David R. Henderson  

Why Bryan Caplan Won His Gasoline Bet

PRINT
The Case Against Education<... Perspective on Yellen...

For some reason, I didn't know about co-blogger Bryan Caplan's bet about gasoline prices with Tyler Cowen, but if I had, I would have taken his side of the bet.

Here's why.

Notice Tyler's argument, in Bryan's words:

Why was Tyler so dismissive? As far as I can understand, he thinks that basic arbitrage theory implies that there can't be predictable price patterns.

That argument is dead wrong, for a simple reason that was behind my reasoning in an Investors Business Daily article in 2000. (David R. Henderson, "America's Free Lunch: Selling Oil From the Strategic Petroleum Reserve," Investor's Business Daily, April 17, 2000.) I later made it in 2004: "Sell High, Buy Low! (Actually, Don't Buy at All)," TCS Daily, May 28, 2004.

Arbitrage goes only one way. Let's say speculators expect a drought next year. Then they will buy one-year futures, which raises the price of one-year futures. Arbitrageurs will then buy on the spot market, thus raising the price on the spot market, and sell simultaneously on the futures market. End of story. Arbitrage works.

But now consider what happens if people expect, with higher oil prices now, that there will be more production a few years later. Why a few years? Time to drill, time to explore, time to discover. So futures prices a few years hence fall. But arbitrage can't go the other way. You can't shift oil from the future (there's no time machine) to the present. So spot prices can remain high even though basic economics--high prices give an incentive to produce more oil in the future--mean that prices will fall later.

How does that relate to my article about why the SPR should have sold oil at the time? Because the price of oil was unusually high and the futures price was well below it. So the only entity that could engage in this kind of arbitrage was one that had a huge reserve that it was not planning to use, namely the SPR.

Two funny stories about this: When I had the idea, I emailed the late Bob Bleiberg, editor of Barron's and proposed it. He pooh-poohed it, saying that arbitragers in the markets would just offset the SPR's move. He didn't get the one-way nature of arbitrage. So I published with Investor's Business Daily. Other funny story: Larry Summers was Treasury Secretary at the time. He had pooh-poohed the idea the week before I wrote my piece. Within days of my article being published by IBD, Larry announced that the Clinton administration would sell oil from the SPR.

I remember pointing out this asymmetry in arbitrage in my energy economics class in April 2014 when the spot price of oil was still quite high. I offered to bet my students that within 2 years the price would of oil would be much lower. (Why 2 years? Because we had had high prices for quite a while, long enough for there to be a long-run supply response any day.) I had no takers. But we all got a pleasant surprise when oil prices fell by about 40 percent within a few months of my offer. My students were wise not to bet me.


Comments and Sharing






COMMENTS (22 to date)
CMOT writes:

I wonder if Tyler was invested (pun intended) in the 'peak oil' thinking of the day back in 2008. Would he have made the same bet on any other commodity?

Mike Sandifer writes:

Great post.

Mark Bahner writes:
(Why 2 years? Because we had had high prices for quite a while, long enough for there to be a long-run supply response any day.)

I don't think this gives nearly enough credit to Bryan.

Let's look at U.S. oil production exclusively.

U.S. oil production

Bryan made his bet right at the lowest point of U.S. oil production since the peak of 1970. That peak in U.S. oil production and the subsequent decline in U.S. oil production were reasonably close to the predictions of M. King Hubbert, who's pretty close to a god (or at least a king ;-)) among geologists:

M. King Hubbert

Very, very few people would have predicted in 2008 that U.S. oil production would again rise to near its 1970 peak by 2018. And I'm talking about people who really know the geology of oil production.

I don't think a high price of any particular commodity for 2 years means that the price of that commodity will magically come down "any day now." Take gold, for instance. If you had said, circa 2008, that, "Gold has gone up significantly in price since 2001, so it should come down in price any day now" you would have been very wrong:

Inflation-adjusted price of gold through July 2009

And I know this from personal experience because I was saying almost that very same thing at almost that very same time. (And citing Julian Simon as having provided ample evidence that the long-term price of essentially all commodities is downward.)

David R Henderson writes:

@Mike Sandifer,
Thanks, Mike.

Charley Hooper writes:

Can we summarize by saying that there are two supply-side ways prices can be held down in the future: (1) Supply today can be held aside and sold at a future date, reducing the price in the future. (2) New sources of supply can be found in the future, reducing the price then.

If someone wants to bet, for example, that prices will be high in the future, they should consider both of these factors.

