With oil at $140 a barrel, can you still love Julian Simon?

by on June 30, 2008 at 6:18 am in Economics | Permalink

Remember Julian Simon, the guy who argued that resource prices would fall, fall, fall in real terms?  I loved spending time with him and to this day he remains an underrated economist.  (By the way, the very first piece I ever wrote was a guide to using Julian Simon for high school debaters.)  But can we still advocate his major thesis?

The possible belief space includes the following:

1. There is still a good chance that future resource and oil prices will fall dramatically, so Simon should not be dismissed.  Still, the single best estimate today can be inferred from the current market price, which implies a good chance that resources will get more expensive.

2. Simon is right and futures markets currently indicate that the price of oil is expected to fall dramatically.

3. Simon is still right, the rest of the world is wrong, and betting on this is how I will get rich.

4. Simon is right but current markets don’t allow us to bet on his major claims.  Futures markets extend for only a few years’ time, not for say the twenty years or so that are needed to validate his prediction.

4b. The deliverance of plenty is truly far away and no one is willing to take those margin calls for the next 187 years; in this scenario the present expected value of the future improvement is pretty low.

5. Simon is right but nominal interest rates will soon fall so low that successive short selling of oil in the futures market won’t yield supernormal returns.  (This can mean, for instance, that you’d rather lock up all your money today at the higher rates, rather than short selling.)

No way does #2 work, though there is often slight backwardation in the futures price.  I’ve never heard anyone argue #5 and indeed most people haven’t even thought of it as an escape hatch.  My belief is closest to #1.  Bryan Caplan argues for #4 but Arnold Kling shows that doesn’t fly.  If you’re always rolling over a successively renewed short position in the futures market, sooner or later the price decline for oil will yield you supernormal profits; in the meantime your margin deposit is earning the rate of return on T-Bills, noting that you must buy into the new contract cycle before your old contract expires so as not to miss the window of opportunity.  OK there is margin call risk, etc. but if Simon is right that is small relative to your potential gains.

(Alternatively you might argue that if you are in contract cycle #3, the good news will arrive to affect the pricing of cycle #4 before you can buy in, adding on that even after the future good news is announced the MC curve is so steep that you don’t gain much on contract cycle #3.  That’s possible but a) ex ante you still have supernormal returns since it may not work out that way, and b) the reality is that huge good supply news, whether for oil or some other energy source, would lead to lots of pumping today and a plummeting oil price right away.)

I invite Alex to accept #1 or otherwise indicate his stance.

It’s amazing how much, on this issue, some people resort to what can only be called technical analysis — inferring future price movements from past trends — when they would scoff at that approach in almost any other context.  It’s OK to argue that belief #3 held for most of world history –before we all read Simon and perhaps before there were futures markets in oil — but I want to know if you are betting on #3 today and if not why not and also what other ways there are to get very rich that you can tell me about (does only the oil market malfunction so?).

I’ll also note that current oil prices hardly suggest (do click on that link) a level of bone-crunching, civilization-ending scarcity, so you can believe in #1 and still be an optimist overall, as indeed I am.  I’m just not nearly as much of an optimist as I was when oil was $10-$20 a barrel, wasn’t it even $8 a barrel for domestic oil less than ten years ago?

Also on belief #4 note that: forward contracts allow for longer bets than do futures contracts, contract length is endogenous to important events (though synthetic contract positions mean we don’t need all of the possible longer term contracts), and it is odd for libertarians — combinatorial prediction market fans at that — to suddenly cite missing markets to defend their broader position.

Addendum: Oh, yes, there is one more option.  I call it "#3 is correct but my wife won’t let us get rich."  I’ll say this in response: for all the virtues marriage has for men, when you look around and study it more closely, you’ll find the institution has even more virtues than you had thought.

Second addendum: Here is Jeffrey Sachs on this topic.

