Economic Theory and OPEC
Professor Ferdinand E. Banks
ABSTRACT: Unfortunately, conventional economic theory has its limitations, but not when discussing the intentions and capabilities of the Organization of Petroleum Exporting Countries - or OPEC as it is commonly known. Almost everything about OPEC's present behaviour was predicted and discussed in my book 'The Political Economy of Oil' (1980), and those observations have been extended slightly in my new energy economics textbook (2007). However in order to insure that the latter book can be easily perused by undergraduates and persons without a background in academic economics, a few important topics could only be dealt with en passant. Several of those are taken up at a slightly greater depth in this contribution. Another purpose of the present paper is to partially survey the aggregate economic situation in which OPEC operates, and to suggest that it should always be kept in mind by individuals who occasionally or repeatedly find themselves confronting ad-hoc speculation on the world oil market. The article is mainly non-technical, however some algebra was necessary to round out the exposition, and so a few equations can be found in the conclusion where they can be ignored if the reader so desires. The section headings are as follows: 1. Introduction. 2. OPEC and its competitors. 3. Some OPEC development economics. 4. Genius speaks: a note for the conference Oil and Money. 5. Conclusion.
Having been referred to on several occasions as a propagandist for nuclear energy, I hesitated to begin this paper. The dilemma for me is that unlike many students and observers of OPEC, I have always been positive to that organization. As in Irving Berlin's great song (from the musical 'Annie Get Your Gun'), they are only "doing what comes naturally", and according to the economics that I teach, deserve to be awarded an Adam Smith merit-badge for choosing prosperity instead of poverty.
As Mr Robin West - chairman of the consultancy PFC energy - recently pointed out, the full effect of the nationalisations that took place in the l970s are now being realised. Several decades ago I informed friends and neighbours that this was certain to happen, although according to the neo-classical economic theory that I was heavily involved with at the time, it should have taken place just before the turn of the century. If it had, the fantasy that the most important commodity in the world should sell for bargain-basement prices would be passé, or confined to the mostly unread learned journals of economics that are still occupy an exorbitant amount of space in our academic libraries. Moreover, comparatively inexpensive alternative motor fuels and synthetic oils might already be available in sufficiently large quantities to put a cap on the oil price - i.e. prevent it from suddenly spiking to levels that could jeopardize the international macro-economy, and in addition inflate dangerous or potentially dangerous social and political tensions.
Macroeconomic considerations having to do with oil price movements play only a minor role in this paper, but there is definitely one thing that all readers of the present offering should comprehend. Regardless of the cheerfulness that often characterizes connoisseurs and calculators of the real price of oil - i.e. the inflation adjusted price - it is an indisputable economic reality that energy-intensive production activities that were state-of-the-art when oil cost $26/b, are unprofitable (or unproductive) with oil at $60/b unless there are major reductions in the remuneration of employees. This explains why many employees in the US and Europe are facing the prospect of working harder for the same income. It also clarifies the preference by many employers for immigrant labour, since in every country these men and women tend to be more upset by unemployment than by lower wages, salaries and social benefits..
The part of OPEC that I am principally concerned with in this paper are the countries of the Middle East. Dermot Gately (2004) has chosen to call three of these - Saudi Arabia, Kuwait and the United Arab Emirate (group of countries) the OPEC "Core", which is an artificial and largely irrelevant designation that I tell my students and anyone else listening to studiously ignore. Like my teacher of mathematical economics, the late Karl Vind, I have found it useful to believe that in economics, empirical work cannot take the place of theory, and this is especially worth remembering when confronted with Professor Gately's tortuous econometrics. Aside from that, I want to use this opportunity to claim that despite their shortcomings, Gately's models deserve more respect than those he has elected to cite in his many papers, the majority of which have been revealed by current developments in the oil markets to be without an iota of scientific value.
When on the subject of OPEC, one fact stands front and center for all thoughtful researchers: Saudi Arabia is going to do everything possible to avoid establishing more than 10 or 11 million barrels of oil per day (= 10-11 mb/d) of 'sustainable' production capacity (to which can be added about 2 mb/d of 'surge capacity' - or capacity that can only be used for a short time without subtracting from the ultimate output of a deposit, where the "ultimate amount" is perhaps best thought of as the total quantity that could be produced over time with an optimal extraction program.)
The 15 mb/d that Saudi oil minister Al-Naimi once suggested that Saudi Arabia could indefinitely supply was a careless oversight, though not to the extent of the 20 mb/d of Saudi output that are implicit in the forecasts for the year 2030 of the International Energy Agency (IEA) and the United States Department of Energy (USDOE), and which - before nationalisation - the foreign oil firms operating in Saudi Arabia foolishly wanted to establish as a production goal.
