Bryan Caplan  

Son of Simon

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Jackson Hole Macro... Technological Independence...

In the spirit of the original Simon-Ehrlich bet, people who disagree about the long-run price of oil are putting their money where their mouth is. According to the Laissez-Faire Books blog, energy expert Matthew Simmons has bet NYT columnist John Tierney and Simon's widow Rita Simon $2500 each that in 2010 the average price of a barrel of oil will exceed $200 - a little more than triple the current price. As far as I can tell, the bet is at even odds.

Here's Tierney on the background of the bet:

After reading his prediction, quoted Sunday in the cover story of The New York Times Magazine, that oil prices will soar into the triple digits, I called to ask if he'd back his prophecy with cash. Without a second's hesitation, he agreed to bet me $5,000.

His only concern seemed to be that he was fleecing me. Mr. Simmons, the head of a Houston investment bank specializing in the energy industry, patiently explained to me why Saudi Arabia's oil production would falter much sooner than expected. That's the thesis of his new book, Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy.

This bet reminds me of the recent WSJ Econoblog with James Hamilton and Robert Kaufmann. Both of these smart and well-informed economists seemed pretty convinced that world oil production is soon going to peak, even though demand seems sure to keep rising.

I don't know enough to respond intelligently to the details of their arguments, but I still found them very unconvincing. To my mind, they kept dancing around the elephant in the room: Predictions of increasing natural resource scarcity, including oil, have been around for over a century, and on average they've been dead wrong. A big part of the problem is probably that responsible experts like to base their predictions on the visible facts at hand, and feel nervous speculating about the impact of future discoveries and innovations - even in industries where discoveries and innovations are the norm.


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COMMENTS (18 to date)
T.R. Elliott writes:

Hubbert was in fact dead right for his prediction of the continental US oil production. His was a prediction based upon sound geological reasoning. The newest predictions also appear sound. There is a great amount of uncertainty in these predictions, but even the best estimates admit that we will have passed peak by 2035. Odds are it will be well before then.

The fact that predictions in the past have been wrong is pretty meaningless. It all depends on how the predictions were made. I don't make investments, for example, based upon all the different opinions based upon different approaches (or lack thereof) that have been made in the past. I look at the data in front of me. People have said all kinds of stupid things, made all kinds of stupid predictions, etc in the past. Give me the data. Production data, depletion statistics, capital investments and time required to deal with depletion and to increase production, and the dependence of the economy on energy, and oil transportation in particular.

The bet between Tierney and Simmons seems pretty silly. The details are over at Econbrowser. But no system can continue with exponential growth indefinitely. That is a physical impossibility (unless you're Julian Simon, but he's dead and therefore can't make such silly predictions any longer). People seem to get excited about that silly meaningless bet with Ehrlich. These are probably the same people who were buying telecomm stocks at the behest of Gilder shortly before it imploded.

Me? I think there is good evidence that economic growth will be increasingly strained and financial systems rattled as energy production tightens. Economists can give us platitudes about alternatives and incentive and demand destruction, but physics has a few things to say about this as well. I'm betting on higher energy costs. The days of cheap energy are almost over.

Don writes:

If oil (and energy generally) is going to be so expensive so soon, why are the Saudis (for example) selling it today? Wouldn't they do much better by sitting on it and waiting for the price to rise to $200 per barrel in a few years? That's about a 200% return (hard to beat). Storage costs can't be that high.

I guess they just haven't been wise enough to seek the guidance of the all-knowing T.R. Elliott.

dsquared writes:

Wouldn't they do much better by sitting on it and waiting for the price to rise to $200 per barrel in a few years?

Yes, but it's been more or less official OPEC policy for a while that they want to manage the price of oil to make sure that as little as possible effort is put into developing alternative fuels ...

Robert writes:


Wouldn't they do much better by sitting on it and waiting for the price to rise to $200 per barrel in a few years?

In addition to not wanting to encourage alternative fuel development, they

(a) have a welfare state to run. The price of oil next year does you no good if the peopel revolt in the mean time.

(b) have customers to maintain a relationship with. If you turn off the tap and cause global economic contraction, you reduce the number of potential customers to buy that expensive oil next year.

spencer writes:

The optimal pricing strategy for an oligopolist is to set the price just below that level that will attract significant new entrents to the market. In the 1970s the Saudis violated this rule when they let prices rise to the point where north sea and north slope oil became profitable.

