Oil and the Future

On oil I will make one point adding and one point detracting from Tyler’s analysis.  First, on speculation remember that demand and supply are both very inelastic so relatively small changes in either can make a big differrence.  That means that speculation, if that is what you want to call it, can shift prices a lot without being very significant in total demand.  Because of this point Krugman’s analysis is quite right for iron ore but a little off for oil – indeed Krugman’s analysis of oil is difficult to square with his analysis of the California electricity crisis.

My disagreement with Tyler is an agreement with Caplan. 

Bryan Caplan notes that commodity prices always have fallen back down in the past and argues that is likely to happen again in the future.  I say no, the current price is your best (rough) estimate of scarcity (adjusting for storage costs), don’t expect mean-reversion, future returns (but not prices) are a random walk, and extrapolation is a dangerous method to apply to financial time series.   

No, two points.  First, commodities are not stocks and nothing need be a random walk.  Imagine, for example, that you can produce 10 units of commodity X but no more (fixed production).  Thus you produce 10, 10, 10…. Now you know that a big technological innovation is about to increase production possibilities to 20, 20. 20…..   Does the price today necessarily fall?  No.  Price today is determined by supply and demand, supply is fixed and if substitution across time isn’t very easy (you still have to get to work today, right?) then demand doesn’t have to fall much with expectations of future supply.  Thus the price is high until it drops, even if everyone expects the drop.

Finally, on oil – who really cares what the price is?  The issue is energy, not oil.  I am confident that the long run price of energy will fall.      

Comments

"Finally, on oil - who really cares what the price is?"

Short term (next few years), you're kidding, right? Long term (when we have cars capable of returning >40 mpg), I might agree with you. There aren't many that do right now though - in the US, anyway.

Also, isn't this statement:

First, on speculation remember that demand and supply are both very inelastic so relatively small changes in either can make a big differrence.

completely at odds with this:

Imagine, for example, that you can produce 10 units of commodity X but no more (fixed production). Thus you produce 10, 10, 10.... Now you know that a big technological innovation is about to increase production possibilities to 20, 20. 20..... Does the price today necessarily fall? No. Price today is determined by supply and demand, supply is fixed and if substitution across time isn't very easy (you still have to get to work today, right?) then demand doesn't have to fall much with expectations of future supply.

Doubling oil output (per your example) wouldn't drop prices?

The problem with this quote is physics:

Finally, on oil - who really cares what the price is? The issue is energy, not oil. I am confident that the long run price of energy will fall.

In most cases, when economists look for falling "commodity" prices they are looking at substitutable goods. Energy is a fundamental category, and there is no reason, after consuming the low-hanging fruit in the category (oil gushers) that we should suddenly find something else hanging even lower.

I mean, it's possible, it would be nice, but it is not guaranteed by the laws of nature.

Reminder: The 1927 Ford Model-A got between 25 and 30 mpg (wikipedia). Why do so many cars to day get basically the same mileage? Physics.

The first thing to remember when one considers petroleum prices is that we are really buying a certain amount of travel at certain level of comfort and prestige. So there are many possible substitutes and even a change in attitudes toward prestige can reduce the amount used. If saving petrol becomes cool no telling what can happen. (see the BMW c1 200)

So my bet is that though petroleum prices may not return to the mean what we really buy most likely will (this is a 60%/40% for me).

f all the wind farms that are being planned in the US right now come to fruition by 2020 or so we will have 20% of our generating capacity from this source.

How many windmills can I put on the roof of my car/truck?

Hehe.....

Battery technology is another category we have hopes for ... but we have been making electric cars for more than a hundred years now ... and we are a little stuck. Low cost electric cars resemble golf carts, and heavier, more conventional electric cars carry a $40K+ premium over the gasoline equivalent.

We may have a breakthrough, and I am cautiously optimistic, but I'm not going to count these chickens before they hatch (any more than I would for hydrogen cars).

Note: The physics batteries have to overcome is "energy density." Cars require a lot of energy to push, which is why we've used as explosive and dangerous a fuel as gasoline. Pack in as much stored electric energy and you face similar problems ... well, see exploding laptops and cell phones.

Alex,

You neglect to add that the forward market for oil should, however, reflect this increased supply with a lower forward price - that's if the market, on average, believe's that an increase in supply will occur. With no ability to sunstitute demand across time, a buyer of oil must still pay the higher price for current demand, but they can benefit from the current BELIEF in higher supplies by locking in cheaper forward oil.

Further, one of the key misunderstandings which I believe is common to much commentary on this subject is in the nexus between speculation and fundamental supply/demand. Speculation by buying spot delivery oil, storing it, and hoping to sell it at a higher price (or locking in sales at a higher price on the forward market) IS part of the fundamental supply-demand balance for oil, but this kind of speculative activity is very limited as it requires a level of interaction with physical oil markets (and storage markets) which most financial institutions don't have.

