sound like geology, but actually the correct approach features the same kind of reasoning highlighted in your favourite intermediate economics textbook. In the U.S. – and probably in most parts of the world – production did not turn down because of a shortage of reserves, but because it was ‘sub-optimal’ from an inter-temporal profit maximization point of view for producers to boost output. Unfortunately, inter-temporal production theory is not a popular theme in the courses on microeconomics in most faculties of economics.

Hubbert undoubtedly began his research by perusing what had happened and was happening in oil fields or oil provinces around the world. What he saw was small and large oil fields with (roughly) bell-shaped production curves, or perhaps an upward portion, followed by a ‘plateau, and then a downward portion. In one way or another he surmised that these could be aggregated into a bell-shaped or approximately bell-shaped curve for an entire region (such as the ‘lower-48’ of the U.S.). Having done that he considered how best to mathematically represent these bell-like curves, and the answer of course was with hyperbolic or normal or logistic equations, or perhaps something slightly more exotic.

The mathematics here is uncomplicated. In her textbook (2004), Professor Carol A. Dahl reproduced an expression of the type that Dr Hubbert used to estimate the date of the output peak for the lower ’48 (of the U.S.). For the purposes of this exposition it can be written as Q = R/[1 + ηe^−μt], with Q cumulative production at time t, R is the conjectured ultimate amount of the resource, and η and μ are the parameters that Dr Hubbert estimated. This equation is logistic, and once we determine these two parameters, it is easy to obtain its inflection point, which for a bell-like curve corresponds to the peak. Equally as important, assuming that the parameters are correct or approximately correct, a simple mathematical operation will indicate that a 1% increase in R will result in a less than 1% increase in the time to the peak. Thus we have one source of an often-heard warning that even if large oil fields are discovered, we could still be in trouble. Despite the cry of “drill baby drill” raised at the Republican National Convention in 2008, most oil experts present knew that no conceivable upswing in drilling could find enough oil to bring the price of motor fuel back to an acceptable level. For that ‘demand destruction’ from the macroeconomic meltdown was necessary.

I can agree with oil optimists that Dr. Hubbert might have been lucky to calculate that 1971 would be the latest year in which the peak for the lower ’48 would arrive. Actually it arrived toward the end of 1970. As it happens though, that is mostly irrelevant, given that some influential observers genuinely believed that a peak for the U.S. would never take place (and apparently there are still some ladies and gentlemen who say that a global peak is out of the question, despite the regional peaks experienced in every part of the world). They believed, to paraphrase Deffeyes, that to obtain virtually any amount of oil, all that was necessary was to stand next to a well with a bucket and a handful of dollars, and with the help of the instantaneous technological masterpieces that are always at the beck-and-call of men of good will, Mother Nature would deliver the goods.

Now we can turn to some price dynamics. Justin Fox once pointed out in Fortune (September, 2002) that ”to keep oil prices from harming our economy, we need high oil prices.” This was a correct judgement at that time, but it no longer applies, because high oil prices of the kind experienced early in 2008 could be very bad news for macroeconomic and financial markets.

In order to avoid this situation we need to think about how we can put a cap on the price of crude. One of the ways to come to the wrong course of action is to listen to Nobel Laureates like Professor Gary Becker, who attempted to explain to the readers of Business Week (March 17, 2003) why the war in Iraq had nothing to do with oil, and in addition “Middle Eastern nations are far less important to world oil production than they were immediately after the formation of OPEC.” This might have been true if, as Stanislaw and Yergin (2003) believed, OPEC was willing to produce 45% of world oil by 2005 (instead of the realized 31-32%), because 45% would have left some of the importing countries with a domestic ‘reserve’ in one form or another that could have been put on the market when or if the oil price escalated.

That brings us to the denouement where the rise in the oil price over the past few years is concerned. Consider the changes during 2007 (since I do not have access to reliable figures for 2008) as indicated by the latest British Petroleum (BP) Statistical Review of World Energy. For China there was an increase in oil consumption of 4.1%, and for India of 6.7%, as compared to a total world increase over that period of 1.1%. On the production side though there was a global decrease that came to (minus) 0.2%, while the decrease in the Middle East (the most important region in the world for the supply of crude) was 1.8%. Despite the claim by certain persons and organizations that a speculative bubble was behind the movement of the oil price to $147.5/b, economics students who are capable of shifting supply and demand curves should immediately recognize that speculation is secondary to these supply-demand trends. (A ‘bubble’ is a price change that cannot be explained by fundamentals).

Some algebra goes with the above, but first we can recall the precipitous descent of the oil price. Behind this is a sudden large fall in oil demand, which could be expected in the light of the macroeconomic meltdown. Some producers probably reacted by reducing output, and OPEC has proposed an output reduction scenario for its members (which Russia may adhere to). But some members of OPEC, and producers outside OPEC, believe that they are best served by continuing to produce at or above previous levels, and would like nothing better than to increase production as other producers gear down. Attempting to explain to ‘certain’ governments that it is in their interest to conform to the OPEC agenda is a waste of time, because some revenues from oil production find their way into the bank accounts of movers and shakers in the upper echelons of ‘certain’ exporters. This procedure is grounded in culture, and is immune to moral niceties or economic logic: the countries in question would maintain or increase output if the price of a barrel of oil fell to the price of a cup of coffee. If OPEC were a monopoly it might be otherwise, because then the issue for decision makers would be inter-temporal production theory, and not oligopoly politics, philosophy and pseudo-economics. Accordingly, they would take the steps necessary to keep the price of oil above ‘$X/b’, where individual readers can fill in their beliefs as to what X should be.

But please do not believe that all of the superbly managed oil companies are now prepared to meet falling demand by greatly reducing output. As those of us who have taught or studied real options theory know, it is expensive to reduce production, particularly when it is evident that at some point in the future it must be restored to an earlier level. And despite what we hear about oil companies becoming hesitant to increase or maintain previous production, the simple truth is that when the oil price was in the neighbourhood of $20/b, global production increased every year.

Now we can derive a simple equation which might have some pedagogical value for readers. First we have a demand curve for oil h_t = a₀ + aP_t , and a supply curve s_t = b₀ + bP_t-1, with a<0 and b>0. Notice that the supply curve is lagged, while the demand curve is called ‘h’ instead of the usual ‘d’. For equilibrium we normally have h_t = s_t, but here I will add trend terms to these relationships, and get h_t = a₀ + aP_t + α_t and s_t = b₀ + bP_t-1 + β_t. Obviously a₀ and b₀ can be included in the expressions for α_t and β_t. which will lead to the first order difference equation:

(1)

For α_t and β_t we might have α_t = α₀ + α₁t and β_t = β₀ + β₁t. In any event, if we begin with a price of P₀, then the solution of the above equation is:

(2)

The expression to the left of the plus sign represents a cobweb model, while the expression to the right is a trend term for the price. On the basis of the figures presented above, at the present time β_t is less than α_t, and so P_t is trending down. Once we have this result, further details are unnecessary or irrelevant, to include opinions about speculation. On the other hand, because of the lagged price for supply, we can have the kind of movements (i.e. oscillations) in the ‘cobweb’ component of the price such as those described in the first chapter of R.G.D. Allen’s important book Mathematical Economics (1961). Basically in (2) there is a trend term around which there are oscillations in both price and inventories. If, for example, supply lags demand, and if there is a spike in demand, inventories will decrease even if the lag is very short.

