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Testata registrata presso il Tribunale di Patti Reg. n. 197 del 19/07/2006
Oil and the Bad News Principle
Ferdinand E. Banks*
According to Matthew Simmons, a
former energy adviser to President Bush, “Too many people are looking at OPEC
through the rear-view mirror. There is a resolve in OPEC’s eyes to never to go
back to the days of cheap oil.” Not only in their eyes but in their actions –
that is to say in their investment policies – which have resulted in (the
unspoken) intention to refrain from bringing too much additional oil to market.
The director of the important consultancy PRC Energy, Robin West, has
brilliantly summed up the present oil situation by saying that “the full impact
of the nationalisations that took place in the l960s and l970s are taking place
now”. They are taking place now and those of us on the buy side of the market
can only “take it and like it”, to use the terminology of Humphrey Bogart.
Key words: Peak oil, real versus nominal oil prices, futures markets
Let’s start this short paper by getting the peak oil issue off the table. Peak oil is not about the future – it’s about the past!. It’s about a (generally unspoken) strategy formulated many years ago by the most important countries in OPEC, which features a decrease in the production of their invaluable oil (and probably also gas) when they get the opportunity. The present high oil price has given them the opportunity!. It’s about more money rather than less – that is to say run-of-the-mill Economics 101 profit maximization – and for students of financial economics, increasing the value of an option whose underlying is the asset called oil, by extending the exercise date (i.e. the date on which that oil will be harvested). As might be shown by serious teachers with a serious interest in the so-called dismal science, it’s about controlling certain elements of the global oil supply curve, which is equivalent to controlling the entire curve. Basically, it’s not about geology but about microeconomics, and as a result the oil price reaching a level that even I thought was impossible. It’s also about macroeconomics.
Perhaps another jolt to the delicate sensibilities of readers might be appropriate at the present time. Neither the OPEC countries nor ‘Big Oil’ have the ability nor intentions of producing the EXTRA tens of millions of barrels of oil that will be necessary to make the half-baked dreams of the International Energy Agency (IEA) and the United States Department of Energy (USDOE) come true, by which I mean the extra tens of millions of barrels that will be required to fill the global demand-supply ‘gap’ in their target year of 2030. And if the major producers do not gradually work their way up to that level, then it will never be realized, and the oil price will continue to ascend unless ‘demand is destroyed’ by an international macroeconomic meltdown. Readers can ponder what this means at their leisure, however the information provided in an important paper of James D. Hamilton (2008) does not leave much room for optimism.
The Oil Price and Macroeconomics
Several years ago, in a discussion in the Journal of Economic Perspectives (Fall, 2006), it was claimed that “disturbances in the oil market are likely to matter less for the U.S. macroeconomic performance than has commonly been thought”. Exactly what this was all about is difficult to say, because macroeconomic downturns which featured real growth falling and inflation rising (i.e. stagflation) immediately followed the oil price increases of 1973, 1980, 1981, and 1990, although a cheerful note was that in the macroeconomic sense recovery took a comparatively short time. There were of course individuals and firms for whom recovery never really arrived, and needless to say recessionary tendencies in the U.S. impacted on the rest of the world to one extent or another, but as to be expected, there were more than a few academic and business economists who claimed that the correlation between oil price rises and macroeconomic downturns had finally been broken.
It would certainly be wonderful if this were the case, because the manner in which the oil price is presently increasing is not reassuring at all according to the economics and finance that I teach. The previous oil price rises were ‘spikes’, but even so economic growth declined in several regions. By way of contrast, at the present time we are facing a sustained price rise, and the possible development of a situation that in some respects contains elements of the scare-scenario posited by the leading investment bank in the U.S. – Goldman Sachs – in its Global Economics Weekly of April 10, 2002.
Two academics who have elected to evaluate the oil price-macroeconomic interconnection mentioned above, and who were (and perhaps still are) not worried about any damage that could be inflicted on the U.S. (and global) economy by high oil prices, are Robert B. Barsky and Lutz Kilian (2004). In one of those many unread journals gathering dust in our academic libraries, they told us that “disturbances in the oil market are likely to matter less for U.S. performance than had commonly been thought”.
