Arnold Kling  

Oil Company Speculators

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From the Economic Report of the President's energy chapter:

Prices on contracts for future deliveries of crude oil (called crude oil futures) indicate that market participants expect oil prices to remain elevated at or near current levels through at least the end of 2006.

...Having experienced past volatility in oil prices, oil companies report using a working assumption of $15-$30 per barrel for the future price of oil when making long-term investment planning decisions.

If the oil company executives want to put money on their "working assumption of $15-$30 per barrel," then they should go short in the futures market. But if their goal is to maximize shareholder wealth, then they should make long-term investment planning decisions based on the futures price of about $60 a barrel. What the oil company executives are doing is equivalent to a mortage banker making a home loan for 5 percent based on a "working assumption" that rates are going to eventually head down to that level.

I don't believe in a "windfall profits" tax for oil. But a "willful arrogance" tax might be in order.

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The author at Econbrowser in a related article titled Oil at $15-30 a barrel? writes:

    Arnold Kling was surprised by what he found in the energy chapter of the Economic Report of the President.

    [Tracked on February 23, 2006 12:36 AM]
COMMENTS (21 to date)
John Brothers writes:

Sorry, I don't understand. They're being conservative, and assuming that new fields won't be profitable unless they can pump the oil at lower than $15/bbl.

Are you saying they should either a) short the futures market or b) throw caution to the wind and assume that $60/bbl is stable now and forever?

That doesn't make sense to me. If the price goes down, and they reported that they were going to earn $60/bbl and they only earn $50, their stock prices go down, and they get sued by irate shareholders.

On the other hand, if they assume $15, and they get $50, they get a big windfall which makes the shareholders happy.

That just seems prudent.

What am I missing?

Bernard Yomtov writes:

John Brothers' point is a good one.

It's not a question of what you think oil prices will be. I doubt you could find an oil executive who thinks they will be in the $15-30 range any time soon, or ever.

The question is one of allocating capital to development and exploration. In dealing with that issue it is surely prudent, taking risk into account, to assume a relatively low price. Whether that should be $15-30 or something higher I have no idea, but it's important to note that there are two different issues being discussed here. Expectation is not everything.

Lord writes:

It is a difference of time horizon, futures over the next year or two, or investments that last perhaps 30 years. Making long range investments over short term price levels would be unwise in the extreme.

T.R. Elliott writes:

My two bits:

1. Ignore the futures market right now. I haven't found it a good predictor of much other than where we've been.

2. Play it safe. OPEC has shown how it can wreak havoc with investment plans based upon higher prices (by increasing production). I believe OPEC is producing all out or near so, but how can we know? If I were an oil investor, I'd incrementally raise the long-term price of oil and invest accordingly. Wait a year, watch world production, then raise again same.

From what I can tell, there are some production increases coming online in the next few years that get us through this tight period--for a while.

Long-term, I think we will see oil companies raise price per barrel projections, but not now.

One caveat: the probability of an oil shock is high at this time in the vent of a production shortfall.

Arnold Kling writes:

If there is an oil exploration effort that will be profitable if the price is $50 per barrel or higher three years from now, then you should be able to buy a long-dated put option, undertake the effort, and make a sure profit.

spencer writes:

The return on exploring and drilling runs over years and years -- the life of the field. So
even if the investment turns out to be profitable in year 3, you are still facing a risk on what it will be in years 5, 10, etc.

Essentially the oil service and drilling industry is operating at full capacity. So it realy does not matter what the oil executives think, the ability to investment is limited to the oil drilling industry capacity.

This is one of the costs of the boom-bust history of the oil industry. in the 1970s it created massive excess capacity when the rig count jumped from about 2,000 to 3,000 during the era of the windfall profits tax. In the mid-1980s the rig count fell to about 1,000 and has been running at about that rate since. So even if you invested like crazy in the oil eervice industry maybe you would get the rig count to grow at a 20% -25% rate.

So if the capacity to invest is severly limited why should the oil executives invest in fields that would only be profitable at $50 if this required them to pass up fields that would be profitable at $25.