Most speculation involves buying and selling forward or futures contracts for oil, and reversing the position before physical delivery takes place. Saying that speculative buying of forward contracts for oil ADDS to demand for oil is wrong. The price of forward oil contracts (collectively the oil curve) reflects the market's current best estimate or forecast of future physical supply/demand balances - the market is in contango between now and winter, reflecting expectations that supply will be reasonably static while demand will increase seasonally with colder temperatures etc. Buying and selling of forward contracts reflects the supply and demand of different FORECASTS of the future physical balance (It's probably more accurate to say supply and demand of CONVICTION in different forecasts, but this sounds a little esoteric). Some market participants act on a new forecast (or an increased likelihood of one forecast being correct) because they are buying or selling for future physical use and the risk to their wider business model of a particular forecast being correct makes the current forward price compelling to buy or sell. Speculators simply generate or believe a different forecast and act on it, expecting that forecast to gain wider market acceptance with time, thus moving the market in their favour.

Regardless, the forward curve at all times remains the best (or average) forecast of the price which will balance of future supply and demand.

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But the problem you mention odograph is developing a new two speed transmission that would deliver the 0-to-60 spec that was promised. The batteries are off-the-shelf and costs and performance are already a known quantity. Even so my understanding is the transmission issue was largely solved and they just need extra time to ramp up the production given the delay.

foo wrote:
If demand declines, pump slower to keep the price up. That way you maximize the revenue from your finite resource.

But you risk a new technology (like firefly's batteries and many other possibilities) that could kill the value of your asset.

My first post here - be gentle.

"T. Boone Pickens is planning a 4,000 MW wind farm in West Texas. It is literally a gold rush right now in alternative energy. All the billions of dollars that was made in the tech bubble of the '90s is now rushing into the alternative energy industry."

He has only ordered 1,000 MW of equipment so far, with the 4,000 MW figure planned for 2014. We need to remember two points when talking about this project - (1) it's economical only because of federal tax credits, and (2) the 4,000 MW figure is nameplate capacity only. Actual production is usually only 1/4 to 1/3 of the nameplate, as the wind doesn't always blow strongly enough much less 24/7.

I know several people trading oil on the NYMEX floor, having traded it myself in the past, and they universally agree that the investment money flowing into oil futures is pushing prices up. When you have a market with buyers and sellers in rough equilibrium, and then add a huge number of players who buy but never sell, there is only one way for prices to go. They tell me that speculators (including themselves) who might want to go short are afraid to do so, in fear that new orders to buy 50,000 contracts will hit the floor/screens and prevent any downward price movement. In the short term, traders are spooked and see massive demand destruction as the only way prices could fall even by relatively small amounts. In the long term, alternative energy technologies and new production (Brazil, Equatorial Guinea, etc) will help, but until then there will be huge wealth transfers to the oil-producing nations. Pumping existing reserves faster doesn't work, because once you hit the right production level, getting an extra million barrels out today means that you lose more than that in the future. Maintaining the right field pressures is a delicate thing, and getting it wrong cuts recovery totals.

Re the "10, 10, 10, 20, 20, 20" example, prices will not drop to fully take the production increase into account, as the new supply can't be used now. The only thing you can do is run down inventory levels ahead of the price drop, and stocks aren't so high that that can affect price to any great degree. But if demand were to go "10, 10, 10, 20, 20, 20", or supply were to go "20, 20, 20, 10, 10, 10", then you will see an immediate impact, as you can store supply now (thus reducing current supply) in anticipation of higher prices. Peak oil fears play to the supply side, and China and India fears play to the demand side of that.

Put all this together, and you have $140 oil.

Tyler,

I wrote carefully also, vis "commodities are not stocks and nothing need be a random walk," that includes returns. In the example I gave, return are not a random walk.

Alex

Alex,

I am confused about what investment you are making in your example - for which the return is not random. Is it buying oil now, storing it until after supply (almost certainly, as per the example) increases, and then selling it? This strategy does return a non-random, negative, return. If there is a forward market whose participants are also aware of and believe in the future supply increase, the strategy's negative return can be made 100% certain by selling the oil in the forward market at the lower forward curve price.

In this case the speculator has made a risk free investment in oil (albeit one in which they are locking ina negative return). Their risky, rather more random-return investment has occurred earlier - when they invested in buying storage capacity and then waited for an opportunity to invest in spot oil for future sale.

Or is it an investment in a forward oil contract - buying or selling a contract for delivery of oil at a time after the supply increase? If this supply increase (and it's price effects) are absolutely certain, then yes there will be a non-random return from this strategy. However in a more realistic scenario, in which the prediction of a supply increase is just that - a prediction - the return will be more random. Believing the prediction, you may sell the forward oil contract today. Tomorrow, new information may become available affecting your belief in this prediction, and your and other market participant's view of the future price. The continual change in information and forecast prices, until the contract delivers, generates volatility in the price walk.