It has also been suggested that there might be a more melodramatic background to the OPEC oil story than is immediately apparent. According to Francisco Parra (2004), the basic reason for the Second Gulf War turns on the desire of the United States to have Iraq available as a source of incremental oil supply - i.e. a 'swing' producer - in case of a reduced commitment by Saudi Arabia. This of course is possible, and perhaps even likely, because Iraq might be the richest oil country in the Middle East after Saudi Arabia, and in addition there are claims that it has not been explored to the extent of others in that region. Some question must be put however as to the conditions under which the government of Iraq would be willing to assume that role, particularly in the light of what is taking place in the their part of the world at the present time. The patrolling of pipelines and pumping stations by thousands of heavily armed soldiers might make military sense, especially if they are supported by armoured vehicles and helicopters, but politically this scenario could turn out to be a fiasco.
Although not widely known, the forerunner of OPEC was the Texas Railroad Commission, referred to on at least one occasion by J.R. Ewing - the main character in the soap opera Dallas - as "The Cartel". That organization consisted of 3 men who met once a month in a public room at the Commodore Perry Hotel in Austin (Texas), where they decided how much oil should be produced in the 'Lone Star State' the following month, and according to Professor Eric N. Smith of Tulane University, they also trained the Venezuelan gentleman who was a co-founder of OPEC. One reason why the general public and media did not concern themselves with the deliberations of the Commission was the minor effect that they had on the price of oil in the US or anywhere else. (The US government was also strangely passive, since the laws of that country do not encourage the formation of monopolies or cartels). OPEC has generally been regarded in a different light, because regardless of the actual oil price, the threat of a ruinous escalation was always present.
In addition, since the attacks on the World Trade Towers and the Pentagon, there is a slight though noticeable belief that the countries of the Middle East are avid supporters of terrorism. The thing that needs to be understood here is that the events of 9-11 were arguably the result of a massive intelligence failure in the US, which has been confirmed and described by a former director of the CIA, Mr George Tenet. As for the copious rhetoric about terrorism that we have been subjected to for the last few years, this is mostly - though not entirely - the "cynical con" that Petronella Wyatt termed it, because it is insignificant as compared to the cheapening of human life and traditional morals that has been brought about by Hollywood and the less reputable elements of the entertainment industry. This might also be the place to mention that according to conventional economic logic, increasing prosperity generally reduces the inclination to participate in or espouse violence, although admittedly there are exceptions in the case of both individuals and countries.
2. OPEC AND ITS COMPETITORS
Professor Gately (2004) says that "rapid increases in OPEC output would increase OPEC's revenues and profits". This is almost certainly wrong, due to his use of the word "rapid". But he adds that "the key question is whether slower increases in OPEC output would increase their profits even more". Slower increases is the correct answer to this riddle, as I attempted to make clear in both my oil book, and to a lesser extent my previous energy economics textbook (2000).
Theoretically, in terms of mainstream development economics, the principal issue for OPEC exporters is not to deplete too rapidly their reserves of irreplaceable oil until they are in possession of replacement assets of one type or another - preferably of physical capital, as well as an appropriately educated workforce. Furthermore, as discussed below, oil and this capital can be a main input for various production activities. Saudi Arabia, Kuwait, Qatar and the United Arab Emirates (UAE) appear to be showing the way here, and it is very likely that Venezuela and Libya - and perhaps others - will follow in their footsteps. OPEC's production of oil is now close to 30 mb/d, but to my way of thinking they will never, willingly, double their output, which is what both the IEA and USDOE implicitly believe to be both desirable and feasible, especially if the peaking of the global oil supply is to be postponed for another decade or two.
In some very advanced course at a university of great renown, this might be the place in a highly abstract discussion of the topic being treated in this paper at which an energetic teacher of energy economics would introduce a computable general equilibrium or econometric model that was painstakingly crafted - perhaps at great expense - to explain most of the economic forces influencing the price of oil. At the same time this exquisite construction might be augmented to describe how the oil price influences the prices of other energy resources, as well as the macroeconomic price level in the most important oil importing countries. From there a discourse on employment and exchange rates might be launched.
I have encountered many departures of this sort in my work on electric deregulation, and I never hesitate to describe them as overblown bunkum. Moreover, I know that paradigms of this nature are constantly proposed and/or discussed in relation to the oil market, which is one of the reasons why I informed energy economics students of mine in Sweden, France and more recently in Thailand that they are strictly taboo in any classroom where I make the rules. I also took the liberty of declaring that any reference, regardless of how trivial, to the work of Professor Harold Hotelling on natural resources, will be rewarded with a failing grade or something close to it.
If we assume that the OPEC countries mentioned above are increasingly reluctant to do their part in keeping our Volvos and Saabs in the fast lane, then the logical next step is to ask whether something might happen to make them change their minds. A serious reduction in their export prospects is one of the first things to come to mind, and here the expression "demand destruction" has turned up in several recent articles that have been brought to my attention. In plain language this means a drastic reduction in the consumption of oil! What we could have here is a new kind of motor fuel (e.g. ethanol, or low-emission diesel or bio-diesel), an improvement in an old technology (e.g. hydrogen and fuel cells), a new technology where less fuel was used in motoring (e.g. 'hybrids' and especially 'plug-in' hybrids), or even a sharp decrease in aggregate miles driven due to a rise in fuel prices together with a greater resort to public transport, bicycles, rickshaws, etc.