T.R. Elliott writes:

I agree with spencer. I understand what Kling is saying in a general sense, but unless I see the math with several scenarios, and how this math works out over the life of that particular field, I'm not buying Kling's argument.

Trevor writes:

To add to spencer's excellent comment, in addition there is generally an organizational inefficiency. The commercial groups that do the trading and hedging are not in very close communication with the exploration groups that make the drilling decisions.

J Klein writes:

On reflection, "willful arrogance" is not. The problem of long term planning in oil is the fragility of drilling rights (and property rights in general) in most of the producing areas. Say I am an entrepreneur and have a 20 year contract to supply oil at the uniform price of 60 $ per barrel. I have a 20 year concession in Venezuela/Iran/Kazakhstan/Vietnam/Equatorial Guinea/Irak/Congo/Las Islas Malvinas/you name it, where I can produce at an average of 30 $. Which bank will give me a long term loan to finance my enterprise? The "political" risk is so high that only the vision of extraordinary profits may motivate me to even think of such adventure.
Now, if only the United States would assume seriously its role of global policeman, securing property rights and so on, long term planning may be possible. I dont think Prof. Kling can invent financial instruments that replace that necessary policing function. Even chimp bands need policemen (sorry, police-chimps).

J Klein writes:

PS I mean that the parallel between mortgage rates in the USA, which are based on clear and stable property rights and enforceable mortgages within the framework of a working system, and the estimated rate applicable to 20 year long contracts with a sovereign entity (if you can call Equatorial Guinea a working sovereign state-like entity, which in my opinion is not and will never be) in an unstable continent, etc. You get my point.

spencer writes:

Just another though on the oil companies selling futures. That has been a regular pratice in recent years for gold mining companies to sell their output in futures markets at prices above spot prices.

But I wonder who would be on the other side of the trade when the oil companies try to sell enough future contracts to make a significant difference for them? Wouldn't the increase in supply of oil futures create "backwardization" where the futures prices is below the spot price.

I don't know, but it would clearly have a significant dampening impact on futures prices.

Ilkka writes:

...Having experienced past volatility in oil prices, oil companies report using a working assumption of $15-$30 per barrel for the future price of oil when making long-term investment planning decisions.

When marginal cost of alternative energy sources is now about and under $30 per barrel oilwise and coming down, one is not very anxious to make a commitment of 40 years in oil investment. Oil price is bound to come down. There'll be no oil shortage in future, even current reserves can stay untouched.
For a farmer it's cheaper to burn grain than oil in his boiler at current prices.

At MC of oil under $10 and other energy under $30, would you bet your own money at future oil price of $100?

Dikran writes:

A big problem with Arnold's suggested strategy (buy 3-year $50 puts, in the comment above) is that the futures market is nowhere near large enough to permit the type of hedging operation an oil company would require. Anyone can verify at the NYMEX site that the current open interest for December 2009 $50 puts is only a few hundred contracts. This suggests that at *best* one could hedge the price of some millions of barrels of oil. The CEOs who Arnold criticizes in his post are operating at a much larger scale.

In addition, at the time of this writing these $50 puts are $5.40, so one has to pay $5.40 plus interest costs over three years to make this work. This means that the cost of production can be at most $44 per barrel, otherwise the operation will lose money.

Further, not all oil is the same, and oil with a high cost of production is often low-quality oil which cannot be sold for the full futures price.

The proposed hedging strategy might make sense for a small oil producer in the US who has no problems with the size of the options market and wishes to buy some insurance. For a large company, it doesn't make sense to consider this strategy.

There are other strategies, for example, hedging with futures directly instead of buying the options, but these have their own problems.

None of this should be news to anyone who has been following the market for oil stocks over the past few years.

The charge of "willful arrogance" is unwarranted.

Bernard Yomtov writes:

Dikran is on target.

From the point of view of the oil companies the supply of puts is upward-sloping. If they start buying puts in large enough quantities the price will surely rise sharply.