NATURAL DECLINE

General Douglas MacArthur once said that his favourite song was ‘Old soldiers never die, they only fade away.’ The same can be said about old oil fields. The three largest fields are indeed still very large, but all of them are fading away, and perhaps at an alarming rate. (These three fields are Ghawar in Saudi Arabia, Cantarell in Mexico, which though in rapid decline may still the second largest producing field, and Burgan in Kuwait, which is second in reserves, but where claims a few years ago about the exact amount of proved reserves were aggressively questioned by outsiders.)

The fundamental theme of this paper and my textbooks is that oil is scarce. It is scarce given the demand that is going to be made for oil in the not too distant future! To understand the unpleasantness that oil consumers could face, it behoves readers to obtain some insight into what is known as natural decline, because there is now a constant reference to ‘decline’ in the press. Some mathematics must be employed in this part of the exposition, but most of it should not disturb readers who prefer a less formal type of presentation. Moreover, just below, and prior to the mathematics, are a few statements about natural decline that should be comprehensible to all readers.

Among other things, I want to eventually put together a semi-formal exercise of the kind I employed in my lectures on oil and gas in Stockholm and Milan (Italy). What I am aiming for is to say something meaningful about investment as well as production. In a more technical presentation I would work toward an implicit function of the type ψ(q₁, q₂, ….,q_T ; I₁, I₂, ….., I_T) = 0, where the ‘q’s are production, and the ‘I’s are investment, but I will refrain in this paper from going off the deep end.

Several years ago Mr Lee Raymond – the former CEO of Exxon-Mobile – gave an interview in which he emphasized the importance of the natural decline rate of oil deposits. Rather than turning to the technical literature, I consulted GOOGLE, where I found a reference to some work of the International Energy Agency (IEA). Apparently, after a study of the 400 largest oil fields in the world, they concluded that (ceteris paribus) the average natural rate of decline is 9% a year, ranging from 4 or 5 percent to almost 20 percent. What is happening is that if the inputs being used are held constant, then instead of the production of an average well remaining constant, or nearly constant, it declines by 9% on the average. This is where ‘natural decline’ comes into the picture, and one way it can be described is in terms of the loss in capacity that would occur in a given ‘asset’ if no remedial or offsetting action is taken.

As for this remedial action, it can take the form of locating contiguous new reserves and drilling new wells, or perhaps taking steps to increase the output of existing wells (via, e.g., injecting water or carbon dioxide or the use of ‘surfactants’ to increase viscosity), and therefore turning more of the oil-in-place into reserves. (Remember that globally, on average, only about 35% of the oil-in-place in deposits can be classified as reserves, and thus are immediately accessible). These procedures can be labelled investment, and roughly have the same monetary significance as the investments required to produce, process and transport in one manner or another the output of an oil field.

It might be useful to add that according to estimates that I have viewed, decline rates for Iran may be as high as 8%/y onshore and 13%/y offshore, while for Saudi Arabia the figure is ostensibly 2-4%. (Determining the accuracy of these estimates however will be left to readers.) Accordingly, if Saudi Arabia’s decline rate averages 3%/y, then – via investment of one type or another – it could be true that additional oil (to the tune of several hundred thousand barrels of oil) must be located every year in order for a sustained output of 9-10 mb/d to be economically viable. A problem here is that while new deposits can conceivably be located, it is not likely that they will be as ‘rich’ as those now being exploited. In addition, the deposits now being exploited are old, and investments required to maintain output could become very costly because of damage sustained by fields due to (among other things) production processes which involve the extensive use of water. As a result, given the expected future demand for (and price of) oil, Saudi oil field managers may have concluded that optimal behaviour on their part takes the form of minimizing the expansion of output.

Natural decline will be mentioned again below, but in order to obtain an optimal clarification I offer as background a simple model that I employed in the first lecture that I ever gave on oil, which was at the Australian National University in Canberra, in what now seems like several centuries ago. This model could easily be extended to take into consideration the natural decline rate.

First of all we need to understand the insignificance of a statement such as “with all the reserves in place now, we have a 40 year supply of oil even if we do not find another drop.” This statement originates with observing that the global reserve-production (R/q) ratio is 40, however the important issue is not the R/q ratio, but when production in a field, region, or for that matter the entire oil producing world turns down. As should be obvious from a consideration of the example below, oil could be present and exploited hundreds or even thousands of years in the future, however once the production peak has been reached, the number of years that oil ‘lasts’ is of minimal interest.

This is not to say that the R/q ratio should be ignored, but a statement such as the above (which postulates a 40 year availability) is scientifically meaningless. In looking at a deposit or field the important thing is that if the R/q ratio falls below a certain level – probably somewhere between 10 and 15 – then the deposit is being ‘damaged’ in the same manner that sucking too hard on a straw will damage an ice-cream soda. This particular R/q ratio can be designated the critical R/q ratio, or θ*, and for simplicity I always take it as 10 – although Flower (1978) prefers the higher figure (for reasons spelled out with some simple algebra in my textbooks). The damage will be manifested by a reduction in the total amount of oil that can ultimately be removed from the deposit.

Now for the important point. When the R/q ( = θ) ratio reaches the critical value, the critical value will determine production in the sense that production should adjust in such a way as to hold the critical value approximately constant. (Should and not will, because there might be valid economic reasons for hastening depletion. Moreover this is a theoretical point in economics rather than physics, and so from time to time it may be possible to see large exceptions.)

My favorite example is useful here. Assume that we have a field with 225 units (= R) of oil reserves, and we desire to lift 15 units per year, and our critical R/q ratio (θ*) is 10. Using the logic expressed in the previous paragraph, it is obvious that we can have an output of 15 units/year for five years. During this period the R/q ratio falls from 14 (at the end of the first year) to 10 at the end of the fifth year, while reserves fall to 150 units. After that, however, if we continue to remove q = 15 units/year, we are violating our constraint: the R/q ratio will fall under ten. For instance, if we removed 15 more units (q = 15), then reserves would fall to 135, and R/q decreases to 135/15 = 9.

To keep this ratio at 10 (= θ*), production in the sixth year should not be larger than 13.64. (Thus R/q = (150 – 13.64)/13.64 = 10.) Continuing, in the seventh year production cannot be larger than 12.4. Readers should be able to get these results by simple trial and error, however this exercise may be generalized to show that 10 ≤ R_t/q_t ≤ (R_t-1 – q_t)/q_t. In turn this expression may be solved to give q_t ≤ R_t-1/11 (or, more generally, q_t ≤ R_t-1/1+ θ*). As explained in my new textbook, this operation is merely another way of saying that in any (e.g.) year, the percentage of reserves extracted should be less than or equal to 10%.

The above is an important exercise, and after making sure that they understand it perfectly, readers should confirm that there is a large amount of oil in the ground when output turned down. Moreover, when we look at the production profiles of actual major oil or gas regions like the United States, what we see is that when peaking takes place (and production sooner or later begins to decline), there is still a huge amount of the resource in the ground, and in addition – if economic considerations are ignored – much of this is immediately extractable. The interpretation here is as follows: the peak is explained by economics and not geology. More is not extracted – and the peak delayed – because in the interests of profit maximization, the optimal behaviour is to extract it later! As explained in Banks (2004, 2000), geology essentially functions as a constraint. This is a crucial point that everyone reading this note should make every effort to understand.