Andrew June 30, 2008 at 7:30 am

The amount of energy available is nearly limitless. The amount of energy a person can use is also nearly limitless. We are figuring out technology to promote the latter faster than the technology to extract former. We used to not use as much energy (before we developed capitalism and stumbled on fossil fuels). We know how to go back, we just don’t know how to maintain trend growth with it.

Buffett became satisfactorily wealthy partly by practicing “time horizon arbitrage.” Markets are short-term oriented. Prices have to come down. Will they come down due to technological progress or due to growth grinding to a halt? I think high energy prices are just the victory lap for globalization.

Btw, price trends do contain information, just not the type a lot of technicians try to impute to it. I’m surprised that some people are using TODAY’s volatile spot price to impute profound information. ;)

Andrew June 30, 2008 at 7:52 am

How to get rich:

A la Julian Simon, issue a challenge for a wager to Al Gore. The money is in the terms, not the outcome. He’s a politician, you will own him on the fundamentals and he’ll overcommit in order to signal his dogma. He won’t even care.

liberalarts June 30, 2008 at 8:10 am

Tyler, you obviously know a lot more about Simon than I, but I always dismiss any theory that feels permanent and inflexible regarding changes in preferences, technology, resources and markets. Thus, I have always lumped Simon in with Karl Marx (permanent instability of capitalism), free banking backed by gold is best people (von Mises thought it was a good idea, so it always will be, and other related theories. Essentially, any idea that people must take on faith feels more like religion to me than economics. I sympathize with #1.

Neil West June 30, 2008 at 8:28 am

Since the oil supply is largely controlled by a cartel, are other commodity models applicable? I wonder if a large amount of the price increase in oil is due to the cartel’s desire to affect politics in the United States. Of course we also know that much of the cost of oil is due to the dollar’s devaluation.

Julian June 30, 2008 at 8:42 am

you are missing an important option:

*Julian Simon was right and resource prices are falling in real terms, but the dollar is falling in value.

(anyone naive enough to believe that adjusting for official CPI transforms data into “real” terms can go to bed while the adults talk)

andrewlehman June 30, 2008 at 8:51 am

Why am I not surprised!

Imperialism and mercantilism ruin the economy of the US, triggering a worldwide economic crisis and the closet socialists bring out the old malthusian arguments to attack consumerism/capitalism/whatever.

Guess what their recipees will be? that’s right: more imperialism, mercantilism and authoritarianism. Damn you Tyler! You’ve sold your soul long ago and you’re not even subtle.

confused June 30, 2008 at 9:04 am

I am absolutely amazed. How can people talk about information contained in prices without even mentioning monetary factors?

Isn’t supply and demand of money half the story behind every price?

I guess you americans just take the dollar for granted.

mpkomara June 30, 2008 at 9:10 am

Tyler, in Caplan’s assumptions, rolling over a short position in a futures contract would earn you no profits once the other participants “catch on” in one year’s time.

Alex J. June 30, 2008 at 9:27 am

I would love to build a coal-to-oil plant and get rich selling oil at a huge profit, but the EPA won’t let me.

Mo June 30, 2008 at 9:45 am

Oil has bee going up in euros as well. Not quite as steeply, but oil prices are still higher.

One could point out that oil bottomed when they had “Oil $5/barrel?” on their cover. My guess is the peak will be when they have “Oil $200/barrel?” on their cover.

Joe T June 30, 2008 at 9:53 am

I don’t think Simon ever suggested that this would apply for every single commodity all the time. If the commodity is “energy”, not oil specifically, there is no doubt what so ever in my mind that it will be *a lot* cheaper in a hundred years compared to today. But what will happen with the oil price specifically? No idea, don’t care, don’t think anyone else should care much either, as long as energy prices decline. So put me down as 1, but note the long time horizon. (If Simon ever said anything about short time spans, put me in the “well, he is wrong” category. I don’t think he said that, however.

3 & 4 are possibly right in theory, but definitely wrong in practice. The market can stay irrational longer than you can stay solvent.

