David R. Henderson  

Bet on Oil Prices

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A Quote I Will Use Often... Moral Theory & Voluntary Overp...

In my executive MBA class yesterday, the one I do by video teleconference, I covered Bob Murphy's piece on oil prices as an application of some of the economics of futures markets. One part of Murphy's article that I highlighted was the following:

When the major oil companies were making investment decisions during the 1980s and 1990s, they underestimated the explosive economic growth in countries such as China and India in the 21st century. Because of this mistaken forecast, the necessary infrastructure was not in place to adequately service the increase in oil consumption. Consequently, spare capacity margins have become extremely narrow, leading to price spikes.

Murphy goes on to point out how much the oil companies have invested in exploration in the last few years. Then I asked the class:
Knowing that now, what do you think will happen to the price of oil by, say, 2018? Why?

My idea here is that the investments oil companies have made, are making, and will make will cause the supply of oil to increase substantially, bringing the price down. One student, Rob Peterson [he gave me permission to use his name], agreed with the reasoning up to the last point about price. He argued that growth of many of the poor countries will shift demand even more, making the price higher than now.

So I offered him a $100 bet, at even odds, that he accepted: in 2018, the inflation-adjusted price of oil will be lower than an $80 average for the year. He's saying it will be higher. I tried to tilt it a little in his favor by naming the benchmark oil--West Texas Intermediate--which is sweet (low-sulfur) and, therefore, higher-priced. I hadn't realized how big a premium when I made the offer. But, oh well, a deal is a deal.

So am I likely to lose or win?


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COMMENTS (33 to date)
Phil writes:

Does a contract for 2018 West Texas Crude trade on any futures market?

David R. Henderson writes:

@Phil,
Good and relevant question. Answer is no, assuming the Wall Street Journal futures section is complete. In WSJ this a.m., it goes out only to December 2013.

mb writes:

My one concern would be political interference. Another 4 years of antagonistic relationship between "big oil" and government could really hurt. I would be worried about "excessive profit" taxes and the like that would inhibit exploration.

Noah Yetter writes:

I worry that inflation adjustment will obscure the truth in this case.

Jay writes:

Beware liquidity issues....

http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html

Richard writes:

Actually, one could argue that you are tilting the bet in your favor by selecting West Texas Intermediate. Given transportation constraints in and around Cushing, WTI is trading lower (in some cases significantly lower) than other world benchmarks. As of yesterday, WTI was at a $13 discount to the Gulf Coast Mars sour crude (and $17 under Brent). Of course, few people believe these constraints are a permanent feature, and by 2018 we'll likely return to more traditional price differentials. As to a Dec 2018 price, CME posts one every day, latest about $92.

Geoffrey writes:

You will probably win. New technologies such as fracking in shale (currently happening in South Dakota) will bring more supplies on line. Marginal supplies such as the oil sands in Alberta are economical at well below $80/bbl real.

David Zamperini writes:

I think you have a very solid chance to win. The combination of hydraulic fracturing, horizontal drilling and other new technologies are allowing us to get at more oil and natural gas then we previously could.
Also, making an assumption here, vehicles will become more fuel efficient even without government CAFE requirements.
There is no reason to think that more advancements in technology won't come and allow us to recover more oil and other resources that are still currently unavailable or haven't been found yet.
Despite government's many attempts to go green, right now the path to cheaper and very abundant energy is still with fossil fuels.
I do agree with mb that the government could continue to ham string the development of oil fields by needless and senseless regulations and restrictions. This could cause the price to remain high.
The private sector did find ways to clean up oil mess better than the government and will continue to find better ways to be more fuel efficient.
I have no problem with green energy or nuclear, I just have a problem with the government subsidizing it not that the government should be subsidizing energy in any form.

David writes:

It's not clear to me who is going to win. There could be government interference which would greatly impact the price (probably to make it higher), but on the other hand, the alternative energy industry could either pick up or be subsidized to the point where it's a viable competitor. That, combined with increasing fuel efficiency could hold prices down. I think it's anyone's game, but I'd lean toward your student winning.

Eric Johnson writes:

I think your student will win.
However I think the main factor in determining who wins is the state of the world economy. If come 2018, the US is still in its lost decade, and Europe is still self-destructing, then weak demand will keep prices low.

However if the US and European economies are back on track, I could easily see oil reach $140/barrel.

Dan Carroll writes:

WTI has been priced at a discount to Brent due to the combination of supply increasing in the central US faster than pipeline capacity(affecting WTI) and supply disruptions from Libya (affecting Brent). Most analysts are aware of the pipeline problem in the central US, but are still assuming that it is only a pipeline problem. We are only beginning to witness the amount of oil we can access using alternative technologies (like frakking), and it has only been applied in limited ways in North America - it has not been applied elsewhere in the world. Most estimates I have seen suggest that the US will be producing almost as much as it consumes in roughly five years.

I think you will win.

Michael E Sullivan writes:

I lean toward your student winning also, given that most of the current sources of oil are declining while the chinese appetite is rising -- it will take significant new innovation, and dipping into the sands and shale just to keep up.