But something is missing, and that something is the natural decline! In the above example, sufficient investment was made to obtain an output of 15 units/year for 5 years, but what would the situation be if there was a natural decline of 5 units a year. Then, instead of the sequence of reserves being 225, 210, 195, 180, 165, and finally 150 at the end of the fifth year, it would be 225, 205, 185, 165, 145 at the end of the fourth year. Thus we would arrive at what might be called the critical reserve level just before the end of the fourth year. Moreover, the decline in output after that would be steeper than in the previous case. But what would happen if we had this decline ‘pattern’ and the intention was to maintain an output of 15 units. This is possible, though perhaps more investment would be necessary, and in addition there would probably be a more rapid ‘depreciation’ of the deposit, unless associated reserves could be increased The decline rate above is probably excessive, and was chosen to make the arithmetic simple, but it did not show is that natural decline is often influenced by the extraction program.

In the example below I operate just on production, although holding output constant as shown may influence exploitable reserves. I don’t treat this because I lack relevant statistics, but the International Energy Agency (IEA) claims that globally, due to natural decline, 3.2 mb/d of new reserves must be found just to maintain output. This cannot be done for ‘lunch money’, because the management of Pemex (Mexico) says that it must spend $20 billion a year for two decades just to keep output (2.8mb/d) stable.

At the same time I want to make it clear once more that when the asset under discussion is an oil deposit rather than a conventional capital good, it is still possible to think in terms of what in economic theory is called “depreciation by evaporation”. What this means in the present example is that the asset is subject to a force of ‘mortality’ that will be taken as constant, and equal to ‘Ө’. If A is the constant annual revenue generated by the asset, or perhaps the size of an annuity derived from non-constant revenues, we can write for the value of the deposit:

V = Ae^{-(Ө + r) (τ – t)} dτ = [1 – e^{- (Ө+r)T}] (3)

Equation (3) might serve as a useful starting point for examining this topic if many readers were not allergic to integrals, because it indicates that the presence of natural decline (Ө) reduces the value of the deposit; but even if readers were madly in love with the calculus, the presentation below is more suitable because the importance of investment is made explicit.

In order to keep things simple, I will take a constant decline rate of 20%. As in the previous example I elect to hold production at 15 units/year, however the initial reserves are increased from 225 units to ’something’ much larger. The reason why I do not specify the size of this ‘something’ is that I am not concerned in this example with e.g. peaking or the critical reserve-production ratio. I simply want to clarify the significance of the natural decline rate, and allude to its influence on investment. If readers want details, they can examine my new textbook. Now we have:

YEAR 1: 15 (I₁)

YEAR 2: 0.8 x 15 0.2 x 15 (I₂)

YEAR 3: 0.8² x 15 0.8 x (0.2 x 15) 0.2 x 15 (I₃)

YEAR 4: 0.8³ x 15 0.8² x (0.2 x 15) 0.8 x (0.2 x 15) 0.2 x 15 (I₄)

YEAR 5: 0.8⁴ x 15 0-8³ x (0.2 x 15) 0.8² x (0.2 x 15)² 0.8 x (0.2 x 15) 0.2 x 15 (I₅)

………………………………………………………………………………………

YEAR T: 0.8^T-1 x 15 ………………………………………… 0.2 x 15 (I_T))

If we look at this tableau what we see is that in YEAR 1, an investment of I₁ was made to obtain 15 units of output. Because of natural depletion, in YEAR 2 additional investment of I₂ was necessary to obtain an additional output of 0.2 x 15 – i.e. the decline rate times 15 – in order to keep the total output at 15 [ = (0.8 x 15) + (0.2 x 15)].

Mathematical induction could be useful here if the logic behind this scheme was not so simple. Let’s take the decline rate as (1 – Ө), which in the example means 0.20, which in turn means that Ө = 0.80. Now let’s see what we have for YEAR 4 in symbolic terms: 15(1 – Ө) [1 + Ө + Ө² + Ө³]. The expression is the large parenthesis can be simplified to [(1 – Ө⁴)/ (1 – Ө)], and so in YEAR 4 we have 15(1 – Ө⁴) + 15Ө⁴ = 15.

Nothing has been said here about the size of the ‘I’s (which represent additional investment in e.g. wells for the purpose (in this example) of holding output at 15 units/year), but as with Pemex it could be an expensive proposition. (Something like this kind of program may be relevant for oil in Saudi Arabia, where for the time being the intention seems to be to hold output in the 9-10 mb/d range.) Note also that if we had numerical values for the value of ‘I’ we could work with an implicit expression of the very useful type such as ψ(q₁, q₂, ….,q_T ; I₁, I₂, ….., I_T) = 0. For instance, if we take T = 5, this expression would be ψ( 15, 15, 15, 15, 15,… ; I₁, I₂, I₃, I₄, I₅,… ) = 0. Putting together an example with explicit values of I, which also said something about the depreciation of the deposit due to additional investment, should not require a great deal of algebraic sophistication, but it would involve a degree of arbitrariness relating to the decline of the deposit that I prefer to avoid for the time being.

IN THE GREAT WORLD OF MONEY

The long-overdue increase in importance of academic energy economics is gratifying in many respects, but disturbing in others. Nobody can doubt its usefulness, given the place of energy in our daily lives, however all except the hopelessly naïve must be aware that economics is not a science in the usual sense. It is like a science, which makes it pleasant to teach and/or study, but there are probably many things that you want academic economics to tell you about the availability of energy that you are not going to find out no matter how hard you stare at the supply and demand curves that caused you such grief in Econ. 101. The reason is provided by Frederic Nietzsche, and it goes like this: “The future is as important for the present as the past”.

As bad luck would have it, reading the future is an art that only a few lucky people can master. For example, despite having studied the global oil market for as long as I can remember, until recently I was almost as much a hostage to (forecasting) fortune as the often-quoted Dr Michael Lynch, who – according to Mr Helman – has apparently claimed that the oil price could “dip briefly into the 20s in 2008”. The only way this ‘dip’ could materialize (unless the macroeconomy collapses) is for the main oil exporters to decide that less money is preferable to more, however for reasons alluded to earlier there are persons involved with the production of oil who would not be upset if the oil price descended to an absurdly low level if their personal net worth expands.

A big issue at the present time is estimating how the oil situation in the Middle East will develop. At one time I was convinced that we would have to accept provisional answers to that question until we know more about the future ownership of Iraq’s petroleum assets, and also how forthcoming changes in the Iraqi government could influence the structure and agenda of OPEC. I no longer believe that this is the case. The overriding fact that everyone reading this article should make it his or her business to comprehend is that most of the investments in new production capacity that the oil importing countries (and the International Energy Agency) want the Gulf producers to make, and which on various occasions these producers say that they will definitely make, will in reality NOT be made. Why should those countries choose to finance expensive investments when, if they don’t, it is almost certain that sooner or later the oil price will rise again?

‘Street smarts’ of this nature do not appear to be a feature of the work of many prestigious energy experts in the academy or the great world of journalism. They can’t fathom that instead of increased investment by Gulf oil producers, what is likely is the adoption of an optimal development economics scenario, where profits from high oil prices are used to promote diversification out of oil. Very likely, the higher the profits the more intensive the diversification. Can we justify this kind of behaviour with conventional economic theory? The answer is definitely yes, because oil is a wasting asset, and if there is no danger of its price collapsing at some unknown point in the future, then it probably makes sense to preserve it as long as possible. Thus it would usually happen in a (reputable) textbook world that a fall in demand will be met by a fall in output. In addition, despite what you may or may not have heard, the value of oil in the ground will not suddenly decline due to the availability of e.g. alternate motor fuels. This is because in the absence of a ‘Manhattan Project’, the availability of alternative fuels will be limited over at least the next few decades. Furthermore, even after those decades are over and forgotten, oil will be invaluable as a petrochemical input. I noted this in my oil book (1980), and now it may be taken for granted in OPEC councils.