Noting that this conclusion follows an econometric analysis – where emphasis should be put on the syllable ‘con’ – I reminded myself once again that despite some lopsided opinions to the contrary, empirical work in economics can never take the place of theory. But even so, of the thousands of papers that in one form or another originate every year in academia, this is one of the few that makes a systematic attempt to judge the impact of oil price movements on the macroeconomic price level, employment, productivity and economic growth. I am also generous enough to believe that the reason those two authors concluded that in general the effect of oil price increases tends to be exaggerated, is because over the period of their investigations (1970-2003), with the exception of the first and possibly the second oil price shocks, they were dealing with narrow ‘spikes’ instead of sustained escalations. Of course, a spike from the present oil price (which touched $138.54/b on June 6) could be devastating for many persons in every part of the world, since changes in the oil price – and particularly upward movements – influences all energy prices.
And when I say “all” energy prices, I do not mean just natural gas. I also mean coal, and that is not something to look forward to, given the amount of coal that is and will continue to be consumed.
There is “no support for the notion that increased uncertainty leads to a sharp fall in investment that in turn contributes to a recession”, the two authors tell us. What they mean by that is no econometric evidence, although it might be suggested that intelligent readers of the business press would be wise not attach any merit to a remark of this nature in the near and possibly distant future. Thus I suggest that we amend their observation to read ‘increased uncertainty can lead to a sharp fall in investment that – if sufficiently sharp – can lead to or deepen a recession, and possible help to generate a depression’.
The economics here is really very simple, and receives an extensive review in my energy economics textbooks (2000, 2007). Uncertainty functions in such a way as to boost discount factors, which as we all know from Economics 102 has a negative effect on physical investment because it means a large reduction in the (expected) present value of distant revenues. It is no more than common sense that investors who could accept a certain (or nearly certain) return of 8%, desire e.g. 11% when confronted with uncertainty because they feel that something might go drastically wrong.
Barsky and Kilian take a cavalier view about physical investment, citing among other things their disbelief in Professor Ben Bernanke’s ‘bad news principle’, which the future Federal Reserve boss applied to oil price shocks (1983). What this comes down to is firms postponing investment “as they attempt to find out whether the increase in the price of oil is transitory or permanent”.
Although Barsky and Kilian say that evidence exists that Bernanke’s “waiting” effect is small relative to the magnitudes that need to be explained, I doubt whether this contention deserves to be treated with excessive respect when the oil price reaches its present level. For what it is worth – which isn’t much any longer – the real (inflation adjusted) price of oil (as compared to the money or nominal price) has been constant or falling for the last 30 years, and until recently the great majority of energy professionals interested in oil have preached from every soapbox between the Bay of Fundy and the Capetown Navy Yard that real prices of oil would continue to decline. As a result many firms were quick to take advantage of what they judged to be decent investment opportunities. In the light of both nominal and real oil price increases over the past two years, however, many or most of these firms are going to be much more careful, which will tend to give extra weight to expected bad news about energy prices.
Incidentally, Bernanke actually said that “of possible future outcomes, only the unfavourable ones have a bearing on the current propensity to undertake a given project”. This kind of thinking ties in with a key postulate of real options theory: when waiting is possible, downside risk is always the major factor.
The Oil Price and the Wisdom of Bill O’Reilly
I hope to wake up some beautiful morning and find that everybody believes in the peak oil theory, even if it turns out to be false. Of course, the boss of the European Union’s Energy Directorate once called it a theory that is no different from any other, but in truth it is somewhat different from the dozens or perhaps hundreds that he encounters every day in the corridors and restaurants of the EU office building in Brussels, most of which have to do with pay increases, the renewals of contracts, and various travel oriented welfare schemes. If governments do not believe in this (peak oil) theory, then they may fail to do what has to be done to keep an energy catastrophe at bay, where such a catastrophe can be generated merely by demand outrunning supply for a long time, without supply actually turning down. Incidentally, this is an application of (Albert) Einstein’s equivalence principle.
Perhaps the most provocative information offered on this topic recently originated with the Cambridge Energy Research Associates (CERA), whose director – Daniel Yergin – is a winner of the Pulitzer Prize (for a book about oil titled ‘The Prize’). Apparently CERA doesn’t believe in a global peaking of the oil production, but instead claims to have theoretical and/or statistical proof that we will eventually experience an undulating plateau. (Let me note though that as a veteran teacher of game theory, I recognize the likelihood that in reality they may believe in a distinct peaking of the world oil production even more than I do, but for reasons of a monetary nature find it expedient to devise a cock-and-bull story about an undulating peak.)