We are going to see increasing amounts of all of these items - with the possible exception of rickshaws - but while they have been approved by the president of the United States, many observers are sceptical. For example, this topic has been discussed in great detail in many non-technical and easily read articles on the site EnergyPulse (www.energypulse.com), and more important almost all of them are followed by invaluable comments by knowledgeable observers. For instance, I would like to recommend the recent article of Alice Friedemann (2007). This is in three parts, and dozens of comments on her work are attached.
What was not brought out in those comments is that it appears that diesel automobiles are capable of overtaking hybrids in the US, because the newer generation of diesel vehicles are at least as clean as the best hybrids, and also at the present time have a cost advantage. This is a situation in which growing concern over global warming and the desire to reduce the dependence on foreign oil have led to tighter fuel economy and emissions standards, which in turn impact on consumer choice. On a more abstract plane, there have been claims that the emphasis on biofuels (e.g. ethanol) has raised some questions about the future profitability of (conventional) oil refineries, and this has had a negative influence on the new investment that is essential if enough gasoline is to be produced to prevent the already high gasoline prices from increasing.
There is still a great deal of talk in some quarters about making greater efforts to find and produce more conventional oil in non-OPEC countries. Mexico and the Caspian region seem to be the most relevant countries here. Mexico was mentioned at some length in my oil book, and I think that I was correct when I concluded that it would never live up to the expectations that were constantly floated as to its ability to provide a large-scale source of reserves that can be accessed by US consumers.
In any event, the study of Mexican oil is in some respects fascinating. The Cerro Azul Number 4 in Mexico was one of the world's great oil wells, however after yielding 60 million barrels, it suddenly began to produce only salt water. Here I can say that there is no price system of the kind presented in your favourite economics book that can deal with this kind of phenomenon. Had a statement of this nature been made to the late Milton Friedman, he would have laughed and called its author a fool: in his world conscientious and knowledgeable geologists and profit maximizing managers would have determined the exact capacity of that well, and it would have been valued accordingly. As it happens however, in every respectable microeconomics or price theory textbook at the intermediate level or higher, it is made clear that uncertainty prevents the formation of theoretically correct 'scarcity prices', unless a comprehensive system of futures and insurance markets are available. Such a system has never existed on the face of this earth, nor should one be expected, and uncertainty is the name of the oil exploration game. (Perhaps the best 'pedagogical' approach to scarcity prices is via the dual of a linear program.)
The Gulf of Mexico is the home of the Cantarell oil field, which may still be the third largest in the world. Unfortunately though it has peaked, and is in rapid decline. There has ostensibly been another very large 'strike' in the Gulf of Mexico that has been given the name "Jack", but according to Fredrik Robelius of Uppsala University, and other commentators, that discovery can be classified as a "bluff" - in other words a flagrant humbug or scam. If Dr Robelius is correct, which seems likely, it means is that this large body of water is just about played out where the oil future is concerned. (Eric Smith however believes that it is too early to write off the US deepwater portion of the Gulf.)
Interestingly enough, Professor Maureen Crandall of the United States Defence University has unexpectedly advanced a pessimistic conclusion about the Caspian (2006). I feel pleased to note that so did I, and much earlier than Ms Crandall. The Russians and some foreigners have been producing oil in that general area for many years - or perhaps decades - and it was quite clear to me that had as much oil been present as some people either think there is, or want us to believe there is, they would have discovered and begun to produce it long ago. Despite their almost unbelievable blundering in some matters, those of us who had the opportunity and motivation to study the Russian armed forces at fairly close range know that when it is absolutely necessary, they can be surprisingly efficient. In considering the actions and claims of certain oil companies in places like the Gulf of Mexico and Caspian, some words of the billionaire Canadian investor Stephen Jarislowsky are highly applicable: "It's absolutely unbelievable what's going on. We're living in just about the most dishonest time in the history of man." He also notes that "the crooks have more weapons than the good people in the fight. They can play fair and unfair." What he means is that a take-no-prisoners mendaciousness is sweeping the world, and those well dressed and presentable ladies and gentlemen in the CNN advertisements have learned how to choose the most favourable occasions to tell the truth or to lie in order to make sure that their dance cards remain filled.
We can conclude this section with a brief look at unconventional oil, which might be called 'the great black hope of the motoring world'. Many oil optimists now claim that much of what is generally called unconventional oil should be upgraded to conventional. If they are talking about modest amounts of tar sand oil and perhaps heavy oil, this might be correct, but despite the good press that shale oil often receives, it will be decades before the exploitation of large amounts of that resource makes even the slightest economic, environmental or technical sense. (Here it might be noted that oil shale does not contain oil and, strangely enough, is not even a shale. Oil is produced by destructive distillation of the organic matter in this material, and this organic matter is called kerogen.)