This might be a good place for an aside on the word ‘value’. Certain teachers of economics will attempt to assure you that price and value are identical, however as I mentioned en passant in my finance book (2001), in financial economics it is often necessary to distinguish between price and value. Price is what you pay to acquire an asset, while value is what the asset is really worth, and the price is called fair when it is equal to the value. Attempting to distinguish between price and value may sound odd to some readers, however what the ‘efficient markets hypothesis’ implies is that in the real as opposed to the logical world of Economics 101, it is difficult to avoid a difference and, more important, on average investors in the share markets cannot tell exactly what this difference is. This is one of the reasons why so many investors are now in possession of assets (e.g. shares) that should have been dumped when it became obvious that something was going wrong in the global macroeconomy, where by investors I include the managers of the 800-1000 hedge funds that go out of business every year because they have made foolish bets and are reluctant to face up to this unpleasant fact.

When it comes to determining value, the study of finance is heavily involved with constructing models that ostensibly will provide us with this information. The Black-Scholes-Merton option pricing formula – which the Economist (UK) incredibly labelled the most important relationship in economics – is an excellent example of this kind of thinking. (For those who are unfamiliar with this model, it is intended to identify the value of an asset; and in theory, if the price of the asset is different, arbitrage should enable somebody to make a great deal of money). Personally I regard many of these models as questionable approximations, although I am willing to entertain arguments that often – though not always – they are more useful than e.g. relying on gut feelings. Another example can be given here. Milton Friedman insisted in the l970s that the price of oil should be less than five dollars a barrel, because he accepted the loony idea that the quantity of proved and hypothetical oil reserves in the crust of the earth was so immense that that it did not have nor would never have a scarcity value. Of course, somewhere in the background to this approach and acceptance was an unspoken belief that the owners of much of this oil were persons who could be tricked into parting with this invaluable commodity if they were exposed to the advice of academic celebrities.

Until a few years ago I was occasionally involved in ad-hoc debates with persons sympathetic to the theories about oil (and other raw materials) prices that originated with the late Professor Julian Simon. People like Simon held the twisted belief that because the cost of producing a barrel of oil in the Middle East was a few dollars, or less, all oil was generally overpriced in world markets, and in reality a barrel of this commodity should sell for the price of a barrel of coca-cola, or perhaps less. What Simon and his cheering-section failed to realize was that if the oil producing countries in that part of the world coordinated their sales, and bided their time, then those very corrupt persons in certain exporting countries who were willing to sell oil at bargain basement prices would eventually move to some other line of work or play, and the price of oil would ascend to a level commensurate to its value.

In terms of mainstream economic theory, this value has no intrinsic relationship to the cost of production in the Middle East. Instead, in the textbooks that Professor Simon read or should have read, the price of all oil would be determined by the price paid for the marginal barrel supplied by the highest cost producer. Today the OPEC countries are the lowest cost producers, with an output of approximately 30 mb/d as opposed to a total output of approximately 85 mb/d, which gives them a distinct quasi-monopoly power. In other words, by being in control of the lower end of the aggregate supply curve for oil, they are provided with an opportunity to (figuratively) ‘control’ the entire curve.

A few years ago there was a widely advertised belief that when the price of oil exceeded thirty or forty dollars per barrel, and there were indications that this price was sustainable, then a great deal of investment would take place for the purpose of bringing new supplies to the market – where in the minds of some experts “new supplies” would include oil that might be located at the bottom of the deepest part of the Gulf of Mexico, or perhaps at a similar depth in ‘Iceberg Alley’, off the far northern cost of Canada. Lately though word is coming from executive suites that the cost of finding and developing new properties may increase by a very large amount, and according to the consultants Wood-McKenzie, oil companies need a price of $70/b in order to obtain the same profit that they would have realized several years ago with a price of $30/b.

This doesn’t sound completely right to me, however it hardly makes any difference. It seems likely that eventually many international firms will have no problem obtaining a sustainable price of at least $70/b for any and all oil that they succeed in producing, but to obtain genuinely spectacular revenues from selling oil at that price it might be necessary to gain extensive access to exploration and production rights in e.g. the Middle East. Whether this will take place is dubious, because to use some of the jargon that was popularized by the greatest singer of the twentieth century, Frank Sinatra, many of the managers and politicians associated with Middle East oil have decided to believe that if you fall into the arms of the major oil firms of North America and Europe, it might be for “keepsville”.

As reported on the Op-Ed page of the New York Times in 2005, the journalist John Tierney and the wife of Professor Simon bet the investment banker and former advisor to President Bush, Mr Matthew Simmons, $5000 that the price of oil would not reach the level predicted by Mr Simmons (which was $200/b) by 2010. While $5000 is hardly Saturday night walking-around money to Mr Simmons, I found the publicity accorded this strange wager an unwelcome distraction, given the real issue. Professor Simon obviously believed or was capable of believing that brainpower and technology could find oil that geologists said did not exist, and so according to this strange logic an oil price that reached astronomical levels was at best a transient irritation, even though a series of spikes in the vicinity of $100/b might unleash the mother of all macroeconomic dislocations. Similarly, certain prominent journalists have elected to tell their audiences that oil price convulsions of any magnitude are no longer particularly relevant as an explanatory factor for economic downturns. To my way of thinking, if the TV audience and their political masters choose to believe this kind of foolishness, they deserve what they will eventually get.

SOME ASPECTS OF OIL FUTURES

In a lecture derived from my unpublished paper ‘Some Analytical Aspects of the New Oil Market’, I provided students in my course on oil and gas economics at the Asian Institute of Technology (Bangkok) with a partial introduction to the use of oil futures. The thing that needs to be appreciated where this topic is concerned is that it is much less complicated than often believed! I also attempt to clarify for my students in all the countries in which I have taught derivatives (i.e. futures, options and swaps), that the attractive salaries and bonuses that traders and analysts of various assets enjoy is due to their ability to learn a relatively small amount of basic doctrine perfectly, rather than squandering time and gusto on more abstract materials. (Derivatives are assets – such as ‘paper oil’ – whose value is derived from other assets, such as physical oil!)

In virtually all of my lectures I employed a stock-flow model of the oil market that I developed after reading a seminal article on copper by Professor Franklin Fisher of MIT. One of the most important purposes of my model is to make it clear that the flow models in your microeconomics textbooks are insufficient for comprehending short-run pricing in the oil market. Everyone who reads the Financial Times (UK) and watches CNN or Bloomberg should already realize this, and the U.S. energy minister (Samuel Bodman) recently attributed the rising oil price in 2007 and early 2008 to actual inventories being under the five-year average. My model will be presented below, but without the differential equation that I often employ to discuss price dynamics. That equation follows from recognizing that the rate of change of oil prices is a function of the difference between desired (D) and actual (A) inventories, or dp/dt = f(D – A). When e.g. D > A, the implication is that the price increases. Readers should appreciate however that this is economics and not physics, and so it does not automatically happen.

This topic will be elaborated on later, while in this section I will make a few elementary remarks about the oil futures market. If you desire further details about the present story, and/or are curious about derivatives such as options and swaps, read the chapter called ‘Energy and Money’ in my new energy economics textbook.