HUMBUG June 30, 2008 at 10:09 am

Bah.
Oil is still the same price as 10 years ago in gold. Just this fact should make you rethink your premises.

odograph June 30, 2008 at 11:01 am

I’m not sure where Simon would come down on this, but what I really dislike is the blithe optimist who (referencing Simon) says we have no need to shepherd resources.

Resources are not equal, and some of the substitutes are inferior.

(I think oil is something we should be conservative with, but we’ve also obviously wreaked havoc on our wild fish stocks. Would Simon himself consider battery chicken a substitute for wild Cod or Salmon?)

Floccina June 30, 2008 at 11:08 am

1. My reading Simon he really only says that life will improve. As for as resources he uses the word effective meaning the amount of the resources that is used effectively will increase. In this case miles driven a given level of comfort will get more affordable. Thus in his model more efficient use is an increase in the effective resource.
2. Is it not true that petroleum is getting more affordable to more people despite the rise in price (see China and India).
3. It is a principle and not a guarantee, in general in the long run things will get more affordable to more people. For example the fact that lobster used to be cheap does not mean that Simon was wrong and by extention he is not wrong now.

Chris Meisenzahl June 30, 2008 at 11:44 am

“I don’t think Simon ever suggested that this would apply for every single commodity all the time. If the commodity is “energy”, not oil specifically, there is no doubt what so ever in my mind that it will be *a lot* cheaper in a hundred years compared to today.”

Well-stated! Exactly what I was poorly trying to get at with my earlier comment.

Bob Murphy June 30, 2008 at 12:05 pm

Tyler,

I actually wanted to buy puts on oil futures about a year ago, and my wife talked me out of it! Phew!

If you’re still checking this thread, can you clarify this?

Still, the single best estimate today can be inferred from the current market price, which implies a good chance that resources will get more expensive.

I’m confused by this claim. If today’s spot price is the best guess of the future price, then isn’t there a 50/50 chance that oil will go up or down? Or is that all you mean by “good chance”?

(For what it’s worth, I think the relation between a current market price and expected spot prices in the future is more subtle than many economists realize.)

Chris Durnell June 30, 2008 at 1:30 pm

If it wasn’t for the huge increase in demand generated by China and others, that did not exist in the 1970s, then the collapse of oil prices would be insured, even in China’s demand remained constant. But it will only increase, so any offset caused by greater efficiency in US, Europe, and Japan and new fields will be temporary. Expect high prices to remain for the next 5 years and then probably a “reasonable? prices that would still be high compared to the ’90s.

Only when the infrastructure of the world economy greatly changes so that it uses other sources of energy will the price of oil be driven down. And of course, someone will make tons of money by doing that. It won’t be by speculating on oil though, but by making the right investments in energy R&D, engineering, and infrastructure. This will all take a long time and require some amount of expertise. It’s like knowing the railroads will be big, but having no idea exactly which railroads to invest in. Not everyone is JP Morgan.

FXKLM June 30, 2008 at 1:59 pm

I don’t think #5 works. You can put your money into fixed income assets locking in interest rates now and then use those assets as collateral for swaps to take short positions in oil. Taking a position on oil doesn’t require you to forego investing in debt.

nick June 30, 2008 at 3:14 pm

Isn’t supply and demand of money half the story behind every price?

With unstable currencies it is far more than half of the story. Small changes in long-term inflation expectations cause large changes in commodity prices. If Tyler applies Lachmannian expectations to the currency side of a trade of currency for commodity I think he will discover why he was quite wrong to say:

On the money side, the low dollar is one factor but it doesn’t account for the leap from $10 a barrel to $142 or so a barrel.

Increased expectations of inflation in future decades, from 1998 (near the end of a decade when deflation was the main worry) to today (even Alan Greenspan said in his recent book to expect 4.5%/year from here on out, and that was well before the Bear Stearns bailout), can easily account for a factor of 14 increase. For example, a Hotelling nonrenewable commodity for which there are no changes in expected consumption (assume the expectation covers the next 100 years), but there is a change in expected inflation from 1.75%/year over that time to 4.50%/year over that time, gives us a factor of 14.3 increase in the commodity price.

