Wishful thinking at the Economist

Tim Worstall

Let me get this straight.
"The ensuing high paper prices have only encouraged producers further to moderate production."
Your argument depends upon the idea that supply curves slope downwards?
Really?
You want to write that up you know, there's a certain Nobel in it if you can prove it. Overturning hundreds of years of economic thought you are there.

Fred Zen

I have to wonder why the Spectator is wasting space with this ludicrous display of economic ignorance.

Mark

Hmmm. I’m not at all convinced. I find it really hard to believe that “at will, Aramco could take us back to production levels that once delivered oil at $30”. In all of the serious analyses and reports that I’ve seen about global oil reserves (proven and as-yet-unidentified) and production/refining capacity, I’ve not seen anything that says we can now easily and simply revert back to good old cheap energy “at will”: that’s incredulous. Certainly, there’s something not right about the interaction between supply/demand fundamentals and market-makers, but I think that on balance the fundamentals are holding sway: quite simply, demand is exceeding supply and it’s not clear where this will end up – something has to give. We’re in a situation where, relatively speaking, demand is infinite and supply is finite. Of course, in the end the supply-is-finite position will hold sway. The puzzle is what happens in between as we all crave the stuff whilst it runs out. I admit to being pessimistic that mankind will quickly and smoothly replace every oil-using machine/process such that we’ll not really notice the move from, say, internal combustion engines to solar-powered vehicles or hydrogen-cell vehicles or whatever. And as for the myriad other activities of mankind that can be traced to dependence on cheap oil/energy, goodness knows how we’ll find energy substitutes for all of those. But transportation is the biggest weakness and its demise (as we know it) will have the greatest effect on mankind – especially the developed world. Increasingly unaffordable transportation will be the primary cause of the most grief in the coming years. The “global village” will die and we’ll need to learn again how to live and work in much more localised and sustainable communities.

Tony Curzon Price

Tim,

Careful what you mean by the supply curve here. The supply today against tomorrow's price, with a storable good is very naturally downward sloping. If tomorrow's price is high relative to today's, I reduce my supply to the market today if that means there is more for me to supply tomorrow.

That is exactly the situation for an oil field that is not producing at full capacity.

The Nobel prize was not awarded to Hotelling for this observation, but he is widely and rightly credited with working out the economics of extraction based on this sort of reasoning - see The Economics of Exhaustible Resources", 1931, JPE. Hotelling models are used all over the oil industry to determine optimum depletion paths for fields and portfolios. I have built some of these models, and they do produce counter-intuitive results.

Fred - Please be more precise and we can talk.

Mark. Here was my reasoning on quantities. Today, Saudi Arabia has approx 2.5m barrels per day of spare capacity. Add the 0.5m of Iraqi production that remains idle - the world has capacity for 3m bpd more than it is producing today. Oil demand is growing by about 1m bpd per year. 2005, 3mbpd ago, was the last time we had oil at the 30 /bll level.

I agree with you, Mark, that demand will come to exceed supply, but it has not done so yet. That is the important point about spare capacity -- as long as there is spare production capacity, someone is currently, as an everyday decision, holding back on supply. Happens to be Aramco, and it happens to make sense in the current environment and according to plausible inputs to a Hotelling depletion model.

I think it is really important to realise that around $75-85 per barrel, there is lots of financially viable liquid fuel. That is approximately the price at which coal liquifaction is viable, and there is a lot of coal about.

I do not believe that supply constraints will force on us the reduction in consumption that the environment undoubtedly requires.

Tony

Tony Curzon Price

.. and in case you want more of the knock-about with Tim, we are arguing out the details on his blog, here:
http://timworstall.com/2008/06/19/quite-remarkable/#comment-14055
( http://timworstall.com/2008/06/19/quite-remarkable/#comment-14055 )

Arneson Stidgeley

But the hoarding isn't been done by those nasty hedge funds and other financial institutions, no?

It is by 'natural' participants in the oil markets - eg, the examples you cite: oil companies and Opec members.

Or have I missed something? Perhaps I have.

tony curzon price

You're right, Arneson, the stockpiling is being done by those with oil wells. Indeed, SA's statement yesterday that it is ready to supply a barrel to anyone who asks for one is a clear indication that it is "storing" in this sense.

But there are 2 key reasons why the producers with spare capacity are storing:
1. it's not clear what you do with cash today because risk free returns seem to be below zero --- this is due to financial turmoil;
2. it looks as if you can sell future oil for $140/bll so why take it our of the ground for less today? (also a financial effect, this one probably caused by the bubble moving from risky-looking credit derivatives to Long Only Commodity Funds).

So financial effects are driving real production decisions today.
I think we can be sure that if SA were selling oil at the well for its long run replacement cost (say $75/bll), then, in the current environment, everyone---hedge funds, oil majors, etc---would be stockpiling like mad. (This is what the tanker-charters have been doing anyway, even at the high well-head price).

I think that SA---(and Russia if it has spare capacity)---is behaving in a sophisticated, rational way given the bubble.

The challenge for the world economy today is how to deflate the serial bubbles without causing great hardship.

Tony

tony curzon price

I have collected a few more thoughts on the commentary around the oil price over here at
openDemocracy

Tony

tony curzon price

This debate continues to set the economics blogosphere abuzz.

Mark Thoma has a summary of yesterday's to-and-fro here. I think the most significant move yesterday came from Krugman changing his tone against the sort of argument I have presented here from: "you can't be serious" to "I see the logic, but you're going to have a hard time getting the data to prove it..." I expect further accommodating overtures ...

I answer Mark Thoma's question about any commonality between agriculture prices and oil prices here.

tony curzon price

As calm returns to the economics blogosphere on the speculation question, I summarise where the argument got to here.

Tony Curzon Price, opendemocracy.net

There is a sort of morbid fascination returning to this argument one year on. It seems to me that I was more right than the critics here. In the face of increasing world oil demand in 2008, prices crashed. That a fortiori counts out the fundamentalists. As well as that, the past year has brought increasing recognition from even those with slight economics -- the brigade that once believed that a downward sloping demand curve and upward sloping supply curve offered deep insights into economic events --- that assets really are different and are ruled by the sorts of effects that I describe here. The most important one -- even in today's context -- is that when you are talking of durable goods with common values, the more people want to sell, the less buyers want to buy. The potential of this simple observation to generate bubbles and cycles is now better understood.

I still look forward to Paul Krugman revisiting the oil price question. He was one of the unlikelier fundamentalists last year, and I presume he must now acknowledge his mistake, if only because of the simple a fortiori argument. But still, I look forward to his saying it.

Tony