We can begin with a couple of terms: physical oil and paper oil. Physical oil is the oil that we have been talking about in previous sections – the black liquid that usually is put in barrels – while paper oil is the oil bought and sold on futures markets, and can be thought of as stored in computers. The relation between these is not straightforward. Present consumption (and production) of physical oil is in the neighbourhood of 85 mb/d, while daily transactions on major futures exchange such as NYMEX in New York and the International Petroleum Exchange in London often total several hundred million barrels of (paper) oil, or more. As with physical oil, each transaction on a futures market consists of a purchase and a sale of a certain number of contracts, where each futures contract represents 1000 barrels of paper oil. Under certain circumstances paper oil can be transformed into physical oil.

The oil futures markets operate as follows: against a background of speculators buying and selling futures contracts for the purpose of betting on the direction in which the price will move, an impersonal agency comes into existence which permits persons involved with physical oil to reduce (or ‘hedge’) price risk. As simple as all of this actually is, there are a great many misunderstandings about these markets.

At least twenty years ago Senator Alan Cranston – who wanted to be elected president of the United States – assured his constituents that agricultural futures markets were responsible for high agricultural prices; and only several years ago the well known television commentator, Bill O’Reilly, informed his large public that “little guys in Las Vegas” were responsible for the sharp rise in gasoline prices. As it happens however, futures trading may have contributed to reducing gasoline prices by reducing the price risk faced by buyers and sellers of physical oil. Mr O’Reilly’s belief that the agonies associated with high oil and gas prices originated on The Strip in Las Vegas, and had little to do with physical supply and demand, is exactly the opposite of the truth.

The success of a commodity futures market is dependent on the satisfaction of several well defined criteria. Perhaps the most important is that the physical item (e.g. oil), which is known as the underlying, is sold in an auction market – e.g. an exchange.. This is a market characterized by the visibility (or transparency) of all prices, and where all transactions involving bids (buying) and offers (selling) are handled almost immediately. A share market is probably the best example. Also, prices should fluctuate in a random or non-systematic manner. Without these provisions speculators may not be attracted to the market, and without considerable speculation futures markets will be illiquid. Without high liquidity (as in share markets) there could be serious delays in buying or selling, and very large transactions will result in large price movements. Markets without adequate liquidity are sometimes referred to as ‘thin’ markets.

Buying or selling paper oil is no different from buying shares. If you are a speculator and think that the price of physical oil will rise, then you telephone your broker and open a position by telling her to buy a certain number of contracts. This is called going long. If you think that the price of physical oil will decline, then you open a position by telling her to sell. This is called going short. The contracts in both cases involve a certain maturity (or expiry date), and assuming that you do not want to have anything to do with physical oil, then at some point before the maturity or expiry date you close your position. How is this done? If you opened by buying (paper) oil, you close by selling the same amount! If you opened by selling a oil, you close by buying the same amount. All of this can take place from your rocking chair in front of the TV. (A security deposit called margin is involved in these transactions, but that will be discussed briefly later in this section.)

What about gains or losses? If you went long and the price actually increased, then you made money. If the opening price was p’ and the closing price was p”, with p” > p’ , and you bought N barrels of oil, then your profit was (p” – p’)N, minus the broker’s fee. If you were wrong and the price actually decreased, then you lost money. If you opened by going short and the price actually fell, then you made money; but if the price increased, then you lost money. If you started out by going short, with the initial price p’, and the price fell to p*, then if N barrels are involved, the gain is (p’ – p*)N minus the broker’s fee. At this point the reader should use some numbers to assure himself or herself that he or she really understands what is taking place. (Something else of great importance: the selling of paper oil in a futures market does not involve selling an asset that you possess, as in a share or physical market! You would simply inform your broker that you want to sell 2000 barrels of oil. You will not be asked, “WHERE IS YOUR OIL?”)

Next we can pay some attention to hedgers, who also buy and sell futures contracts, depending upon whether they want to guard against price rises or price declines. Consider, for example, someone who has contracted for 2000 barrels of oil (= 2 contracts) that are to be delivered in a month, but who is not allowed to pay for this oil in advance, and instead must pay the market (or ‘spot’) price of the oil at the time it is delivered. This buyer thus faces considerable price risk (i.e. ‘exposure’) in that the price of (physical) oil might rise sharply. Airlines typically have to deal with this kind of complication where fuel is concerned, and so by reducing this price risk, the futures market has helped many of these firms to a higher profitability.

Risk averse buyers can use the futures market to ‘lock in’ the price at which they will receive their oil. At the time they contract for 2000 barrels of physical oil, they buy (go long) two futures contracts, which provide 2000 barrels of paper oil. Later, just before receiving and paying for their physical oil, they close their futures position by making an offsetting sale of 2 futures contracts (= 2000 barrels). If the price of physical oil increased, so will the price of paper oil, and so the loss on physical oil is offset. (Another important point is that a futures contract is also a forward contract, however delivery does not have to take place on a futures contract because transactors have the option of making an offsetting transaction before the maturity/expiry date. Observe, before the expiry date! On the other hand, forward contracts involve delivery, they can be for any amount, and normally offsetting transactions cannot take place.)

The key point in the above procedure is that if the price of the physical oil increases, and for one reason or another this is ‘bad’, so does the price of the paper oil, which is ‘good’. This is how we get the ‘locking in’ effect. Similarly, if the price of the physical oil decreases, so does the price of the paper oil. Thus a loss or gain for physical oil is compensated for by a gain or loss on paper oil. There are reasons why full compensation cannot always be realized, and there is also the matter of a fee for the broker arranging the transaction, but viable oil futures markets have turned out to be very efficient and popular establishments for hedging price risk.

Sellers of oil are usually afraid of price declines, and so their hedging activity begins with selling paper oil – NOTE, going short in paper and not physical oil, and so they do not need to store any barrels of physical oil in their kitchen and bedroom. If the price of physical oil declines, so does the price of paper oil, and so approximately what they lose on the physical market they gain on the paper market. I can refer readers to my new energy economics book for a more comprehensive discussion of the above, but there is an important matter that deserves attention immediately.

Assume that you believe that the oil price will rise, and to take advantage of this you go long in paper oil. Now suppose that the futures price declines instead of rises. What this means is that your futures contract loses value. When you open a position it is customary to pay a certain amount of margin, which is a security deposit. If the contract loses value (because the futures price goes the wrong way), you will usually be asked almost immediately by your broker to ‘top up’ your margin account, assuming that it does not contain excess margin.

Take the example above, where you bought 2000 barrels of paper oil. Suppose that margin was 10% of the price, and the opening price was $90/b. The total value of the transaction is $180,000, and so margin is $18,000, which is placed with your broker in cash or negotiable securities. Suppose that the futures price fell to $85/b. Your contract has now lost $10,000 (= 2000 x 5), which – via your broker and the futures exchange – ‘belongs’ to the person who was the seller of the contract, (or the person(s) who bought it from the original seller). Your margin account has now decreased to $8000 (= 18,000 – 10,000). Accordingly, if your margin account did not contain sufficient cash (or highly liquid securities) as a result of previous transactions, your broker might ask for more margin. If you don’t comply immediately the usual procedure is to closes your position.

By way of ending this discussion I can mention that in l980 the volatility of physical oil prices became so large that a futures market became extremely attractive to speculators as well as dealers in physical oil. For instance, there was a decreased propensity by some categories of the latter to hold inventories as a precaution against having to buy in a rising market. Instead, individuals and firms requiring oil in the future bought a number of futures contracts, which (as noted above and explained in my textbooks) enabled them to lock in the existing oil price. Later they went into the spot market to buy their oil, while at the same time making an offsetting sale of futures contracts. The markets for oil options and oil futures-options also functioned well. Without going into detail, the presence of these derivative markets usually contributed to restraining rather than increasing the price of oil, since they reduced the risks faced by buyer and sellers. They upgrade market efficiency by providing an increase in the quality and quantity of information and, as noted once by Professor Lester Telser, “they facilitate trade among strangers”. Well, so do some of the bars near the university where he teaches, but perhaps that subject belongs in another scientific discussion.