Whenever I hear talk about shale oil I remember my initial enthusiasm for this expedient, which was quenched for good when an American business executive brusquely informed me that water requirements for processing shale made it certain that only a small amount would ever be produced in the United States. A few months ago I heard shale praised to the high heavens by a Swedish commentator, but if its environmental disadvantages in Europe and probably elsewhere match those in the United States, it could be the 22nd century before a large of amount of it is exploited anywhere in the world. For example, processing shale rock causes it to expand by more than 20 percent, and thus volume-wise it produces more waste than the hole from which it originated. Energy requirements on the input side are of course enormous. The CEO of at least one major oil company has taken what amounts to a sacred oath that his firm will develop the technology required to make a winner of tar sands and heavy oil, but I doubt whether he would be so confident in the matter of shale.
The principal bonus of tar sand oil and heavy oil is quantitative, and thus at face value they are tremendous morale builders for oil optimists. The quantity of tar sand oil that can eventually be obtained from Canada has been compared favourably with the known reserves of Saudi Arabia, and assertions have been made that Venezuelan heavy oil more than matches that of Canada and Saudi Arabia combined. Being aware of the official estimates of tar sand oil production (as compared to reserves), I see no reason to be particularly relieved. This topic is often considered by the very reliable Oil Depletion Analysis Centre (ODAC), which can be reached via GOOGLE, and they provide the following figures: 2mb/d of tar sands oil for 2015, and 3mb/d for 2020. The Financial Times has from time to time provided slightly higher estimates, and these can be compared with a present output of 1.2mb/d. According to Professors Kjell Aleklett of Uppsala University and Douglas Reynolds of the University of Alaska, the production of oil from tar sands will only exceed the decrease in the production of conventional oil in Canada by a relatively small amount.
Heavy oil was mentioned in my paper 'An applicable update on the world oil market' (2007), but I forgot to note that this resource has the consistency of molasses, as well as a high sulphur content, and it features a much smaller net energy output than any grade of conventional oil. Moreover, it is so viscous that less than 10 percent of a typical deposit will flow to the surface if conventional pumping is employed. Refining heavy oil is also an expensive activity, especially if obtaining a large amount of light products (e.g. gasoline) from a refinery slate is desired. As indicated above, Venezuela is the undisputed world leader in heavy oil, but Major Chavez is apparently in no hurry to speed up its exploitation. Why should he? His agenda is better served if the price of oil remains high, which would not be the case if very large quantities of heavy oil could be produced and then dumped on world markets.
A year or so ago the Major reputedly came out in favour of OPEC defending an oil price of at least $60/b. I find this easy to believe, because he and other OPEC decision-makers have very likely come to the conclusion that a price on this level will not lead to the kind of macroeconomic distress in the oil importing countries that would restrain demand. Whether this is a correct assumption, or not, cannot be taken up in this article.
3. SOME OPEC DEVELOPMENT ECONOMICS
At one time - particularly when I taught at the African Institute for Economic and Development Planning (IDEP) - I was an enthusiastic student of development economics as it was presented by Hollis B. Chenery of Harvard University. Unfortunately the Nobel Prize that Chenery should have received was given to another gentleman, but a reason for this was probably Chenery's close association with certain movers and shakers in Washington D.C., and perhaps elsewhere. In any event, Professor Chenery was a great believer in the theory of comparative advantage, and occasionally I attempted to make it clear to students and colleagues that for countries that were rich in oil and/or gas this meant commencing or expanding, as soon and to the greatest extent possible, the transformation of crude oil into oil products and petrochemicals.
In my oil book - which was written in l978-79 - I made the following singularly unpopular statement about the petrochemical goals of Saudi Arabia (page 192): "These are ambitious targets, and it will be interesting to see whether they are realized or even partially realized, because if they are, it signifies an important breakthrough on the development front: the ability of a less developed country (although a rich LDC) to mobilize, in less than a decade, the capital and skill necessary to challenge some of the industrial giants of Europe on their own turf".
I can still remember the offence that remarks of this kind generated when I gave a series of lectures in Australia in the l980s - particularly during one acid-like exchange at the Australian National University. But a few years later a Shell Briefing Service document found it possible to make the following statement about some of the petrochemical projects of the Saudi Basic Industries Corporation (SABIC): "These plants, based on the latest chemical technology, have been completed on or ahead of schedule, which is a considerable technical achievement."
And that was only the beginning. Middle Eastern ethylene - which is the largest- volume petrochemical and the basic building block for plastics - appears to be on its way to 30 million metric tonnes (= 30 mt) by 2010, which would mean a market share of about 20% of predicted world consumption. Its output in 2000 was 6 mt.
Jenny Luesby (in the Financial Times, September 21, 2005) examines this important topic, but according to Professor Smith she makes a serious mistake in not recognizing the importance of natural gas and natural gas liquids on the US petrochemical scene. She is however aware of the value of cheap gas for the countries of the Middle East, which is something that I emphasized in a talk that I gave at the Copenhagen meeting of the International Association for Energy Economics l5 years ago, calling attention to activities in which natural gas liquids and the heavier components of natural gas - propane and butane - can be 'cracked' to become important inputs in the production of base chemicals known as olefins (which includes propylene and butadiene, as well as ethylene). Plastics, paints, fibre/textiles, pesticides, synthetic rubber for tires and pharmaceuticals are among the end products from olefins.)