One big wild card is a possible carbon tax/trading scheme. If that ever gets off the ground, depending on how and to whom it is applied, it could end up being built into the price of oil, or not, and which one could make a huge difference in the outcome of a bet like this.

Arthur_500 writes:

There is one aspect of pricing that you have left out - to your disadvantage. When I price a good I cover my costs and try to determine a price point at which my customer will buy my product and I can maximize my profit. Why should my price be lower tomorrow than it is today?

David R. Henderson writes:

@Arthur_500,
Because I expect supply to rise, as I said. In fact, right now in the oil market, there’s backwardation (futures prices being lower the further out you go), not contango.

rikhard writes:

hello all,

i guess US and German army are saying that you'll loose...

http://www.karavans.com/USArmy.html

http://oilprice.com/Energy/Crude-Oil/German-Armys-Peak-Oil-Report-Predicts-Rising-Oil-Prices-Another-Recession-and-The-Demise-of-Banks.html


and wikileaks has something to say too...

http://thinkprogress.org/romm/2011/02/09/207484/wikileaks-peak-oil-saudi-arabia-reserves-overstated/

Michael writes:

I think you might end up winning for a reason you didn't even consider: that the supply curve doesn't shift right but the demand curve over the years shifts left. If the price of oil climbs to $150 or $200 a barrel, people will start bailing out of petroleum. Trucks will run on LNG. Trains will go electric. People will buy CNG or electric cars. SASOL will excellerate their efforts to convert natural gas into liquid fuel. And when someone buys an CNG car, they are no long on the demand curve for oil at all. So when the demand for oil begins shifting left, the price comes back down. And it stays down for some time because all those people with CNG cars will still use CNG whatever the price of gasoline.

My prediction. Look at the graph for the price of oil from 2005 to 2009. Pretend it repeats like a cycle. That is what were in for.

-Michael

Bob Murphy writes:

David, I think that CPI will rise so much that the world economy will be devastated, and you will win this bet. Then you will have the money to pay me on our CPI bet.

adam writes:

I'm not even going to comment/guess what the price of oil will be in 2018. There are too many factors at play and any bet would be purely for entertainment purposes. I get the point of the bet, however, I just think that whoever wins will do so by luck not by their knowledge of oil prices 6 years from now.

@Michael,
Their is no bailing out of petroleum...PERIOD!!! Just because you don't burn gasoline doesn't mean you are no longer on the demand curve for oil. Are you serious? Everything that your car is made of is petroleum based. We live in a petroleum based society that would not exist and will cease to exist, without petroleum. So, petroleum demand may very well decrease due to fuel alternatives; not my view, but to say that by driving an electric or CNG car makes you independent of petroleum is absolutely incorrect.

David R. Henderson writes:

@rikhard,
The U.S. Army and Think Progress think I’m wrong? My confidence just rose.

Phil writes:

Assuming an efficient market, the expected price of crude in 2018 cannot be more than: today's price, plus storage costs, plus the risk-free rate of return. Otherwise, people would just buy crude now and store it.

That gives you a maximum price. The minimum expected price, on the other hand, could be zero. If the efficient market were expecting a lower price, we would just burn all the oil now. But today's price might still be high, and there would be no obvious indication that the price is expected to drop.

So, I would tend to agree that down is more likely than up.

Is there something wrong with my logic?

Phil writes:

Sorry, not risk-free rate of return. I should have said risk-adjusted rate of return.

David R. Henderson writes:

@Phil,
Great logic. One quibble: add in insurance costs to storage and interest.

Phil writes:

Right, insurance. Good point, thanks.

How about we just combine that with storage and call it "carrying cost"?

Mr. Econotarian writes:

Do we know where carbon taxes may be applied? Upstream or downstream of the WTI quote? Might be good to make sure the bet is exclusive of per-barrel taxes.

roger cyrus, m.d. writes:

Supply and demand will determine the price. Demand will continue to rise, even in the producing nations, e.g. OPEC. There will be conservation efforts and alternatives to reduce the rise. Nat gas will diminish the use of oil in the U. S. for transportation which is where we use most of it. Difficult to find oil will come slowly on line, but only if the price remains high to justify the effort to look for it. Easy to find oil is done. It has been found. The net effect is that demand will continue to rise at a greater rate than supply. Charlie Maxwell the dean of oil analysts would agree. In short, the price will be high, much higher than you think, in 2018.

diz writes:

A couple points -

1) Shale drilling, tar sands, aren't going to produce enough volumes to put domestic production at the margin any time soon. No way by 2018. They have begin to more than offset domestic decline, but that means we will import slightly less. World prices will continue to be set by OPEC - AKA a government cartel sepcifically formed to restrict access to most of the world's oil supply.

2) At sub $80 oil, these plays may still be economic, but there will be a lot less enthusiasm and capital deployed into them. At around $60, they probably start to slow dramatically.

3) China India etc will keep pressure on demand and OPEC at the margin. The US demand is stagnant to declining due to the economy and the potential for cheap and abundant natural gas to make inroads into markets where we have not seen it. Still we are talking about +2 to -2% kinda numbers. The supply/demand changes in the US are likely to be small compared to the overall forces affecting world crude markets at the margins.