David R Henderson writes:

@Charley Hooper,
Can we summarize by saying that there are two supply-side ways prices can be held down in the future: (1) Supply today can be held aside and sold at a future date, reducing the price in the future. (2) New sources of supply can be found in the future, reducing the price then.
Yes, but if you summarize that way, you miss a lot of the reasoning. If the spot price today is less than the futures price say one year hence, arbitrageurs will do what you say in (1). But if the spot price today is greater than the futures price one year hence, they won't. That's why I singled out the SPR as about the only entity that can do so.

mike davis writes:

Your arbitrage argument is fine unless you think that the SPR actually had some strategic importance. To see why, build a simple example. Suppose the spot price is $100/bbl and the 12 month future price is $75. The arbitrage play would be to drain the SPR today and then buy an equivalent quantity in the future market. (To keep things simple, let’s suppose that you could do that without changing the spot or the future price.) Next year you could refill the SPR and pocket a nice profit or more than $25/bbl (it’s more because you’d get the cash from the sale today and you could make a bit interest as well).

That makes money but it means you don’t have the oil in the SPR over the next 12 months to help in whatever crises might arise. (Insert scary story here about how some evil foreign power casts a magic spell on oil markets making it impossible to refuel American warships on their way to bomb the evil foreign power.)

I don’t think the SPR serves a strategic need and I’d be surprised to learn that David thinks it does. But if it does function as a kind of backstop insurance policy, the arbitrage would take that way.

David R Henderson writes:

@mike davis,
Your arbitrage argument is fine unless you think that the SPR actually had some strategic importance.
Correct. When I was the senior economist for energy at the Council of Economic Advisers, one of my two bosses, Bill Niskanen, and I argued for a price rule. (Ideally we wanted to sell off the SPR but we knew that wasn't going to happen.) How do you know if there's a crisis? The price. So we advocated price rules like (and remember that this was 1983 $) "If the price goes above $40, sell; if the price falls below $20, buy." Of course, we got nowhere.
That makes money but it means you don’t have the oil in the SPR over the next 12 months to help in whatever crises might arise.
True, but that's why you don't sell it all. Arbitrage isn't all or nothing.

Mark Bahner writes:

Hi,

I made some comments that contained three hyperlinks that I think caused them to get sent to the moderation bin. In the comments, I mischaracterized David's position a bit (sorry David, didn't read carefully enough), but I'd rather re-state after the original comments are published. I didn't make a copy, and it would take some time to regenerate the comments.

Thanks!
Mark

David R Henderson writes:

@Mark Bahner,
Your earlier comment is up now. So I'll wait until you make your next comment before replying.

mike davis writes:

One more thought about the SPR: David’s analysis of the possible arbitrage is yet another reminder of how hard it is to get politicians and policy makers to properly understand costs. I’m pretty sure that even if David could have gotten someone who matters to engage the question of whether the SPR is worth it, they probably would have said something like “well, it’s not really that big of budget item. It’s mostly full and the costs of maintaining the reservoir aren’t really that high.” But capacity is around 700 million barrels and there were several times when it was substantially full while oil was selling for over $100/bbl. Sure, the cost of paying the engineers and technicians in California and Louisiana was just a few million. But, as any econ 1 student should know, that’s not the right cost.

mike davis writes:

One more thought about the SPR: David’s analysis of the possible arbitrage is yet another reminder of how hard it is to get politicians and policy makers to properly understand costs. I’m pretty sure that even if David could have gotten someone who matters to engage the question of whether the SPR is worth it, they probably would have said something like “Well, it’s not really that big of a budget item. It’s mostly full and the costs of maintaining the reservoir aren’t really that high.” But capacity is around 700 million barrels and there were several times when it was substantially full while oil was selling for over $100/bbl. Sure, the cost of paying the engineers and technicians in California and Louisiana was just a few million. But, as any econ 1 student should know, that’s not the right cost.

David R Henderson writes:

@mike davis,
I’m pretty sure that even if David could have gotten someone who matters to engage the question of whether the SPR is worth it, they probably would have said something like “Well, it’s not really that big of a budget item. It’s mostly full and the costs of maintaining the reservoir aren’t really that high.”
Actually, people we talked to understood that, but one thing you learn quickly in Washington policy-making is how attached people get to policies simply because they're there.

Mark Bahner writes:
Your earlier comment is up now. So I'll wait until you make your next comment before replying.

Hi David,

Thanks! So, first I wanted to correct and apologize for the part of my previous comments that mischaracterized what you wrote. I wrote:

I don't think a high price of any particular commodity for 2 years means that the price of that commodity will magically come down "any day now."

But I see you actually wrote:

I offered to bet my students that within 2 years the price would of oil would be much lower. (Why 2 years? Because we had had high prices for quite a while, long enough for there to be a long-run supply response any day.)