It cannot be overemphasized that since energy costs are the key burden for chemical industries, the combination of inexpensive energy and state-of-the-art technology will ensure that the center of gravity of the global petrochemical industry will move toward the 'least-cost' Middle East, and probably sooner rather than later.
"Center of gravity" though does not mean complete domination. At any time this industry is a mixture of small and large, low and not-so-low cost, new and old, etc, and the price will be high enough to keep some of the less favourably endowed plants in business in order to supply total demand, but even so firms that sell large amounts of e.g. ethylene are finally waking up to the new realities brought about by proficient and cheaper methods of production at the disposal of countries that no longer want to be a hostage to unfavourable oil or gas prices.
Exactly how traditional firms will react to this challenge is uncertain, particularly in the short run. In the long run, of course, many of them have no choice but to cut-and-run, to use one of President George W. Bush's favourite expressions. Here it is interesting to cite a contribution of Professor Morris Adelman - who is no friend of OPEC - and his co-author Martin B. Zimmerman (1974). "Petrochemical prices (or margins) will move downward. Secondly, in the production of petrochemicals, most LDCs are at a severe and permanent disadvantage for lack of know-how, and the high opportunity cost of capital and feedstocks. Other countries, particularly OPEC members, who do not face these obstacles are expanding their petrochemical capacities. This too will drive prices down, lower the profitability of all plants built today, and force losses on many investors. Few can compete with those that get their feedstocks at a fraction of world prices, and are willing to earn low or negative rates of return."
Earning "low or negative rates of return" is not (and probably never was) the intention of the new OPEC petrochemical giants, particularly since the first large scale methane-to-ethane plants may be moving into the starting blocks. As the McKinsey consultant Jens Riese makes clear, this process constitutes a technological breakthrough that could inflate the outlook for petrochemicals, although if it doesn't, given the huge quantities of methane at the disposal of OPEC, acceptable margins should be available for a very long time. And even if this technology does not provide the desired effect right away, the major oil producing countries should eventually be able to enjoy lovely profits if they have the capacity to transform inexpensive refinery products into higher-priced petrochemicals.
Adelman and Zimmerman also provide a theory of investment that is intended to explain why there has been so much investment (or overinvestment) in this industry, despite the constant disappointments of managers and investors. "If a new plant made enough money in the first few years, and then lost money, it would still be a profitable plant to build. High near-term profits followed by moderate profits or even losses add up to a good present value, greater than the investment needed to get the required return."
The pivotal term above is "present value" - or better, expected present value. What these authors are talking about is the economy of mass or large volume production. It can then be shown that (ceteris paribus) an increase in volume obtained by lengthening production runs while holding the rate of production - i.e. output - constant will often (though perhaps not always) reduce unit costs, since bad news in the distant future will be outweighed by earlier gains. In the classroom a little algebra works well here.
A few words about refining might also be appropriate before moving to the next section. As pointed out in the Financial Times (September 29, 2005) "Although soaring demand has lifted margins in the downstream end of the industry to record levels, oil companies are reluctant to invest in new capacity.
That certainly sounds right to me, because I can remember an important refinery executive describing refining as "misery on stilts". In my recent lectures however I spent a great deal of time pointing out why of the five largest refineries in North America, four are owned by major oil companies, and also why the good fortune enjoyed by these large and prosperous enterprises will almost certainly be available for the oil exporting countries. Where the oil majors are concerned, when things went bad on the refining side, they had their profits from crude output to fall back on. Some of the OPEC refiners are in an even better position, because they have large supplies of inexpensive natural gas that be used as feedstocks and also provide the energy required for the production activities of both refineries and petrochemical installations. This is an unbeatable combination, and the icing on the cake is that the expanding refinery sectors in OPEC countries can install the absolutely latest technology in these new installations.
As Nancy Yamaguchi (2007) correctly noted, the increased revenue gained by OPEC countries over the last few years due to high oil prices have made an expansion in hydrocarbon processing eminently possible. The word that I have always used here is inevitable! Iran, for example, has apparently already commenced a refinery expansion and upgrading program that was indirectly referred to by the last Shah of that country, and I have heard that Bahrain, Kuwait, Qatar, Saudi Arabia and others have now accepted one of the basic lessons in their Economics 101 textbooks, which is that comparative advantage is a concept that it is expensive to disregard.
4. GENIUS SPEAKS: A NOTE FOR THE CONFERENCE 'OIL AND MONEY'
An unsolicited and perhaps undesired note is perhaps the correct term here. Every year a distinguished conference is held in Paris or London with the title 'Oil and Money', and for well over a decade, when I saw a notice of this conference in the New York Herald Tribune, I immediately begin writing and circulating articles and notes in the hope that my work would be detected by the sponsors of that conference, and perhaps sufficiently appreciated to gain me an all-expenses-paid invitation to e.g. give a 'keynote' speech in the 'City of Light' - a metropolis that I first visited not too long after being unexpectedly expelled from infantry leadership school in the United States Army.