4) There are long dated bilateral markets for crude. I'm pretty sure they are well over $80. There is a general belief that demand is depressed due to wordwide economic conditions and that OPEC is low on excess capacity. Vehicle penetration in Asia is still a small fraction of what it is in the West, and substitution to gas or other fuels is likely to be insignificant in this timeframe.

Floccina writes:

I would bet that real dollars of fuel cost per mile of travel will not rise more than 10 percent. We do not so buy gallons of gas but miles of travel at a given level of comfort, prestige safety. Due to China and India emerging from socialism demand is rising rapidly, but that is a good thing. ICE efficiency has been growing.

Vangel writes:

So I offered him a $100 bet, at even odds, that he accepted: in 2018, the inflation-adjusted price of oil will be lower than an $80 average for the year. He's saying it will be higher. I tried to tilt it a little in his favor by naming the benchmark oil--West Texas Intermediate--which is sweet (low-sulfur) and, therefore, higher-priced. I hadn't realized how big a premium when I made the offer. But, oh well, a deal is a deal.

I have a few problems about the bet. First, is the 'inflation-adjusted' part. Given the fact that the BLS bureaucrats have constantly understated inflation by using various tricks that would have shown little inflation in the 1970s. Second is the use of WTI, which trades at a huge discount to the dirtier Brent or to the Dubai or Nigerian light sweet oil.

That said, I feel very confident betting on much higher prices as long as there is no major contraction in the economy. The arguments made by naive individuals like Murphy do not stand up well in the real world. Oil production depends on the discovery of economically viable deposits. The problem for the Murphy/Henderson position comes from the cost side. Most of the 'discoveries' that have been made are not economic at $80 a barrel oil. These discoveries will need to replace 30 million barrels of production lost due to depletion from existing fields AND to add enough new supply that would meet the growing demand from the developing world. The math simply does not work, which is why I am surprised at the blind optimism of what I consider to be intelligent individuals.

Vangel writes:

You will probably win. New technologies such as fracking in shale (currently happening in South Dakota) will bring more supplies on line. Marginal supplies such as the oil sands in Alberta are economical at well below $80/bbl real.

The problem is depletion. Each year we lose more than 5% of existing production from old oil fields. This loss has to be made up from new investment in production. Note that this loss takes place every year but as more and more new oil comes from unconventional sources the depletion rate goes up. Deep water oil depletes much faster than the old giant fields found in the 1930 to 1960 era of great discovery. A typical shale well loses more than 75% of its production in the first year. Unfortunately, it does not generate enough cash to finance further drilling after the investment is paid off. In fact, the typical shale well consumes capital because it cannot produce enough energy to offset the energy that it cost to drill the well, and gather, transport, refine, and distribute the product.

For those that are buying into the shale hype I recommend listening into the conference calls and reading the filings with the SEC. Most of the initial players in the sectors abandoned natural gas as the big loser that it is and are now trying to hype shale liquids. But if you look at the cash flows and the actual production data you find that the projects are far from profitable and cannot be self financing. Expect to hear and read a lot more about funding gaps and asset sales.

groundhogsteve writes:

Fracked fields burn out much faster. The current plays are mere blips in the supply, smaller than the North Slope. The Niobrara play is not really panning out so far, and much of the other plays are still speculative.

The relentless depletion rate of 4-5% per year means that another 30 million barrels per day of worldwide production has to come online just to maintain the status quo. A review of the big projects coming on line in the next few years shows nothing that begins to approach that volume of oil. And there just aren't enough drill rigs to poke enough holes in all the shale plays to make much of a dent.

Barring a major economic calamity, oil will be above $100 in 2018.

Floccina writes:

My post fixed:

I am a with you and Julian Simon but I would only bet that the real dollars of fuel cost per mile of travel will not rise more than 10 percent. We do not so much buy gallons of gasoline but miles of travel at a given level of comfort, prestige safety.

This is an unusual period because of China and India emerging from socialism is causing demand to rise rapidly, that of course is a good thing but not without it problems.

One thing that helps is that ICE efficiency has been growing steadily and with India and China contributing more to making better cars that could very well accelerate.

floccina writes:

http://www.ricardo.com/en-gb/News--Media/Press-releases/News-releases1/2011/Ricardo-study-suggests-global-oil-demand-may-peak-before-2020/

Research challenges concept that ‘Peak Oil’ will be a supply side phenomenon Instead, demand for oil may well peak before 2020, falling back to levels significantly below 2010 demand by 2035. Significant changes in future demand patterns strongly influenced by global energy security policies, the technology change that they promote, and demographics Evolutionary change in automotive technology is predicted to bring revolutionary change in fuel demand Increasing disparity of demand between fuel types – diesel volumes are buoyed by heavy duty transportation use while gasoline declines due to increasing powertrain efficiencies and higher pump blends of bio-ethanol Improved supply prospects for natural gas likely to lead to decoupling of oil and gas markets
Wayne writes:

Ah, there's a great diversity of opinion here. This why the market works.

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