Btw I say "more" random as I don't believe that all financial instruments follow completely random walks. There is almost always an element of uncertainty but sometimes clear probabilities of a move in a certain direction.

Odograph says: The 1927 Ford Model-A got between 25 and 30 mpg (wikipedia). Why do so many cars to day get basically the same mileage? Physics.

I am a physicist and I say that's wrong. Automobolie engine efficiency has increased by more than an order of magnitude since that time. If you were to put a modern engine and drive train in a model T and drive it arround at 30 miles/hour, you could get astounding MPG figures. We are getting the same MPG figures today because we have chosen to use our efficiency gains to go faster, add heavier, safer, and more luxurious bodies and interiors, and run radios, headlights, and air conditioners. The market simply valued those factors more than than fuel efficiency.

You can trade NYMEX oil futures out to 2018, the prices are nearly the same as next-month prices, so the mean prediction is that oil will NOT go down substantially in price.

Don't any of you think one important reason that oil is high is because the dollar is low?

David, I think you caught me on (slight)hyperbole rather than physics. Now, did you go a little wild there yourself?

"Automobolie engine efficiency has increased by more than an order of magnitude since that time."

I

The cars I know of that approach an order of magnitude increase do it by (a) radically reducing the mass and frontal area, as in the Volkswagen 1 Litre, or (b) by using extreme "pulse and glide" driving techniques.

Show me, a modern production car that will do an order of magnitude increase (10x, 260 MPG) at constant 30 mpg & with similar mass and frontal area to a Mode A

... or admit hyperbole

Note to Eric, in terms of "who's tried," I'd say Honda sure as heck tried with their small and aerodynamic Insight.

That represents the best-ever for a real American-market production automobile. It went faster than a Model A, but probably carried less ... topping out at about 70 mpg.

This is where I really think the limitations of physics show. To get ever 2x or 3x the Model A we need to pull every trick in the book.

Or as another example, the Prius merely doubles Model A mpg.

Future technologies are a Schrodinger's box experiment. The future is in an indeterminate state. I remind people of that, when they assume an outcome, and you fault me ... for what?

Show me where I did the actual converse and declared future failures. No, all I've done, consistently, is remind people that these promises are just that and that the actual outcome is indeterminate. When you say "I suspect therefore that it is intended to suggest that no significant changes are forthcoming" you do exactly what I suggested above. You extended my statement beyond my words or intent.

Are you old enough to remember the Dale Car? In 1974 people assured me that the Dale would give 70 MPG and sell for $2,000! This was to be followed by a $2,450 car called the Revelle that would give 50 MPG, and an eight-seater station wagon, Vanagon, for the same amount that would deliver 40 MPG.

I learned quite early that promises are different than production. I also learned that investment does not guarantee success.

And sure, I know all about the "hacked Prii" and that one caught fire last week.

Does that actually give lie to the future being unknown? Are you going to sell me a plug-in hybrid right now Eric? At what cost and with which features?

odograph - A Model A only weighed around 2200 lbs, it only had 40 HP, it didn't have A/C, it didn't have any pollution controls. Building to that type of design criteria we could get a lot higher mileage than the Model A. Even an entry level car today (at least entry level in the US) might weigh more, and generate around 3 times as much HP.

BTW, the physicist above claimed an order of magnitude increase in engine efficiency. Note that the gallons of gasoline to move (or accelerate) a ton has stayed pretty constant. The insight/prius owe much to aerodynamics rather than engines, more to transmission technology, tire technology, etc.

Understand what it is we are perfecting, and you'll have a better feel for our our actual headroom.

I don't have time to read it all unfortunately, but I think most of what I read is over optimistic.

Oil output is bound to fall in the long run, since it is dependent on the pressure inside the oil pits. After peak production, output (amount of oil over time) is limited even if it takes a long time to "run out". so let's say it's we've been going at 20, 20, 25, 25, 25, 30, 30, 30 for the past few decades and after this peak moment 28, 26, 22, 18, 17 and so forth.

More in depth explanation in the movie "The end of Suburbia"

Instead of an oil crash we will have and "oil downhill slope" of raising prices and ever shrinking middle class. There is debate about when we'll peak, some say we've peaked already.

I strongly recomend the film.

Brazilian Petrobrás has found some pretty big ass reserves at very very deep waters, and at even deeper soil and is currently working on the technology to extract it. Though that makes for a smaller chance of "running out", it's not likely to cheapen anything. It will be expensive oil.

ps: please do not invade my country, kthxbye.

Brazilian Petrobrás has found some pretty big ass reserves at very very deep waters, and at even deeper soil and is currently working on the technology to extract it. Though that makes for a smaller chance of "running out", it's not likely to cheapen anything. It will be expensive oil.

Or as another example, the Prius merely dbles Model A mpg.

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