When floating currencies bob in the waves, price changes in commodities, especially less renewable or substitutable commodities like oil, easily swamp traditional fundamental factors.

Tyler’s list (1)-(5) completely misses the problem with trying to go short commodities (which is of course to also go long a floating currency) in an era of changing expectations about long-term inflation. A bet to go short would be a bet that the Fed, ECB, etc. are going to get their act together and behave quite admirably in future decades, and thus that inflation expectations are too high. If you really know that inflation is only going to average 3.5%/year instead of 4.5%/year in the coming decades, and furthermore you know that everybody else is going to (magically!) realize this just a few years from now, you can indeed make a killing with this rollover short position. But predicting the future of central bank behavior is a far dicier proposition than predicting the future of geology or even of technology.

If you put Julian Simon’s bet as the price of an industrial commodity basket in terms of gold, it has been, is now, and quite likely will be in the future, a winning bet.

Here is my overview explaining the recent dramatic runup in commodity prices.

nick June 30, 2008 at 4:17 pm

Incidentally, if you think Julian Simon is wrong, and you think we have reached “peak” for certain industrial commodities, due to geological and technological rather than monetary causes, and that substitutes for these commodities will be less efficient, due to which real prices for those commodities will rise, here is the bet for you:

(1) go short gold, or silver, or both.

(2) go long a basket of whatever industrial commodities you think have “peaked” and are not readily substituted for over the long term: oil, coal, iron, copper, etc.

This is a nice bet, as close as possible to being currency neutral(*), that commodities that are necessities for industry will be consumed faster, or supplied more sparingly, or both, in the future than commodities whose value comes almost entirely from their monetary and luxury value. If your long position is a broad commodities basket, it is a bet that the future will move us closer to Malthusian doom and farther away from a world of greater luxury.

(*) It’s not completely currency neutral because gold and certain industrial commodities might react to future inflation expectations differently, e.g. based on the respective costs of “storing” them above or below ground, including costs from the insecurity of property rights. But this is about as close as one can come to being currency neutral for a long-term bet.

M1EK June 30, 2008 at 5:42 pm

“It won’t matter, energy will be cheaper.”

Survivorship bias.

Economics can’t beat physics or chemistry. Battery tech is limited by the periodic table itself. Oil is effectively burning thousands of harvests of ‘biofuels’ all in one go. Etc.

Petroleum was around when we transitioned from whale oil; it was a known quantity – the EROEI was good even though the infrastructure hadn’t been built. Nothing today comes remotely close to matching petroleum’s EROEI, much less exceeding it.

Eric H July 1, 2008 at 12:11 am

David Wright says it better than I would have, which would have been something like:

6. Oil may become cheaper, or simply irrelevant. Not a clear enough choice for me to bet the farm on.

Economics does not have to beat chemistry or physics: economics only helps *different* physics or chemistry beat physics (or chemistry). Examples: Video teleconferencing and Acrobat. Not to mention better genetic engineering (and not just of the “frankenfood” variety). And supply substitution (i.e. the bus for cars, better cities for the ‘burbs). We forget that we have built an entire culture around having cheap oil and that we can change our minds about many of those choices once we accept that the fundamental assumption has obviously changed.

Bill R July 1, 2008 at 11:55 am

Uh… The only possible belief spaces are all variations on Simon being right? How open-minded! Especially on a planet with many non-renewable and difficult to renew (old growth forests, fish stocks, soil) resources during a period of EXPONENTIAL population growth. From an reality based ecologists point-of-view how about broadening the discussion to #6; Simon is WRONG. Humans ability to innovate can surpass ecological and enconomic constraints for a period and drive down costs of resources, but at the point at which the resource returns on energy invested become marginal, the ability to drive those costs down collapses, as the production of that product peaks. We MAY replace oil with another energy source and keep energy cheap, but we WILL run out of oil this century. In the next 2-3 decades oil will be volitile, but it will go UP in price.