Another person who has forwarded an offbeat hypothesis about the oil price is Mr Bill O’Reilly, who is an important political and social commentator in the United States. Let me make it clear however that he is considerably less than important to me, even if I agree with a few things that he says.
To O’Reilly’s way of thinking, a large portion of the increase in the oil price is due to the machinations of speculators in – according to him – Las Vegas. I think that we would all be better off if we completely ignored that gentleman’s opinions and pronouncements on this subject, to include his famous statement “supply and demand my carburator”. It very definitely is supply and demand that explains all except a few dollars of the oil price, Bill, regardless of your opinions and the opinions of certain researchers in some of the largest financial institutions in the world.
What Mr O’Reilly was alluding to are the activities of hedge funds, which are also mentioned quite often in the financial press. I once knew quite a bit about hedge funds, but lost interest in them after being given a boring lecture on the beauty of those assets by a hedge fund hustler just before I departed for a visiting professorship in Hong Kong. The truth of hedge funds is similar to the truth of operations like the Nordic Electricity Exchange (NORDPOOL), whose strength is in the laziness of their clients. There are approximately 8500 hedge funds in the world, and every year about 1000 either go out of business or are close to shutting their doors, but even so they are treated with a respect that bears no correlation to their performance.
Before concluding I note that Professor Martin Feldstein (of Harvard University) recently made some Cassandra-like statements about oil. Specifically, he said that this is the worst possible time for an oil price escalation. (In case you forgot, Cassandra really did have the gift of prophesy, but it was her fate not to be believed.) Memories are short, and so it might be useful to call attention to what happened in l982, following the Iranian Revolution: unemployment in the U.S. reached 10%, employment actually fell for a few months, and some interest rates came close to 20%. Incidentally, a question that should have been asked is why didn’t the ‘Fed’ reduce the discount rate? Answer, because despite what your Economics 101 teacher tried to drum into your head, Central Bank discount rates hardly matter when really bad news arrives! I seldom make heavy weather of this unfortunate reality, because if the directors of the Swedish Central Bank did not have discount-rate posturing and game-playing to occupy their precious time, they could just as well stay at home, collect some unemployment compensation, and check out the latest in daytime soap-operas on the box.
In the Economist (May 29, 2004), there was a long discussion that focussed on the so-called “spare-capacity crunch”. In l985 OPEC apparently had about 15 mb/d of spare capacity. Five years later there were down to 5.5 mb/d, and today they may have only 2 mb/d, with most or even all of the latter located in Saudi Arabia. This kind of arrangement should make it clear that the price forecasts of four or five years ago – when the oil price was pictured as falling to $21/b – were not only inaccurate but foolish. At the same time though the Economist still peddles the song-and-dance that “the rise of energy futures markets over the past two decades also offers some scope for the world to deal with short-term price shocks.”
“Short term” could mean anything, but regardless, the oil futures markets are some of the best functioning in the world, and I am sure that there are many transactors who are grateful for the facilities that are available for hedging price risk. But even so, it needs to be appreciated every minute of every day that the most efficient and best functioning futures markets (and other derivatives markets) cannot ameliorate the miseries that could be caused by a long stretch of tight physical supplies. As far as I am concerned, this can only be done by imaginative economic policies, designed and implemented by intelligent governments that accept the seriousness of the present situation and are capable of thinking in terms of both long and short-term realities
Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory
Textbook. London, New York and Singapore: World Scientific.
Banks, Ferdinand E. (2001). Global Finance and Financial Markets. London, New York,
and Singapore: World Scientific.
_____ . (2000). Energy Economics: A Modern Introduction. New York: Kluwer Academ.
Barsky, Robert B. and Lutz Kilian (2004). ‘Oil and the Macroeconomy since the l970s’.
Journal of Economic Perspectives (Fall).
Bernanke, Ben S. (1983). ‘Irreversibility, Uncertainty, and cyclical investment’.
Quarterly Journal of Economics. (February).
Erdman, Paul (1988). What’s Next? New York: Bantam Books.
Feldstein, Martin (2006). ‘America will fall harder if oil prices rise again’. Financial
Times (February 3).
Hamilton, James D. (2008). ‘Understanding crude oil prices’. Stencil (revised),
Department of Economics, University of California (San Diego).
Silverstein, Ken (2006). ‘Peak oil: real or not?’. EnergyBiz Insider. (February)
* Uppsala University (Sweden)
Pubblicato su www.AmbienteDiritto.it l'11/06/2008