In any event, in December, 2005, on the Swedish TV program 'Genius Speaks', a group of new Nobel Prize laureates spent a relaxed hour speculating on the human condition in the light of existing and possible scientific advances. As usual, the two economics laureates revealed themselves to be hopelessly naìve about what is happening in the real world, as compared to the fantasy worlds in the papers and lectures with which they provoke or bore their students and colleagues. As compared to the other laureates, they displayed an almost bizarre lack of poise or imagination, and one of them was barely unable to conceal his disgust at having his ineptitude paraded before the television audience.
Although macroeconomists, they were luckily not requested to explain or try to explain what might take place in the event of an oil price escalation which resulted in a barrel of oil trading for something around 75 $/b, as was the case several years ago. Had they been asked however, they would almost certainly have responded that such a high price, if sustained, would speed up the production of large quantities of synthetic oil from gas and coal, and in addition more effort would be put into exploiting the huge deposits of tar sands and heavy oil discussed above. What would not have been mentioned is the time factor, because in mainstream economics textbooks, the huge amount of unconventional oil that would be required to offset a 'run-up' in the oil price can virtually appear over night. They would also ignore the fact that when the initial millions of barrels of new non-conventional oil and/or motor fuel appeared, they would probably sell at or near the same price as the real thing, especially if their producers preferred more money to less.
Another gentleman - this one a professor of financial economics at Harvard, and writing in one of the leading natural science journals - went on record as believing that high oil prices were not of themselves a clear and present danger to the international macro-economy because of the ease with which derivatives - e.g. options and especially futures - could be used to hedge both short and long term price risk. As it happens, futures contracts with a maturity over 6 months have hardly any liquidity, and occasionally this is true for contracts that have a maturity in excess of 3 months.
Incidentally, the new chairman of the US Federal Reserve System, Professor Ben Bernanke (of Princeton University), remarked shortly after assuming office that on the basis of prices in the futures market he could not detect any danger of a spectacular oil price escalation. He had somehow come to the conclusion, or been informed, that long-term futures contracts - if indeed such assets exist - can provide valid information about long-term oil prices. This is not even wrong, because it is a statistical fact that severe oil price escalations have never been indicated by movements in futures prices, but instead tend to be the result of anomalous events (such as rifle-play in certain sensitive regions of the world). Of course, in terms of financial theory, futures prices are not 'efficient' estimators of physical oil prices in the future.
Having mentioned two former economics winners of the Nobel Prize - which probably should be called the ersatz Nobel Prize, because at no time in his highly productive life or for that matter his nightmares did Alfred Nobel contemplate founding an award that would be granted to some of the recent economics laureates - we can consider a likely future laureate. This is Professor Robert Schiller of Yale University, whose specialty is finance, and if I were on the Committee he would definitely be on my Very Short List for an award, particularly when I consider some of the other future candidates. His knowledge of oil however contains the usual defects, which to my way of thinking is always the problem when energy topics are broached in 'academia'.
Schiller points out that using futures may be a problem for low-rollers, but he neglects to mention that the oil futures market has occasionally been labelled 'The best game in town' by ladies and gentlemen that the novelist Tom Wolfe identified as "masters of the universe". Mr Wolfe is referring to people who not only possess the smarts required to earn a few million dollars a year well before they are thirty, but also have the intelligence and taste to spend it in an enlightened manner. In the United States these individuals attract a certain amount of attention in the business press, but while they undoubtedly outnumber successful rappers and hip-shakers on video clips, it is unlikely that there are more than a few thousand of them.
The future laureate believes that at current usage rates, proved reserves of oil will be exhausted in a few decades. A hundred decades is probably closer to the truth where exhaustion is concerned, because the bad news for those of us on the buy side of this market will come with the peaking of oil production. He also thinks that the price surge of oil "has the look and feel of a speculative bubble". In his opinion the six-fold price increase for oil between l998 and 2004 does not jibe with the change in "economic indicators". I have some problem sympathizing with this approach because of my familiarity with the work of Professor Alfred Marshall about a century ago. Marshall made it clear that price is determined by demand and supply. Demand now includes the voracious requirements of China and India, while the situation with supply is perhaps best characterized by the failure of most of the largest oil firms to replace their reserves of oil. Those two things do not add up to a "speculative bubble".
Of the 'majors' the failure of Shell (the third largest of the Non-OPEC majors) is the most flagrant, which is perhaps why the director of that enterprise implied that the blame for high oil (and gasoline) prices should be placed on the financial markets. Of course, when he expands on this hypothesis, he gets just about everything wrong. He says "So if inventories are normal, why should the price be so high?" He answered his own question by saying "I know various pension funds that had money in bonds, in shares. Now they went into commodities." I don't think so, Mr van der Veer. Actually, most of the money that you are talking about went into paper commodities (i.e. futures and options on oil). Another expert on this topic is the Fox News story teller, Mr Bill O'Reilly. His genius led him to provide the following reason for high oil and gas prices: "those Vegas type people who sit in front of their computers and bid on futures contracts" (Fortune, May 29, 2006, page 28). The following diagram shows inventories as explicit, while "Vegas type people" are implicit - i.e. contributing to the formation of the expected price ( pe). (As Geoffrey Styles points out though (2007), the arrow connecting flow and inventory should go both ways.)