McBlogger July 1, 2008 at 4:03 pm

M1EK

No, of course not. However, economics can provide incentives to get very imaginative with both physics and chemistry. Personally, someone is going to find a way to make a very nice WTI equivalent crude. Actually, someone already figured it out, all that remains is to scale it up. I’m just waiting to see who will roll it out first.

Beyond that, there’s high temp GaAs PV’s. Again, you’ll need good batteries but that may not be as far away as you think.

Greg July 1, 2008 at 5:18 pm

Agree completely with the comments on solar and nuclear energy. Add in wind, wave, biomass, etc. Then consider the population bust that seems awfully likely in the next 50 years or so. How can the price of oil not go down? Really, it seems inconceivable.

As for getting rich on it, that’s harder. Between the time value of money and the risk of making a mistake and losing my shirt, I’m wary of it. But I am talking myself into it a bit. Anyone want to go into further detail on how one would construct a long-term short on oil? I’m a little ignorant of how rolling over a short would work. Should probably call some of my trading friends…

Greg July 1, 2008 at 5:20 pm

Oh yeah, and as far as pet investment hypotheses go, I’d be much more interested going long on desalination than short on oil.

odograph July 1, 2008 at 5:38 pm

Let’s try this again: “Greg, if those alternatives were now cheaper than oil, they would [now] be used in preference to oil.”

TheGreyZone July 1, 2008 at 6:20 pm

Oil is a finite commodity. Eventually demand will (and probably already has) exceeded capacity to supply. This is common enough. It happened with whale oil and it happened with timber as well as other commodities. What occurred in the past though was a changeover to a different, interchangeable and often better form of energy. Coupled with that changeover was also the observation that civilization increased in complexity to accommodate the adoption of the new energy source.

Faced with limits on a current energy source (fossil fuels), civilization thus has two alternatives available – increase complexity and replace fossil fuels with a different energy source or reduce complexity and reduce energy use. There are no historical examples of any other response by a civilization to a resource constraint. In the category of complexity reduction and resource usage reduction, some past contractions were voluntary but most were not and constituted civilization ending “collapse” events, often spanning decades to centuries. Those are the historical facts across all observed human civilizations.

Thus, while I can see a possible future with even more energy available (fusion anyone?), I can also see a future in which we might have to contract either voluntarily or otherwise. This all depends upon our response to the current resource constraint problem. If we keep trying to hammer the fossil fuel nail, we’ll probably hammer ourselves into pretty deep trouble. If we change tools and learn to bolt together a different solution, we don’t have to get into trouble.

Unfortunately, the human propensity when in a deep hole is to continue digging.

On a separate note, some people seem incapable of grasping that oil is a finite quantity. We have consumed, in roughly 150 years, somewhere between one half and one third of all the oil that previously formed and survived to the present over the last several hundred million years. Only an innumerate demagogue would contend that such consumption rates can continue forever. Oil ultimately must be replaced and anyone who thinks we will be producing 85 million barrels per day in 2060 is apparently incapable of basic math. The future of technological civilization is electric and revolves around wind, solar, nuclear (fission and hopefully someday fusion), hydro, and other renewables.

In fact, a changeover to an all electric transport grid would basically free that grid from sudden obsolescence, since any energy form can be converted to electricity. Thus if the transport grid is all electric, it won’t matter if we derive our electricity from fission, fusion, or swarms of monkeys on bicycles. I remain amazed at how many people are too dense to understand that simple point.

Accepting and acting upon these truths is part of the response to a resource constraint that can lead to a better tomorrow. Failure to act upon these truths will lead to much grief.