Unfortunately, even seasoned observers can make mistakes. Barbara Lewis, in the International Herald Tribune (May 23, 2008), says that the change in the oil market has been indicated by “record-high oil prices for (futures) contracts stretching out to 2016”. This statement is incorrect, because anybody who possesses a practical knowledge of the futures market would make a point of avoiding contracts of that maturity (8 years), for which there is hardly any liquidity, and therefore the price of the contract might be very unfavourable when the position is closed. This matter of liquidity and its relation to maturities should never be overlooked by serious students or investors.

INVENTORIES AND SHORT-RUN PRICING

On the basis of the previous section, readers should now possess an elementary insight into what a futures market is all about, and how simple are its mechanics. There are a few more aspects of this topic that should be considered, although a more thorough discussion – at an elementary level – is presented in my new energy economics book or my international finance book. Accordingly, at this point, I want to present my stock-flow market, which is shown in Figure 1.

Readers should not make the mistake of thinking that this diagram possesses the same order of difficulty as the diagrams in their courses in electric circuit analysis. As noted, s and h are flows whose units are the same as in your elementary economics textbook (e.g. b/y), while AI and DI are stocks (i.e. inventories), and do not contain a time dimension. For instance, they might simply be barrels of oil.

Earlier I presented what I regard as an indispensable expression for discussing price movements. This was dp/dt = f(D – A) ≡ f (DI – AI), where AI and DI have been shortened to A and D. What is essentially being said here is that if , for example, D > A, then price increases; and if flow supply and demand are a function of prices – i.e. s = s(p) and h = h(p) – then flow supply increases (because price increases), while flow demand decreases (also because price increases), and the difference between supply and demand, (s – h), goes into increasing inventories. This is the explanation that I expect my students to be able to repeat verbatim (although dp/dt is often replaced by Δp/Δt, which economics students should recognize from their work on elasticities in their first course in economics). Readers who desire more can examine several of the papers mentioned in the references, where simple differential equations are formulated. Here I would like to emphasize that all of the differential equations in my papers and in the papers of other authors are arbitrary. The ‘truth’ that I am primarily interested in is in Figure 1 and an interpretation of the expression for dp/dt above.

That brings us to a topic that is not stressed in those papers, but which ties in with the discussion of oil futures markets. By way of an introduction though, let’s note that if you decide to open a position (by going long or short) in futures contracts, it is also necessary to specify a maturity – i.e. ‘running time’ – for your contract. You should also be aware that the price of paper barrels on contracts with different maturities are not the same! Something that is very often forgotten is that there is very little liquidity for long-term futures contracts, and this influences their price. A scholar at Harvard recently assured his readers that all was well in the oil market because it was possible to hedge production and consumption for several years in the future with futures, although from a liquidity point of view, three months was probably the optimal hedging period. (He also was unaware that the reserve-production ratio is an inadequate measure of oil availability.) Now let’s look at Figure 2.

A normal arrangement in this matter of holding inventories, and perhaps hedging with futures, is that holders of inventories will only increase ‘inventory coverage’ if the spot price declines relative to futures prices. This makes sense for several reasons, one of which is that inventory holders expect to be compensated for tying up cash in buying and storing a commodity instead of e.g. purchasing interest bearing financial assets such as bank accounts.

Figure 2 is special in that to the left of A, present prices are higher than futures (or forward) prices. This situation is called backwardation, and is attributed to a comparatively low inventory coverage. In this situation we say that there is a positive ‘convenience yield’ associated with a larger inventory coverage!. The opposite situation, to the right of A, is called contango. As it happens, oil markets have shown a surprising tendency to be in backwardation a large part of the time, although over the past few years contango has been the rule.

I do not want to make heavy weather of the present topic, but a slight rephrasing and extension of the above discussion might be useful. First, note that if producer or consumer inventories of a commodity are low, then each extra unit held in stock reduces the possibility that e.g. industrial operations will have to be scaled down because a crucial input is unavailable. Remember that both producers and purchasers of industrial raw materials are bound by contractual obligations to their customers, and so inventories must be held (as a kind of insurance) as long as uncertainty exists as to whether an essential input or promised output will be physically available during the period when it is required.

Moreover, even if the expected money yield from acquiring, storing and later selling a commodity does not cover such things as its storage cost, this negative aspect might be regarded as counterbalanced by a positive marginal convenience yield. When the size of inventories is small relative to the amount of the commodity being used as a current input in production processes, then it could make economic sense to store more of the commodity. An effective price system should function in such a way as to ration existing stocks among perhaps many demanders of inventories, and if stocks are generally judged to be too small, we get a departure from what we usually think of as normal (i.e. a contango). Instead find the spot price ending up at a premium to the futures price (backwardation), and/or the price of futures contracts whose maturity dates are in the near future being higher than the price of contracts that expire later.

Perhaps the most immediate impact that variations in inventory levels have is in the spreads between the nearer futures contracts. Until comparatively recent, market actors apparently believed that there was a light surplus of oil on the market, or coming to the market, which meant that ‘A’ in the diagram would be fairly far to the left. As it happened though, for various reasons this opinion changed, which is shown in Figure 2 by a shifting down of the curve. ‘A’ would then be located a considerable distance to the right, and the familiar backwardation that often characterizes the oil market would be intensified.

Before leaving this section I want to systematize, on a very elementary technical level, the most important aspect of short-run pricing in the oil market, even if it has been claimed that oil traders are altering their views and focus on the oil markets, shifting from short-term to long-term. This is not entirely false. You already know something about this topic if you are a careful reader of the financial press, or have watched BLOOMBERG and perhaps Fox News instead of the daytime soap operas.

A few years ago, in the Financial Times (November 4, 2004), the commodities page contained the following information. “Crude oil futures moved lower in volatile trade, following a large increase in U.S. commercial crude inventories, signalling that the oil market is well supplied.” Let’s put this statement in equation form: the change in price (Δp) of physical oil is a function of the difference between desired inventories (DI), and actual inventories (AI). If that equation is linear, then we could write Δp = λ(DI – AI), where λ (or ‘lambda’) is a constant, and Δp (‘delta’ p) is the change in price. I wouldn’t be surprised if I could explain this simple relationship to the students at the secondary school I attended in Chicago – which, at that time, was one of the worst in the U.S.

Both CNN and Bloomberg – especially the latter – constantly mention inventories, but without explicitly referring to a relationship of the type presented above. That expression is also completely absent from mainstream microeconomics textbooks, and the same is true of most books on energy economics. This is one of the reasons why many academic discussions of the oil and gas markets are without any scientific value.

We are now going to work our way up to the above equation again, and in the course of doing so readers should take another look at Figure 1. To begin however, I slightly extend the above discussion. Oil inventories (i.e. oil stocks) are a stock concept : they are defined in e.g. barrels, and measured at a certain point in time, but they lack a time dimension. They have been designated AI and DI. On the other hand, current production (s) and demand (h) are flow concepts: they are defined and measured in terms of a certain unit of time (e.g. million barrels of oil per day (= mb/d).