Hedge funds and futures markets (i.e. "Vegas types") influence to some extent the expected price, and as a result desired stocks (i.e. inventories). If for example DI > AI because it is expected that price will increase, then price will increase as an attempt is made to increase stocks. But the key items in this price formation model are stocks (i.e. inventories), which are more important than the supply (s) and demand (d) flows. The mechanics of this market (and also futures and options markets) are explained in detail in my energy economics textbooks. I can reveal though that the word "normal" - as used by Mr van der Veer - carries very little scientific weight. Another way of looking at all this is considering the possible 'abnormalities' that could arise if there was a sudden shift in e.g. DI. If you enjoy manipulating differential equations this is a comparatively simple exercise, but for the present exposition it might be useful to make a few remarks about the importance of inventories, and what changing DI could mean.
Average inventories of oil for the US, Europe and Japan from January 1991 through March 2005 came to about 775 million barrels. These were fixed inventories, and an additional 830 million barrels (called floating inventories) were in transit at sea. More commercial stocks were held in the rest of the world, but there are no figures on the exact amounts. (There might also have been a billion barrels in official inventories - e.g. the US Strategic Petroleum Reserve (SPR) probably has about 800 million.) Now suppose that for one reason or another there is an increase in DI, and this is accompanied by an intention to raise AI by some fraction of one percent (1%), and in addition to do so in a short time.
In terms of the diagram above this puts a pressure on supply (s) that it cannot easily support, given the absence of reserve production capacity in the real world market. As a result the price (p) will immediately increase, and perhaps by a large amount. Yes, the people in front of computers may have contributed to this situation by misjudging the developing situation in the oil market, and thus playing a small or large part in causing pe to become something that it should not be, but the big problem was the failure of Mr van der Veer and his colleagues to locate sufficient new reserves and to invest in new capacity. Just as serious, the knowledge of these deficiencies is widespread, and so when market actors decide e.g. that they need larger inventories, their behaviour is vigorous.
Professor Shiller also says that the futures market expects oil prices to keep rising because it displays a condition called 'contango', with futures prices greater than the present spot price. This is interesting, because oil futures markets generally tend to be in
'backwardation' - with the spot price higher than the future price. Perhaps the main reason for this is given in the last sentence of the previous paragraph.
I think that by way of summation we can say that while Professor Shiller deserves his Nobel, his knowledge of the economics of energy markets would be much more sophisticated if he had taken a front row seat in the course on oil and gas that I recently gave in Bangkok. As for the excellent Bill O'Reilly and Mr van der Veer, they possess defective judgements of the role played by "Vegas types" or "Masters of the Universe" (or for that matter hedge fund hustlers) in the formation of oil prices. One of the masters, Mr John Brynjolfsson, says that he and his happy band deserve a pat on the back for bringing capital into the "commodities" markets, because that "helps these markets to work better". I believe that the gentleman means bringing it into the futures and options markets where it increases liquidity, because as far as I can tell, the strictly physical side of the oil market (and gas and coal markets) can function very well without the assistance of young millionaires.
".......never underestimate the power of oil"
- The Economist, 13 April 2002
The expression that we often hear now is that OPEC is back in the driver's seat. I think that this more or less sums up the situation, if by being in the driver's seat you mean that they have decided to function at the top of their game. Here I am thinking of a recent article in Fortune Magazine (March l9, 2007) in which Abu Dhabi (in the UAE) is called "The Richest City in the World", which means that the author of that article considered it richer than nearby Dubai. In point of truth neither of these cities is richer than Geneva and Zurich when everything is taken into consideration, but Abu Dhabi and Dubai have made remarkable progress. The most interesting thing for me in that article was someone saying that "They know that they have to diversify their economy away from just oil". This kind of logic permeated my book on oil, and it has also taken hold in Saudi Arabia, where six industrial "clusters" are apparently being planned.
Murray Duffin notes that "the supply of light sweet crude has surely peaked already, and about 70% of world refining capacity is geared to light sweet crude (2007). He adds that upgrading refineries to handle heavier crude is going to be an expensive proposition, but I suspect that this is exactly the sort of challenge that the oil producers of the Middle East are in position to accept.
During the last 20 years there has been a concentrated effort to convince obtuse or lazy students of the oil market of the lack of importance of OPEC in the oil producing world. One of the persons helping to sponsor this loony judgement was the Director of the Energy Research Centre at Columbia's Lamont-Doherty Earth Conservatory, and according to that gentleman the oil problem is not worth losing any sleep over because "if you pay smart people enough money, they will figure out all sorts of ways to get the oil that you need."
