Arnold Kling  

Forward prices and oil

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Charles Engel writes,


The amount of oil pumped out of the ground doesn’t just depend on the current price. If I don’t pump the oil today, I can pump it tomorrow. Tomorrow’s price matters, bubble or no bubble.


Let’s start with the market when there is no bubble, and, as economists do, let me make this as simple as possible. Let’s assume there is no uncertainty about how much oil is in the ground, or how much people will want to buy at any price, and no cost of extraction. What should happen then is the expected rate of increase in the real price of oil should equal the real interest rate. Why? If I sell my oil today, I can take the proceeds and get the real interest rate. If I don’t sell my oil, its price goes up at the real interest rate. The incentive to “hoard” is exactly balanced by the incentive to sell, and any individual producer is indifferent between selling now or later.

This is what is known as the Hotelling rule for pricing oil in the ground.

Engel continues, contra Krugman,


In this case, there is no excess supply of oil. End users buy as much as they want at the market price, and producers pump out exactly that much. Ultimately the level of the price is determined by the condition that, as the price rises at the rate of interest forever, the sum of demand over the current year and all future years equals the amount in the ground.

Later, he says,

if the run-up in prices were too rapid, so that the “expected” growth rate of the price exceeded the interest rate, there would be a strong disincentive to sell any oil. Producers would want to keep the oil in the ground, and, as Paul Krugman has argued, speculators would have an incentive to hoard oil. We see very little of that type of behavior going on, as Krugman has noted.

To drive this sort of speculative hoarding, we would need the futures price to be above the spot price by more than the real interest rate. That was not the case last time I looked.

As Engel points out, the description that bets fits the data is one in which the market has been continually surprised by fundamental factors. These could include anything. I can think of all sorts of possibilities. Suppose that the market thought that ethanol mandates would restrain oil demand, but that instead it failed to do so, or perhaps even increased demand indirectly because it takes energy to run farm equipment.

Anyway, there are all sorts of possible surprises.


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COMMENTS (6 to date)
BrotherMaynard writes:

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Mitch Oliver writes:

This is related something I've been considering for the past couple of weeks. Some congressman (Rockefeller, I think; for reference his name was definitely followed by a 'D') made a statement to the effect that no matter what legislative steps Congress takes to expand drilling and refining there will be no new oil on the market for 10 years.

It would seem to me that the prospect of additional future supply would begin to drive the price of oil down much sooner than 10 years in anticipation of this additional supply.

Obviously that is hand-waving, but am I missing something?

Arnold Kling writes:

Mitch, you are correct, although the effect is likely to be small because of discounting effects as well as uncertainty about whether the future oil will really arrive.

tom writes:

Can we tell whether it works the other way, whether increases in the futures prices have been driving up the spot prices?

James A. Donald writes:

There are three relevant prices. The present price, the price on the futures market, and the price that businessmen use to judge whether investments in increased oil production will be profitable. The futures price, and the estimated future price used to judge investments, has persistently been wildly wrong - far too low.

Therefore businessmen were caught with their pants down by a supply shock.

Expected and actual increases in the price of oil should lead to increased efforts to obtain oil. Unfortunately, the major form these efforts take is terrorism, blowing up pipelines, political demagoguery, and so forth - the supply of oil is likely to respond perversely to increased prices due to ill defended property rights.

Demand is increasing. Supply is not, will not, cannot, therefore prices will rise further. The only remedy to this situation is coal to liquids, but this is politically infeasible, due to greenies.

Karina writes:

One of the factors in how oil companies are calculating their minimum return on investments (base case scenarios for oil prices) is political forecasting.

For instance, the company I work for is effectively ignoring the price of oil because taxation in this particular country is on a sliding scale with prices. Even dramatically higher prices won't necessarily get investments past the hurdle rate.

And of course, the costs of drilling are non-negligible because some of the greatest potential greenfield projects worldwide are massively capital-intensive, second only to the defense industry, and costs have been rising almost as fast as government take. Given the fact that all costs involved with oil extraction, such as drilling rigs and personnel, are skyrocketing, this makes some important investments cash-flow negative.

I'm not sure how much these cost increases are due to oil-extraction-specific demand or how much they are general commodity demand (steel, etc.) however.

I think the oil company forecasters have been putting the price too low in their forecasts, as was said. Nonetheless, even with high profits due to demand for their existing production, expansion of production can be unattractive.

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