A Glimmer of Hope on Oil

Arnold:

The model you describe is the Hotelling theory of exhaustible resources. It has been shown by many people (primarily Adelman) that it only applies when the finite total amount of the resource is know. The finite amount of oil isn't known: as inventories drop, more oil (reserves) are added to the inventory.

If we ever get to the point where new oil stops being discovered, then Hotelling kicks in. In the meantime, in a free market for mineral commidities prices will tend to drop as technology improves (this is why Julian Simon won his bet with Ehrlich.)

Oil prices are currently determined not by competitive market price theory, but by the behavior of a dominant cartel. And as long as the Saudis keep cheap oil locked away in the ground, the competivitve price (estimated to be between $8-$10 per barrel) will be far exceeded, as it is in all Cournot markets.

Barry,
Good point. In the long run, I agree that substitution, technological change, and the potential for new discoveries all matter.

I was thinking in the short term, about the relationship between forward and spot prices for a storable commodity.

I think that most people believe that since gas prices are so high relative to the average of recent times, then they are bound to come down. But in an efficient market you would not expect them to come down. You're right that a cartel probably messes up the efficient market story, but some people don't think the cartel is really effective.

But the story I linked to gave me a glimmer of hope that prices would break.

Things are not so simple.

Reserves change based on the price. If you can’t produce it at a profit, it’s not a reserve. This caused a downward revision in reserves in the US in 1998. Likewise it caused an upward revision in later years as prices moved higher.

Also, a very low oil price caused a severe reduction in exploration for new reserves. Companies had better things to do with their money. We only replaced 24% of our production in 1998. As crude prices went up exploration increased, and in the US, we replaced over 100% of our production from 1999 through 2002. I haven’t seen 2003 data yet.

You’ve also got some other dynamics at work as we reduce finding and production costs.

http://www.eia.doe.gov/pub/oil_gas/natural_gas/data_publications/crude_oil_natural_gas_reserves/current/pdf/ch3.pdf

It would appear to me that there is the current pricing assumption that inventory of oil and gas on hand is the determinant factor in the price realized. This assumption might be valid if the annual oil and gas resource discovered was consistent or greater than the annual production.

Mr. Gustafson's comment regarding the pricing of oil and gas is also true, as the scarcity of oil and gas increases so will the prices. This pricing model invokes consumers to consume less of the resource, and increasing the volume of economically, recoverable reserves, and therefore reflecting that the market will never run out of energy resources. This pricing model reflecting the efficient market hypothesis whereas the reserves in the ground are always economically recoverable to meet the needs of the energy consumer.

I would assert that OPEC has kept the price of energy below its true market value and therefore removing the real economic pricing model invoked by the above theory. As the rest of the worlds easily recovered reserves were depleted, a period of time would occur where the world supply of energy would be substantially below the markets demand (today), allowing the OPEC producers to reap the windfall pricing they are about to realize. (Real market price is greater then $125.00)

Best to consider this over a $33.00 per gallon cup of Starbucks coffee.

I suspect the basic arbitrage relationship here is not particularly strong for oil.

Isn't the equation relating spot and futures prices modified, in the case of a consumption good like oil, by something called convenience yield, which lowers the futures price?

In an uncertain supply environment like that of oil wouldn't the convenience yield be relatively high, driving futures prices down?

On the other hand, the negative correlation of oil prices with stock and bond prices should tend to drive futures prices up relative to expected spot prices.

It's not clear to me how these forces interact at any particular time, but they do suggest that that the futures/spot relationship is not very stable.

Of course, my thoughts are not troubled by any actual data on this subject.

The market price for oil today is being driven by speculation. The same thing occurred immediately prior to the war in Iraq. OPEC was putting more oil on the market and the price was still going up. Oil prices started to fall the day the war started. Uncertainty causes price increases. Once the uncertainty goes away, so does the price bubble.

Right now I think that the uncertainty is centered around instability in the middle east – Saudi Arabia, Iran, Iraq… I’m not sure what will cause it to go away this time.

As to filling the SPR contributing to the price increase, if I recall correctly, when OPEC wants to drive prices up by about $6 per barrel, they need to remove 1.5 mbpd from the market. At that kind of elasticity, filling the SPR at 160,000 bpd might add 65 cents to the price.