Stocks and flows are closely related, since the change in stocks is determine by the net investment (or disinvestment) in stocks during a given period, or s – h: i.e. flow supply (s) minus flow demand (h). Moreover, in this model we define that famous concept equilibrium as the situation where desired stocks (DI) are equal to actual stocks (DI = AI), and the resulting ‘state of rest’ (i.e. equilibrium) is characterized by Δp = 0.

But if the stock market is out of equilibrium, e.g. DI > AI (because of expectations about present or future demand), then in the flow market we must have s > h in order to close the (DI – AI) gap. To obtain s > h, price must increase: the increased price raises flow supply (s) while decreasing flow demand (h). The size of (s – h) says something about how rapidly inventory holders want additional inventories. Hopefully, in the analysis, DI will eventually equal AI, and Δp = 0. Please note that the equation, Δp = λ(DI – AI), or p_t+1 – p_t = λ(DI – AI), is a simple linear relationship between excess stock demand and the price change, assuming λ is a constant. Now let us return to Figure 1.

The current (or flow) supply (s) goes into stocks (i.e. inventories) and current (i.e. flow) demand (h). Price is formed by the relation of actual stocks (AI) to desired stocks (DI), with the flows playing a secondary (but important) role. The equilibrium expression is AI = DI, and when this situation prevails, s = h, and price is constant (i.e. Δp = 0)! Put another way, a stock equilibrium implies a flow equilibrium, while a flow equilibrium does not imply a stock equilibrium. In this type of model expectations are very important because of their influence on desired stocks, and futures (i.e. paper) prices have some influence in forming price expectations in the physical market. Expected prices are undoubtedly more difficult to describe than via the simple implicit expression shown in Figure 1 – i.e. p^e = f(p) – but the main thing to recognize is the non-trivial role of expectations in determining the oil price, even if it was only when the oil price moved past $100/b that they received their true weight in the scheme of things.

Students of electrical engineering should immediately note that the diagram (with its feed-back ‘circuit’ p↔DI) takes on the appearance of a servomechanism, in which case very volatility is perfectly natural. This volatility is one of the reasons why futures and options markets for oil are so important, because they have permitted buyers and many sellers to hedge price uncertainty. For example, even though price spikes might be moderate, there are times when they can ruin unhedged buyers or sellers.

SPECULATION AND THE PRICE OF OIL

Some observers think that speculation is the cause of the escalation of the oil price over the past few years – an escalation that, as I have pointed out in many lectures and publications is capable of cutting the ground out from under the international macroeconomy. Put another way, these ‘pundits’ (= self-appointed experts) believe that we are dealing with a bubble, which is a price movement unsupported by fundamentals

Among the gentlemen claiming that excessive speculation is responsible for the bad oil news now being experienced by the buy side of that market, are the billionaire financier Mr George Soros (who admits that he is not an oil market expert, and accepts that what he calls the oil price bubble has strong fundamental underpinnings), the influential television personality Mr Bill O’Reilly, and Lord Megnad Desai, who is a professor of economics at the London School of Economics. Many years ago Lord Desai and myself had a disagreement about the price of copper that was concluded in the select learned journal Econometrica. I don’t recall how the referees ruled on that dispute, although I do remember that with copper – as at present with oil – I took great care to avoid making embarrassing mistakes.

Nor do I intend to make one here. The steadily rising oil price that we have witnessed of late is basically explained by the relation between ‘flow’ supply and ‘flow’ demand, where the term ‘flow’ was defined earlier, and with or without speculation the result would be almost the same. What has happened – as pointed out early in the present contribution – is that ‘normal’ demand is tending to outrun ‘normal’ supply, causing a fundamental supply-demand imbalance that is mostly (though not entirely) independent of speculative activities. This keeps inventories below the desired level, and leads to the earlier rather than later production of a certain quantity of oil, although later production could reduce the present value of intertemporal production costs by allowing a less intensive exploitation of high cost deposits. (Among other things, this might lower the rental rate for some production equipment, as well as reduce ‘overtime’ costs for employees.)

It should not be denied however that the financial market is now playing a more meaningful role than usual in the forming of (oil price) expectations, which is largely due to the price of this crucially important commodity rising or falling faster than the great majority of observers thought possible, and also in some cases the ‘formula pricing’ of physical oil taking place that has the futures price as a component. Accordingly, buyers and sellers of physical oil observe and think about the oil price much more intensely than before. This mention of very close observation brings to mind Werner Heisenberg’s uncertainty theory which, employed in financial economics rather than physics, means that false signals are often generated. For instance, when the influential oil investor T. Boone Pickens stated that oil could surge to $150/b, prices immediately moved higher. This display of respect for Mr Pickens’ acumen was impressive, although the term ‘over-reaction’ immediately flashed through my brain.

I don’t know if Lord Desai is familiar with enough academic energy economics to understand what is going on in and around the oil market today, but I am sure that George Soros has a superior insight, and Mr O’Reilly is probably ready to claim that he deserves to be honoured for merely taking an interest in the topic. For instance, in l992 Mr Soros was responsible for a magnificently correct bet that the British government would be forced to devalue sterling. Ostensibly, Soros’ Quantum Group of hedge funds had ten billion dollars on the table, and London wine-bar gossip then and later was prone to claim that a billion of the resulting windfall ended up in Mr Soros’ pocket.

While not short of ready cash, Mr O’Reilly does not operate at those heights, but he has blamed “little guys in Las Vegas” for high oil (and motor fuel) prices. As Tina Turner might say, ‘what’s Las Vegas got to do with it’, in that he not only was wrong, but expressing himself in that carefree manner would hardly endear him to more sophisticated members of his congregation. Similarly, Senator Joseph Lieberman was considerably out of his depth when (in l990) he asserted that “It’s startling to think of oil prices being set by young guys on the floor of the exchange screaming at each other on the basis of rumours’. Actually, it is so non-startling that ten years later, when Lieberman was Senator Al Gore’s running mate in the U.S. presidential election, I forgot my allegiance to the Democratic Party and didn’t bother to exercise my franchise.

A more important person on the oil price scene is Abdullah el-Badri, secretary-general of the Organization of Petroleum Exporting Countries (OPEC), who recently summarized his thinking on the oil price by saying “The market is really crazy”. In a broad sense this is absolutely correct, because much of the craziness originates with politicians and civil servants in the oil importing countries, who until recently believed that OPEC would never get its act together, and as a result the oil price was destined to go south rather than north. If anything this incoherent behaviour has intensified, since there is a bizarre craving in certain up-market circles to believe that the OPEC countries would really and truly like to see lower oil prices. What they should believe is that very high oil prices provide those countries with the wherewithal to continue the diversification of their economies ‘out’ of the export of crude oil (and possibly gas),

The chairman of BP (British Petroleum) offered some quaint remarks on this state of affairs recently in Stockholm, saying that “the (present) oil price has an influence on the world economy that is not positive. To deny this is silly.” As Dave Cohen, who writes the weekly column for ASPO-USA (http.//www.aspo-usa.com) has pointed out though, the denial club still has many important members.

FINAL STATEMENTS AND CONCLUSIONS

In 20 years I predict energy wars over oil and gas resources. By the time it becomes politically profitable to react to problems in the transport energy sector, it will be too late for significant development of alternatives and too politically risky not to fight over remaining supplies.