So, sorry for the mischaracterization. But still, even with what you did actually write, it seems to me that the situation of gold in 2008 is very similar to what you were writing about. I told family and friends in 2008 that, even though gold had risen from about $350-400 in 2001 to about $800 in 2008, that the price of gold was going to come down. Trust me, I said. Julian Simon's observation that the long-term price of virtually all commodities is downward is based on lots and lots of evidence. A high price ($800 :-)) of gold was going to bring on lots of supply, and the price of gold would go down. But that certainly hasn't happened (as of today):

Ten years later, $1350 per ounce, my family and friends are still waiting :-))

And I also want to emphasize again that M. King Hubbert's predictions about U.S. oil production was treated by lots of people as the definitive correct prediction about how U.S. oil production would behave. (Nothing can overcome geology, right?) So I want to congratulate Bryan again. I think his win was spectacular. It probably will never be as widely known as the Simon-Ehrlich bet, but in my mind it's just as definitive.

Best wishes,
Mark

Bob Murphy writes:

Great post David. I can't believe I never thought of this before (and I've written on this stuff). In fact, I am running it through my mind from different angles to make sure we're not missing something.

David R Henderson writes:

@Bob Murphy,
Thanks. It's basically why backwardation, which you've written about, happens.

Mark Bahner writes:

Hi,

Another comment of mine has been captured by the spam filter. I wanted to include an additional hyperlink that shows the price of gold from 2009 to the present. I think the spam filter really hates hyperlinks! :-)

Best wishes,
Mark

David R Henderson writes:

@Mark Bahner,
Apology accepted, though not needed.
But still, even with what you did actually write, it seems to me that the situation of gold in 2008 is very similar to what you were writing about.
True. Two answers:
1. As Julian once said, "That's why it's a bet." In other words, there's no guarantee that he would win.
2. I think gold is different because people run to it when they fear some cataclysmic event or even fear a particular president. I don't think oil is in the same category.
And I also want to emphasize again that M. King Hubbert's predictions about U.S. oil production was treated by lots of people as the definitive correct prediction about how U.S. oil production would behave. (Nothing can overcome geology, right?)
But not by me. I was betting based on my knowledge and understanding. Hubbert committed a spectacular fallacy of composition: because each reservoir hits peak production, oil production in total will hit a peak. Also, there are other countries in the world that produce oil. Here's how I put it in various talks I've given: "Every time in history when people have said we would hit peak production, even when prestigious geologists said it, they've always been wrong. Could they be right this time? Yes. But I'm quite comfortable betting against them."

Mark Bahner writes:
Hubbert committed a spectacular fallacy of composition: because each reservoir hits peak production, oil production in total will hit a peak.

I don't see that as his error. I see his error as not appreciating the motivation that high prices produce to develop new technologies. He simply didn't see the possibility of horizontal drilling combined with hydraulic fracturing.

But very interestingly, Dave Rutledge at Caltech has done a similar thing with coal, and the results appear reasonably predictive:

Projections for Ultimate Coal Production...

2. I think gold is different because people run to it when they fear some cataclysmic event or even fear a particular president. I don't think oil is in the same category.

Yes, that's true. There's also the fact that governments hold large amounts of gold. But still...gold has been very high for a very long time. It's making Julian Simon--and more importantly, me--look bad to my family. :-)

David R Henderson writes:

@Hubbard,
I don't see that as his error. I see his error as not appreciating the motivation that high prices produce to develop new technologies. He simply didn't see the possibility of horizontal drilling combined with hydraulic fracturing.
Fair enough. I think I overstated. In fact, your point reminded me of a slide I use in a talk I give on this:
U.S. Geological Survey: “86 percent of oil reserves in the U.S. were the result not of what was estimated at the time of discovery but of revisions and additions from further development.”
--Daniel Yergin, “There Will be Oil,” Wall Street Journal, September 17-18, 2011.
But still...gold has been very high for a very long time. It's making Julian Simon--and more importantly, me--look bad to my family. :-)
Yes, I think I was a little too quick to make my point here. I probably would have bet wrong on gold.

John Hall writes:

How far can this line of thinking take you on arbitrage?

In particular, I'm thinking about covered interest arbitrage in FX markets. If covered interest rate parity holds, then there are few opportunities for covered interest arbitrage. However, evidence for uncovered interest rate parity is weaker due to the weaker connection between forward FX rates and expected spot FX rates.

John Hall writes:

@Mark Bahner I would add that you should probably be thinking about the real price of gold, rather than its nominal value. It tends to be rather mean-reverting over a long history. It had peaked in 2012 and has been trending lower since then.

Comments for this entry have been closed
Return to top