DaveinHackensack July 1, 2008 at 6:44 pm

Did Simon or Ehrlich ever read Hot Commodities by Jim Rogers? Rogers seems to know a thing or two about commodities, and he explains the obvious:

1) Secular bull markets in commodities are driven by years or decades of underinvestment in supply (e.g., during the dot-com boom, how many venture capitalists were investing in opening a new copper mine?).

2) Years of underinvestment in supply lead to lower supplies and higher prices: a secular bull market in commodities begins. After lots of investment goes into increasing supply, commodity prices go down, and you have another secular bear market in commodities.

Rogers says that secular bull markets in commodities have lasted between 15 and 23 years, historically.

Gerg July 2, 2008 at 2:28 am

“Thats a little over on ten-thousanth of incoming energy. There are (large) practical problems gathering that enery, but physics is on the side of cheap energy.”

Wait, so you’re ok with a 1-m^2 solar panel every 100m as far as you can see?

People’s intuition fails them when talking about 2-d and 3-d quantities. 1/10,000 is actually pretty far from adequate. Building and maintaining solar panels covering an area 1% of the width and 1% of the length of the US would be a monumental (and monumentally expensive) task

McBlogger July 2, 2008 at 12:19 pm

Mike, I know. Now. But 100 years ago, lead acid was high technology and I’m almost certain there was someone like you telling someone like me that the limitations were permanent.

I think battery and capacitor technology is about to get a whole lot better. I also think biofuels are going to be so plentiful and cheap that $1.50 gas is not more than 3-5 years away.

nick July 2, 2008 at 4:29 pm

Re Odograph: Some alternative energy sources like nuclear are to the best of my very limited knowledge already cheaper than $140 per barrel oil, but there are political and capacity constraints.

Since the oil price rise is primarily monetary rather than fundamental, these relative nominal prices are highly misleading. As price stickiness is overcome inflation will spread from oil to other inputs into energy capital. (This would be true even if oil itself were not used as an input, since this again will be more a monetary than a fundamental phenomenon).

Inflation is already starting to hit nuclear power — cost estimates for new plants have risen dramatically in the last two years. We will soon see it hit the various other alternatives. Barring substantial technological breakthroughs, the price of alternatives in the coming decades will rise faster than the price of oil.

Jake July 3, 2008 at 1:10 am

1) There is a way to invest in shorting Commodities in the long term although it’s in the LSE.

http://retirementtrader.blogspot.com/2008/03/how-to-short-commodities-using-etf.html
http://www.etfsecurities.com/csl/short/index.asp

2) Do you think part of the reason we are experiencing high volatility (and maybe high prices) for oil is linked to tight inventory and supply chain supplies of oil and therefore, any small disruption in supply leads to huge price jumps because there is very little “cushion” in the inventory? Do you think the strategic reserves that many of the developed countries have might be in a way subsidizing the oil companies so they don’t feel such a great need to have their own reserves, thus leading to a tighter and tighter overall inventory supply chain over these past few years?

jackthehat July 29, 2008 at 10:44 pm

Very interesting blog i just stumbled into! I havent read all the responses yet – there are so many. However, here are some points that were perhaps missed:
1. Most oil is comsumed as car/plane/vehicle fuel (7/10 barrels in US).

2. Hybrid cars are in the mainstream with 300K Prius sold in the US in 2007. (Q. i wonder how much gas has been saved from the 1million Priuses worldwide the last 3 years?)

3. Alternative fuel cars are already viable but not readily availble.

4. Likely a more flexible car company (not US but probably Toyota/Honda) will release a gas-free vehicle into the mainstream within 1-2yrs. Note that the first to market will make biggest impact and hold market share – the race is already on! The markets are ‘driving’ the demand

5. New British independent car company released all-electric sports car (this week July 08) with 0-60mph <5secs!

6. Long term oil prices should remain steady (in line with real dollar/euro price) as decrease use in developed nations is ofset by increased use by Chinese.

azdırıcı May 18, 2009 at 7:37 am

thanks for all

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