At $60 a lot of oil can be found that can not be found at $40. For example, the extractable oil in ANWAR almost doubles if you use a price of $60 rather then $40.

This is happening again. But do not forget the lead time on bring that new oil on line is very long, and during that lead time the price rises to well over the long run equilibrium price.
This is what we are seeing now even though the new equilibrium price will be higher then it use to be.

Don writes:

dsquared wrote:

"Yes, but it's been more or less official OPEC policy for a while that they want to manage the price of oil to make sure that as little as possible effort is put into developing alternative fuels ..."

I was expecting somebody to provide this reply, but not somebody as smart as you are. Surely you understand that holding the price below its optimal path to discourage effort into alternative fuel development will only accelerate the draw-down of oil reserves and hasten the profitability of alternative fuels.

Robert wrote:

"(a) have a welfare state to run. The price of oil next year does you no good if the peopel (sic)revolt in the mean time."

Imagine how much you could borrow using all that oil as collateral, particularly if it's going to be $200 per barrel!

spencer wrote: "The optimal pricing strategy for an oligopolist is to set the price just below that level that will attract significant new entrents to the market."

The optimal pricing strategy for an oligopolist is much more complex than that, and is nowhere near as general as you claim. I recommend Church & Ware or Cabral for excellent discussions of optimal pricing strategy for some oligopolists in particular strategic situations.

T.R. Elliott writes:

I agree that there is merit in much of the speculation regarding the production of oil. I also have high regard for the analysis and identification of phenomena (e.g. externalities) that economists bring to the study of human interactions within the broader ecosystem. My point, which unfortunately I make with an attitude, is that economists cannot tell us that much about what is happening now (explanation) and even less about the future (prediction). The problem is that human interactions are a complex system, humans are not that rational (economists bend themselves over backwards to define and redefine "rational" in order to meet the facts), and humans have a strong herding component to their behaviors.

So all the above speculation about what the Saudi's are doing is interesting. Could be. Might not be. The facts that I can get my hands around tell me that world energy production is going to have problems keeping up with demand (and please let's not get into a demand definitional debate). And capital investments necessary to deal with depletion and to meet new demand will stress the system. And the arm-chair discussions of "what price oil must be at in order for other alternatives to be economic" is just that--armchair hypothesizing. A good look at the physics of this issue says oil is going to remain expensive for a while.

But be my guest. Bet that it's going down. I think oil will hit $80 before it ever hits $40. I'm not convinced we'll ever see a $40 barrel of oil again.

Robert writes:


This is happening again. But do not forget the lead time on bring that new oil on line is very long, and during that lead time the price rises to well over the long run equilibrium price.
This is what we are seeing now even though the new equilibrium price will be higher then it use to be.

The South African firm Sasol produces something like one-fourth of that country's liquid fuel from coal. Now a number I've never seen but would very much like to is the long-term equilibrium price at which this fuel becomes viable without the subsidies it receives in SA.

The technology is mature, and compatible with existing infrastructure. Given the abundance and wide geographical availability of coal, once this technology is brought into play, it will stabilize the price of oil; but I've never seen anyone speculate with confidence on what the new equilibrium price will be.

T.R. Elliott writes:

Robert: Excellent point. I wonder the same as well. My own feeling is that the price will not based upon production costs. Oil has not been priced in those terms in quite a while. This is why I don't believe the arguments that alternatives are viable at a certain price point. Now I'm not saying that they aren't viable at a certain price point. But supply/demand is the crucial point. And I think there are capital investment and scalability problems that will make it difficult for coal to produce at volumes that will price oil based upon production costs. Supply/demand will determine the price point. So it's a matter of the economy's ability to handle higher prices. I don't think anyone knows what that price point is.

Phil writes:

Aren't there Oil Futures five years ahead that Simmons could have bought, and gotten much better odds?

Sounds to me like he didn't really make a bet, he just bought $5,000 worth of publicity for his book.

rmark writes:

and Hubberts method failed for several other predictions on resources. He may have just gotten lucky on U.S. production.

Dez Akin writes:

It appears Bryan, while I'm sure he knows more about economic theory than I do, is an excessive true believer in perfect substitutes.