Arnold,
The efficient market must account for irrational buyer and seller behavior. It is not enough to say they would not exist in an efficient market. They always exist due to non-economic commitments. OPEC nations have too excessive Government program commitments to maintain an efficient market.

Paul Cox also mentioned the real market price should actually be $125/barrel. This is an unfunctional price, as could be exhibited by an Energy Cost/Employment curve. Some friends of myself suggest (real friends-they'll let me take it on the nose)that any price above $68/barrel will cost 70 million Workers per dollar until $80/ barrel, then escalating into more extreme unemployment. lgl

In the short run the relationship between the spot and futures market oil prices should be dominated by interest rates. But in the long run the price of oil should be a function of the costs of bring new oil supplies on line, and interest rates would play a very small role in that.

In the long run the price of oil should be determined by the marginal price of bring new supplies on line. The major oil firms are now using something like $16 to $20 in determining their drilling budgets. For all practical that is the marginal price of oil and higher prices in the short run do not have that much impact of drilling plans because the major oil firms plan on the basis of worse case scenario ie., where are prices likely to be when that oil comes on line. It makes no sense to bring $40 oil on line if the market price is $20.

The major oil firms believe there is sufficient oil available at $20 in central Asia and offshore Africa to meet world demand for the planning horizon -- +/- 10 to 15 years.

$125 for oil is an unreasonable price based on the assumptions that the consumers use of oil and gas are to be provided at the lowest possible prices. That $40 appears unreasonably low when the consumers assume that the commodity is scarce, non-renewable and no reasonable alternatives exist.

The point that "spencer" puts across is the main point of contention here. Until the investments in oil and gas production can make the criteria that the return provided is adequate for the marketplace, those high risk projects will not come on stream.

The deliverability of oil and gas is currently extremely high in comparison to the reserve base that proivdes that deliverability. As a result, critical shortages will occur, causing prices to reflect the risks of further exploration.

Of note the Brent field in the North Sea is reputed to have produced 97% of the oil in place. This is a significant oil field whose days are numbered. It is also not the only field that is producing faster then the markets assumption, supporting much higher current and future prices.

Some historical data on exploration and development costs per barrel of oil. Note the difference between US and foreign costs.

http://www.eia.doe.gov/emeu/aer/txt/ptb0408.html

For 2003, according to ExxonMobil’s annual report, their finding and development costs were $4.77 per barrel of oil equivalent. For ConocoPhillips the number was $4.29.

From the data it’s hard to tell if it’s becoming more or less expensive to find oil. The changes could merely reflect diminishing returns as more effort (exploration money) is expended.

Bernard is correct; convenience yield is a big issue here and a big reason why backwardation in oil futures markets doesn't track interest rates at all well. If you are a refinery running a continuous process which needs oil and you are close to running out, then your "convenience yield" is the entire cost of shutting down and starting up your refinery, which could be massive compared to the cost of the load of oil. If, conversely, you're an oil producer and all your onshore storage facilities are full, then your "convenience yield" can be strongly negative; you need someone to take the oil off your hands right now.

I'd also add that, as I posted on my own blog the SPR's buying power is magnified out of all proportion by the hedge funds. This is a good reason why governments shouldn't be involved in trading; if you knew that there was a buyer out there with no real regard for value and unlimited resources, you would exactly be short, would you?

Allan Sloan's proposal looks rather like an idea Fischer Black had for stabilising the gold price without the need for reserves; it seemed funny to me at the time but I didn't do any real work on it.

Efficient markets assume rational participants, who maximise utility.

I don't have such a high opinion of most market participants.

Efficient markets do not assume rational participants. Instead the assumption is that since participants who make rational decisions are rewarded with better outcomes, the market will create a result that would happen as If the market was made up rational actors. In other words, it's very similar to evolutionary theory which sometimes describes species as adopting 'strategies' to deal with problems. In reality, no biologist thinks that single celled organisms took a vote and decided to take a shot at breathing oxygen....

What critics of the SPR miss is the danger that an irrational actor will get control of Arabian oil fields. An 'oil embargo' is relatively meaningless, as we have learned, because while a country may refuse to sell to the US the US can simply buy from whatever country the oil exporter sells to. But what if a Bin Laden type gov't took control of Saudi Arabia and declared it would sell oil to no one? Even though such a policy would be economically suicidal it isn't unthinkable. Isn't it?