Len Gould (in EnergyPulse, Jan. 8, 2008)

Someone who is alarmed by the turn of events in the great world of energy is the former oil producer T. Boone Pickens, who is now a billionaire and hedge fund manager, and believes that the only way an energy disaster can be avoided in the U.S. is to fuel commercial vehicles with natural gas instead of diesel and gasoline. His position is that the supply of low priced oil is limited, while the U.S. has or will have access to an abundance of natural gas. He has accepted an estimate that the U.S. has a 100 year domestic supply of natural gas, and this is without accessing the supply of really exotic gas resources. I discuss this in a forthcoming survey of natural gas, and the conclusion I reach is that there is insufficient gas to do what Pickens would like to see done.

As an aside, according to a Rand Corporation report that was prepared for the U.S. Air Force and Energy Department, oil would have to cost between $55/b and $65/b before it was economical to produce coal based transportation fuels. (Mr Pickens has also expressed enthusiasm for a sizable CTL (coal to liquids) option). The same Rand report concludes that coal could provide 3 mb/d of transportation fuels for 90 years. Readers should perhaps think about this estimate, because in a country where oil consumption is now 21 mb/d, and a barrel of conventional gasoline requires more than a barrel of oil because of refining ‘mathematics’, CTL may deserve to be an important part of the energy policy that the new American president might soon propose.

In one of the latest issues of Business Week, there is a long article on the adventures in Russia of one of the most prestigious oil-field services firms, Schlumberger, where this multinational giant (with French roots) is frequently engaged in many countries to carry out exceptionally difficult drilling. Schlumberger has experienced considerable success, and among other things they have a reputation for leaving the politics to others, and concentrating on outperforming competitors and potential competitors.

This does not mean, however, that the presence of this and similar firms with state-of-the-art technology at their disposal will make the impossible possible, by which I mean find and produce oil that does not exist. Instead, the thousands of wells that reputedly will be drilled by Schlumberger are necessary to prevent a steep decline in Russian output. This is an important observation, because Professor Gary Becker has advanced the opinion that we can find a portion of our energy salvation beneath the frozen tundra of Russia. One of the most important energy players in Russia has said that it should not be expected that Russian production will ever exceed 10 mb/d, and since domestic consumption is increasing in that country, exports will likely decrease.

There is little or no good news in this paper for those of us on the buy side of the oil market. One of the reasons is the stunning failure of key experts and players to draw the correct conclusions about the structure and mechanics of the world oil market. In addition, in considering the actions and claims of certain oil companies who are involved with activities in places like the Gulf of Mexico and Caspian, some words of the billionaire Canadian investor Stephen Jarislowsky are highly applicable: “It’s absolutely unbelievable what’s going on. We’re living in just about the most dishonest time in the history of man.” He could have added that a large part of this dishonesty originates with so-called students of the oil markets in the universities and ‘think tanks’, who have decided that their best career move is to take advantage of the veneration of their devotees by abandoning the restraints imposed by history and conventional logic. Instead they turn to mythical claims that the price system will relieve our oil anxieties.

A few provocative observations are in order at this time, beginning with one offered by Professor Michael Klare, editor of the important journal Current History. “If the oil from the Persian Gulf cannot be kept under U.S. control, our possibility to remain the dominating power in the world could be brought into question.” A useful comment on this can be derived from the likely outcome of the present war in the Gulf, which is that it may no longer be possible to ensure that the oil in the Gulf can be kept under U.S. control. Of course, for what it is worth – which isn’t much – it may still be possible to guarantee the stipulations of the Carter Doctrine from 1980: “Every attack by a foreign power to win control over the Persian Gulf will be interpreted as an attack on the vital interest of the United States. Such attacks will be repulsed employing all necessary means, to include military force.”

One problem here though is an interpretation of the term “foreign power”, which at the time that President Carter issued this warning almost certainly meant the Soviet Union. At present it could mean countries to which the oil legally belongs. I see no evidence that a peaking of the global oil supply will take place in the very near future, but if it did some doubt must be expressed as to whether the countries in e.g. the Persian Gulf would be encouraged/allowed to produce oil at the rate that they consider desirable. The energy wars to which Len Gould referred can only mean wars between some oil exporters and some oil importers, since even owners of a fleet of SUVs might hesitate to endorse nuclear war in order to enjoy the thrill of zooming down the Pacific Coast Highway at speeds close to those registered in a Monte Carlo Rally.

In another Business Week article (January 21, 2008), it was stated that six Gulf States control sovereign wealth fund assets of about $1.7 trillion – or as much as all the hedge funds in the world. Since I consider the prestige of hedge funds largely an illusion, the deal-making referred to in that article belongs in a soap opera as much as it does in a serious business publication, and I have attempted to make this point whenever I get the opportunity. However, I am prepared to admit that something that cannot be disregarded is the ability of money generated in that part of the world to influence the price of oil by financing the diversification of Gulf States away from oil and into ‘something else’. This is not the place however for me to elaborate on that observation, other than to say that the kind of economics that I have studied and taught informs me that (ceteris paribus) the greater the pace of diversification, the less will be the effort made to produce and export oil and gas. The decision makers in the oil (and gas) importing countries would do well to focus on this point.

One more item needs to be mentioned before closing this exposition. This concerns the real price of oil – which takes into consideration inflation (and perhaps also) exchange rates – as compared to the money (or ‘nominal’) price. The real price has to do with how much ‘real goods’ that a certain amount of money will buy. It is often claimed that although the money price of oil may have touched e.g. $100/b, the real price was much lower on that occasion.

The excellent Josh in the soap opera ‘The West Wing’ informed that program’s faithful listeners that the highest real price since October 1973 (which was the date of the first oil price shock) was in l980-81, when a change in the political situation in Iran led to the nominal oil price spiking to $40/b. His contention might be correct if the base date for the calculation of the real price was 1973.

I prefer to believe that the base date for calculating the present real price should be in the middle of the l980s, or perhaps the middle of the l990s, after adjustments had been made to the earlier price shocks, and large industries – to include oil producing firms – as well as consumers, were making plans and investments to deal with a future in which there was talk in the corridors and restaurants of power that someday the oil price would stabilize at $28/b (which was OPEC’s goal), or even in the low 20s, which oil firms said that they were using as a benchmark for their investment plans.

For the persons and firms who accepted those forecast prices as realistic, and who adjusted their investment and consumption to deal with these expectations, an oil price in the range that we have experienced in the last year or two is capable of bringing about real sacrifices. For instance, at the present time the economy of e.g. the U.S. is in the process of weakening, leading to serious job losses and/or lower standards for millions, while at the same time in the Gulf, economies have been strengthened to a point where until recently there was talk of constructing a new Olympus. The rising oil price might also have had a major influence on share prices, and what we may be experiencing now is the start of a cycle in which falling share prices will impact GDP via the wealth effect, which in turn will put a further downward pressure on shares and reduce aggregate demand. As they might say on Wall Street: ‘no, Virginia, the declining real price of oil that ill-informed observers often discuss in those unread journals gathering dust in our academic libraries does not pertain to real people’. Really.

And finally, in the light of all that has been said above, I would like to get the peak oil issue off the table (again) by repeating something I once wrote, and replay in all my lectures on oil, to include this one, as well as any and every conversation touching on that subject, regardless of how inappropriate the occasion. Peak oil is not about the future – it’s about the past!. It’s about a (generally unspoken) strategy formulated many years ago by the most important countries in OPEC, which features a stagnation or decrease in the output of their invaluable oil (and probably also gas) when they get the opportunity. High oil prices gave them the opportunity last year and earlier this year, and it makes sense to believe that it will give them the opportunity again!. It’s not only about more money rather than less, but using that money to obtain the kind of future that many importers of oil thought that they alone deserved.