Oil: Some Tentative Conclusions and Open Issues

Maybe China burned some of those too

The incomplete answer is, yes, they most certainly have. Here's a report from Deutsch Bank Research - it's from 2006, and only covers through 2004, but you can rest assured that the Chinese commodity importing juggernaut has been on one heck of a buying binge, which may have just peaked in 2006-07. Since then, they've still been on a buying tear, but have slowed down somewhat, perhaps finally constrained by higher commodity prices.

If I were to assign probability weights, they'd be 0.85 for A, 0.05 for B and 0.10 for C.

Right after the dot com bubble popped, housing prices took off in the San Francisco Bay Area where I live. After the mortgage market imploded last year, commodities started taking off. Seems like more than a coincidence to me. In the first two cases, there were good reasons to believe that it was more than a bubble. I think that you can't have a bubble unless you can make a good argument that it isn't a bubble this time.

(a) Inelastic and increasing demand - 70%
(b) Devaluation of numeraire [USD] by 30% - 30%
(c) Silly stuff - 0%

AK writes:

My problem with (a) is that, given my infinite-horizon perspective, I don't see the news in oil markets over the past year as sufficiently dramatic. On top of that, one has to come up with plausible "big news" in various other commodity markets.

For those following energy markets in the past few years (and I count James Hamilton among them), what has happened is a gradual realization that there are physical limits to some resources, oil being one of the most important. The price run up in the past 10 years, 2 years or 6 months can be explained by market participants (producers, speculators and consumers) gradually coming to the same realization. No "big news" is necessary; only slowly mounting evidence that demand continues to rise and suppliers cannot or will not produce more even in the face of very high prices.

One question; in you infinite horizon viewpoint, where do you see global oil consumption being in, say, 2050? If you see oil consumption rising from 87 mbd to over 150 mbd by 2050, then you are what some refer to as a cornucopian; you foresee no long-run limits. If you foresee oil consumption falling significantly, say to 40 mbd, then you believe in peak oil. In that case, you are an optimist if you believe peak oil happened because oil was replaced by other energy sources, or a pessimist if you believe the energy available to mankind is limited even though we are pumping every last drop of oil we can find.

Problems with (a): Why are so many commodities booming? Is it reasonable to think that there were so many mistakes in market expectations last year (or today, or both)? (That would sound too close to arguing that "the market is stupid", or easy "market-failure" arguments)

Those problems can be answered quite well with (b), considering the monetary shock as a massive market distortion yielding unpredictable results.

It could very well be a monetary/financial shock originated in the central banks of the US and Japan (and to a lesser extent the ECB and the BoE), combined with a very expansionary fiscal stance in the US (also, to some extent in the UK and some Euro countries), transmitted through the exchange rate regimes of developing countries. This pushes up commodity demand, and as it builds steam there is a massive monetary relaxation (monetary shock -with unheard-of negative real interest rates) in the US in mid-2007, combined with liquidity migration from the housing market and very recently from some emerging markets.

That could explain both the violent spike in commodity prices since 2007 and the broad-based boom in commodities.

The arguments for disdaining (b) are maybe a little "ad-hominem". And the Fed abandoned its inflation fighting when it instituted negative and highly distortive real interest rates in 2001-2002.

I agree that (c) is baseless. Autonomous speculation cannot be so broad-based and have enormous inflationary consequences across the globe unless it is combined with a strong monetary shock.

the problem is that economists have this mind set from their models that free markets are efficient.
All that means is that markets clear. It does not mean that free markets are not wasteful just like government.

The long run history of capitalism is a record of overshooting and undershooting and cycles of over and under investing. What we are seeing is just another example of these long cycles that have been a basic characteristic of capitalism from day one.

The problem is that every time it happens everyone starts arguing that it is different this time and that is just not true.

I'll just stick with my basic rule of thumb that the surpluses or shortages that everyone sees five years down the road never materialize.

You assume efficient or at least partly efficient markets. What if the oil market is not effiecient at all, since most of the oil is in the hand of politicians? Those politicians want to maximize their profits, but have some constraints, e.g. due to political reasons they can't sell whole oil fields (they cannot privatize them). Then in order to maximize short term profits (knowing that they won't be the leader for the rest of their lives), they produce as much oil as possible today and spend as little money to increase long-term production as possible.

This would lead to the following situation: When oil prices are low and profits from oil are low, oil production is not on the radar of politicians. But when oil prices are higher, there is an incentive for politicians to maximize production today and defer investments into the future. That would lead to a vicious circle that might be broken at some point (probably because of public pressure or because private oil companies can increase production).

I think a great example of this is Venezuela, where all the oil money is spent on some political programs, but oil production is declining due to lack of investments. I'd say this is because Chavez knows that he has to give the oil in the ground to his successor "for free". So it doesn't really matter to him in what condition oil production is then.

Speculation is dollar weighted voting that your information is better than the current convention.

Let's say that the center of oil trading is an autocratic country in which the dictator wants to know the best price the market can bear. This country produces no oil. It consumes a lot.

Natives grow restless, blame high prices on speculators. Dictator, fearing loss of power issues a "spectwa". All speculators will be dragged into the streets and shot. Autocrat and opponents know speculation can continue ex-futures exchange. Spectwa also includes those who use their cell phones to speculate in the spot market.

All you have done is decrease information flow. Does this actually reduce price or does it start crazy rumors about what so-and-so heard the price was?

Would the nasdaq bubble have stopped earlier if had made people run around the NYSE 3 times before they got a mutual fund quote in 1999?

Too much money chasing too few commodities. I do not think that production has fallen. Why commodities and not all goods, becuase China and technology have kept non-commodities from getting more expensive.

As far as importance of oil is concern, I think this is machine age where our whole pattern of life fully depends on the machine and they require oil to feed. So it can be easily understand as the fuel prices increase in the world market, the growth value and the economical rate act inversely proportional to each other.
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allankz

http://www.widecircles.info

Oil is the most essential commodity of the present times. The demand for oil increases rapidly whereas the supply is limited. Hence the prices are increasing exponentially. It is high time we think of a solution to this problem. Which could be the best substitute for oil?
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Wendell

http://www.widecircles.info