Also interesting is the implication that the people running these huge companies are grossly incompetent and are overlooking an easy arbitrage opportunity. Seems unlikely to me.

Perhaps the "willful arrogance" is not with the oil executives.

Dezakin writes:

Let me get this strait: Oil fields around the world are in terminal decline, with no new large discoveries besides the caspian and all potential discoveries in ultraexpensive places like ultradeepwater or some frozen hellhole like antarctica or the frozen wastes of Siberia. China and India continue to grow, creating new demand at an amazing clip and show no signs of slowing for the next twenty years or more...

And the price can drop down to 15 dollars per barrel for a sustained period?

This makes no sense at all.

These execs are just being loss averse because they got smacked in the face when the asian financial crisis hit. Demand wont ever get that low again, and the supply is approaching peak within decades at most. If these execs have long time horizons they'll see their investments increasing profitability as the rest of global production goes into decline.

jaimito writes:

Oil is replaceable, is polluting, is bad-smelling. Oilmen have large experience, China and India and South Korea did not start growing yesterday, and the price was dirt cheap for extended periods of time. Would you, Dezakin, invest your pension money in a very costly hole in the Antartic?

Dezakin writes:

Its not replacable by anything at less than 15 dollars per barrel; South Korea is insignificant, wheras China actually did start to matter significantly to commodities markets only several years ago when it finally became a force large enough to be felt.

These guys really dont know what they're talking about when they are setting the floor at 15 dollars per barrel. We're dealing with an industry that historically has put risktakers out of business and thus you have self selected for a bunch of cowards that are so risk averse they wont cross the street without getting a release form and police escort.

How much oil can be produced globally at less than 15 dollars per barrel? maybe 80 million barrels per day, and we're at it now, with the supply of the cheap stuff dwindling.

Sure we've got trillions of tons of coal and it can all be turned into gasoline and diesel fuel profitably with a sustained cost of 30 dollars per barrel, but we will never have a price slide to 15 dollars per barrel again.

jaimito writes:

It is only natural and proper that leaders of very large businesses behave prudently. They are certainly no cowards (it is a fact that some of them even go quail hunting with Dick Cheney). Historically, the oil business was created by risk-taking adventurers, and something of it still remains. Thousands of capitalist entrepreneurs and Chinese mandarins are touring the world and organizing operations in the most unlikely places. No one is stopping them except the market.

Bob Knaus writes:

Doesn't marginal cost of production come into play in making these decisions? If I'm in a competitive business, whether I'm building a factory or drilling a well I want to think about what it costs my competition to produce... not merely what the current or projected price level might be.

If I make a long-term capital investment in a facility that has twice the marginal production cost of my competition, I have put myself in a very risky position.

Gassy writes:

I tend to agree with Yomtov and Dikran, however, believe that *investors* would be willing to buy long-dated derivative instruments on oil at an optimally risk commensurationed level.

Your conundrum seems to highlight an inefficiency within our financial system (as much as, or more than,) a problem within a specific industry. Why doesn't Wall Street allocate capital away from inefficient users of capital to ones who can exploit the inefficiencies? Shouldn't the market inefficiency create both the sorcerers and userers of capital?

It seems that energy companies (even non-oil alternative energy one) should be able to raise capital by selling, for example, a long term bond with an embedded call option on oil, or long-dated derivative instruments, swaps, forwards, futures contracts, etc, that strike oil way above 15-30 per barrel.

If the (gapping?) inefficiencies that you highlight actually exist, and, if your economic and capital allocation system worked properly, there should not be any need for government intervention or even action by existing companies in the industry. Capital, pushed by speculators, arbitrageurs and entrepreneurs should flow to newly formed companies designed to exploit the market inefficiencies. Why doesn't capital easily and quickly flow around the "willfully arrogant"?

Furthermore, whether or whether not a government bureaucrat correctly or incorrectly suasions some aspect of an efficient capital allocation system should be irrelevant.

Larry writes:

I think we can assume either a) misprint on number, or b) should read cost of finding. Simple answer usually the best

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