Oil is certainly running out; Geology tells us how much of the stuff is in the ground and how much is physically extractable, and oil demand growth intersects with physical supply sometime in the next fifty years in just about every plausible model of oil resources. So oil going up to $200 per barrel isn't an impossible scenario.

There are oil substitues: Coal, tar sands, natural gas can all be refined into liquid hydrocarbons (gasoline, diesel, kerosene) at certain price points. Coal liquefaction is profitable above 30 dollars per barrel, tar sands are recoverable at 20 or so, shale maybe 30. So there is plenty of resource substitution avaliable but the majors with the capital to invest all remember the price of oil plunging down to 10 dollars per barrel less than a decade ago and are worried that curret pricing activity is just a bubble, so are holding tight on the purse strings.

This exascerbates the price situation of course. And when projects finally do get funding, they often take years to complete and begin production. Investment even in ordinary crude oil drilling is slow, so a huge price run up isn't impossible to imagine, but eventually demand destruction happens.

Of course coal resources are limited as well, but eventually we will see what fossil fuels really are: not energy but chemical feedstocks for fuels. Peak oil certainly will happen and will be an economic event, but it will not be the end of cheap energy. Possibly the end of cheap liquid fuel.

This is because we have about 10^16 watts of sunlight insolating the earth, and about 10^14 metric tons of nuclear fuel (enough for about 10^9 years of running our current civilization with breeder reactors.) Energy in terms of kilowatt hours per man hour will undoubtably eventually be cheaper than it is today.

But there are tens of trillions of dollars of infrastructure invested in our current arrangement of liquid hydrocarbon fuels, so the road will likely be bumpy given that the substitutes aren't perfect.

rmark writes:

plus there I suspect that he used a bell curve for convenience, while rising prices should reduce use, stretching out the right side of the curve..

aaron writes:

"Imagine how much the Saudi's could borrow using all that oil as collatoral."

The answer is ~$66 a barrel minus a risk premium. They can borrow more as the price increases and sell oil to pay off the debt and realize profits near peak. But you don't know what the peak is, when it will occur, or how long it will last. At some point that oil will decrease in value (if supply cannot grow, it will become a smaller part of our energy consumption over time, meaning price will grow at a slower rate than expected return in that economy. If more efficient energy production methods develop, the price will plummet.) You don't want to be stuck with a bunch of oil and debt in 30 years.

If you know that oil will go up more than the interest, you borrow the money.

If you think oil production will peak soon, you had better be ready to get it out of the ground.

dsquared writes:

Don: in a world of perfect foresight you would potentially be right but given the uncertainty about oil reserves and about the cost of non-oil technologies keeping the oil price low increases the incentive to wait and invest in non-oil technology in the future (and it has had this practical effect).

Don writes:

I don't follow you. I'll agree that there's uncertainty about the extent of oil reserves. I'll also agree that there's uncertainty about the cost of alternatives and about the returns to investment in cost-reduction R&D. Those uncertainties would result in a substantial risk premium for investment in alternative energy. But those uncertainties exist even if the oil sellers pursue a profit-maximizing time path of prices, and it's not clear at all to me that these uncertainties increase if an oil seller pursues a suboptimal time path.

Also, the claim that it has had this practical effect is an empirical claim, for which the evidence is ... what?

Best regards,

Don

T.R. Elliott writes:

I suggest taking a look at this post in order to come to grips with the capital investment issues and enormities that we face as oil production peaks and starts depleting from existing wells. [link]

As oil production peaks, we will face crises like this again and again and again. At one time, the Saudis could just pump more. It's not clear they can do that any longer. For the time being, there is enough oil (just not enough gas). Refining capacity will help with that. And demand destruction--which means less idiotic SUVs on the road--will also help. But once we squeeze the inefficiencies out of the system, we still face continued depletion and the race to organize the capital required to deal with it.

Economists who don't give these issues enough thought (those that operate within the realm of substitution as a word on the page and a formulate in equations that exist within a vacuum of economics journals) don't understand this. They will.

Don writes:

Mr. Elliott,

Sadly, you've missed the point. Again.

I'll repeat and elaborate on my question. Suppose you're right, and oil will soon be $200 per barrel. Why, then, are oil producers selling it today at $60 per barrel, rather than waiting and selling it at $200 in a couple of years? Moreover, why aren't entrepreneurial individuals buying oil today at $60 in large quantities and storing it in anticipation of the massive price increases you predict?

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