Putting himself in the shoes of one of the smart people that he has so much confidence in, he claimed that the total expense of producing a barrel of oil from natural gas has been reduced to $20. He then proclaims "That will effectively put a ceiling on the price that anyone can charge for a barrel of oil - which is something that has never existed in history. The moment anyone tries to charge above this amount, people will switch to fuels derived from natural gas" (Discover, June 1999, pg 85).
The very moment this scholar claimed! Well, goodbye to my plans to publish a long article in Discover, because I doubt whether the logic in a paper such as the present one is publishable in that prestigious journal. I am aware however that I should have informed the President of Columbia University that I was available for a director of energy research job, because when someone makes a goofy statement like the one above about replacing oil, it gives smart people a bad name. Regardless of what conclusions are arrived at in the laboratories or investment banks, oil is not going to be put on the block for $20/b. What has happened is that the OPEC countries have finally learned to work together, and so they do not have to accept the kind of oil price that would be in effect if the price setting mechanism were e.g. a Nash-type arrangement in which 'cheating' made more sense than cooperation. ( Instead, it can be shown with a little algebra that a Pareto Optimum might now apply for a producer association like OPEC.)
Having mentioned a "little algebra" I will close this paper by slightly reformulating some important work of Alhajji and Huettner (2000). Take Q0 = QM - QN, where Q0 is the demand for OPEC oil, QM is the market demand, and QN is non-OPEC supply. Differentiation gives dQ0 = dQM - dQN and dividing both sides by Q0 we get:
Elasticities can be formed if we divide both sides by dP/P. On the left hand side of (1) this would give us E0, or the elasticity of derived demand for OPEC'S oil. On the right hand side we will have ?, the market elasticity of demand for oil, and ?, the elasticity of supply of non-OPEC sellers. Another simplification is to define as positive the elasticity of demand - which is naturally negative - and to work with market shares instead of quantities: i.e. to deflate the Q's with QM. This turns the above expression into:
The first term, ?/Q0 shows why the demand for OPEC's oil could be very elastic (i.e. price sensitive), although the overall demand for oil might be fairly inelastic. If, for example, OPEC has 25 percent of the market for oil, then just considering that term, the elasticity of demand for its output would be four times that existing on the overall market. Assuming that OPEC decided that it wanted a higher price, then (ceteris paribus) it could find itself absorbing virtually the entire reduction in export output needed to support the higher price, and the smaller its share the greater the burden.
As for (1 - Q0)?/Q0, this can reinforce the first component in the expression. If OPEC's market share is small, and the non-OPEC supply elasticity was large, then an even greater reduction in OPEC export volume is necessary to maintain the target price. What (2) and its interpretation indicates is that, to make itself highly effective, OPEC requires a sizable market share and, in addition must face fairly low non-OPEC supply elasticities. Since I make a practice of ignoring most of the elasticities that one finds in the econometric literature, I will confine myself to reminding readers that OPEC's market share is increasing all the time, just as the supply elasticities of non-OPEC producers are very likely falling.
Before finishing this discussion, and the paper, readers should be aware that a peculiar variety of irrationality has characterized the 'debate' about what OPEC should and should not do, and how it should be confronted. Several years ago at the Rome meeting of the IAEE, I was grandly informed by a so-called expert on the world oil market that without foreign investment the OPEC countries were riding for a fall. I can understand - though not sympathize - with this kind of warped thinking because there is an enormous amount of money on the table. If the OPEC countries open their energy sectors to the major oil companies, and give them the return on investment that these enterprises feel that they are entitled to, then it would amount to a major triumph for various tender-hearted guardians of human rights that are pouring billions of dollars into marginal business ventures in corrupt countries, when they would like to see those billions go into the Middle East, where genuine oil prizes might still be located. As it happens however, given the technical skill available to the OPEC countries, either domestically or on hire from abroad, they seem to be reluctant to roll out the welcome mat for the wrong kind of guests where oil and gas are concerned, as is President Putin of Russia. (John Irish (2007), however, seems to think that this might be changing.)
As I have found out over the past few years, the above kind of reasoning on my part has caused quite a few persons to question my competence and perhaps my sanity. "Fruitcake" was one of the delicious appellations directed toward my good self by a young lady. I don't worry at all about this, because I know that in order to win the energy wars a large amount of publishable and applicable research is going to be essential, and this is one leadership school in which my approach is likely to be tolerated. Of course, I might someday have a reason to reflect on how decision makers like a Former Deputy Assistant Secretary of Energy for Policy in the US would react to the way that I express myself. As he says in the latest IAEE Newsletter, "oil policy is too important to be left to politicians". In his candid opinion "Governments are the source and not the consequence of the energy security dilemma; their withdrawal from the marketplace would provide the condition precedent for rational use of oil". He does not say in this article however that the peak oil hypothesis is hogwash, because although he believes it with all his heart and soul, saying it would cast an ugly shadow over the remainder of his precious thoughts. For this and a few other reasons, it might be possible that we are gradually getting closer to a debate or something like a systematic debate on the future of oil that is free of its long-standing and gratuitous irrationality.
Professor Ferdinand E. Banks
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