Energy Independence and Analysis

The revolution in production of unconventional oil and gas in the United States is no doubt an important development for the economy. But it also has been accompanied by a lack of analysis. Case in point, Sunday's NYTimes piece on the "Dark Side of Energy Independence."  The authors, editors at Foreign Affairs, argue that increased US production could lead to a 50% reduction in oil prices, and then analyze the effects of this on oil producers elsewhere.  They point out that:

lower energy prices will undermine the stability of the Persian Gulf monarchies, whose hefty oil revenues have allowed them to win their populations’ loyalties through patronage and a lack of taxation. These countries do not always share American values or help advance American interests, but anything that destabilizes them would create problems that Washington could not afford to ignore.        

What is amazing about their argument is that they never consider how oil producers will react to lower oil prices. They do not consider the impact of $50 per barrel oil on the profitability of unconventional producers. If prices fall in half which oil projects are likely to be cut back? Presumably those with the highest costs. 

Nor do they consider how OPEC producers might react to this increase in oil production from elsewhere. They could, cut back their production, as comments from Saudi oil minister, Ali Naimi, suggests. But if OPEC cuts back then why would prices fall in half? Alternatively, facing lower prices desperate countries might increase production causing a further fall in prices, as Michael Levi notes. 

But the key point to remember is that unconventional production of oil and gas is a response to high oil prices. As prices fall the projects that are cut back are those that have the highest marginal cost. Failing to consider this is an invitation to faulty analysis.

Uncertainty

How difficult is it to forecast oil prices? Compare the prediction of Philip Verleger, as reported in Bloomberg today, with the forecasts I talked about yesterday in my post on speculation:

Crude oil will collapse to $20 a barrel this year as the recession takes a deeper toll on fuel demand, according to academic and former U.S. government adviser Philip Verleger.

“The economic situation is not getting better,” Verleger, 64, a professor at the University of Calgary and head of consultant PKVerleger LLC, said in a telephone interview yesterday. “Global refinery runs are going to be much lower in the fall. If the recession continues and it’s a warm winter, it’s going to be devastating.”

But as I noted yesterday, these are not the only predictions for oil prices. Many forecast higher prices in the future. As the Bloomberg reporter notes:

At the other end of the spectrum from Verleger, Goldman Sachs Group Inc. predicted in a report yesterday oil will rally to $85 a barrel by the end of the year, and recommended that clients buy futures contracts for delivery in December 2011.

Why is it so hard to predict oil prices? These two quotes demonstrate that there are deep differences on fundamentals. That is, it is very hard to predict what will happen to fundamental factors like demand and supply in one year. Then it should not surprise that prices are hard to predict.

So oil prices are pretty surely to be either $20 a barrel or $85 per barrel. That is what I call uncertainty in forecasts.

Shoot the Speculators

Lenin could just order that speculators be shot. Today we have to have an investigation by the CFTC. So we learn in the Washington Post:

"Here we go again," Bart Chilton, a commissioner at the Commodity Futures Trading Commission, said late last month. "Crude oil prices are up 60 percent on the year. Supplies are at a 10-year high, and demand is at a 10-year low. You do the math. Why should prices be over $70?"

Last week, the CFTC said it would consider new measures to curb speculation and increase transparency in energy markets, where the agency's data suggest that a substantial amount of oil trading was concentrated in the hands of just a few investment banks and trading firms. Also last week, the leaders of Britain and France urged measures to counter "damaging speculation."

The argument seems to be that with oil demand lagging and inventories very high, that oil prices should be falling. Current prices of $60 per barrel must thus reflect the role of speculators. Worse, financial speculators!

It is always hard to understand how people can make money by moving a price away from its fundamental value. And what is most important about oil is how difficult it is to predict its future price. Oil prices are volatile, they tend to resemble a random walk, although for most of the period since 1859 (when oil was discovered in Pennsylvania) real oil prices have rarely exceeded $25 per barrel in current prices (see here, for example, for excellent charts).

Another reason why investors are looking to oil is because of fear of inflation. Oil can be a hedge against inflation:

Many of these investors are seeking to diversify their holdings or protect themselves against inflation that governments and central banks might foment while jolting the global economy. "It's like a barbecue that is not catching fire," said Jan Loeys, J.P. Morgan Chase's London-based head of market strategy. "You put all kinds of lighter fluid on it, and it's not taking. Then at some point, it takes, and then you don't have a lot of time before it blows up in your face."

So the actions of governments are leading to speculation that oil prices will increase. Either because they will head off recession and thus spur oil demand, or because they increase debt so much that there will be inflation. And, if the dollar declines in value oil prices will rise simply due to the fact that the price is denominated in dollars.

The fundamental point, of course, is that oil prices are just very hard to forecast. Each day, the price moves up or down, and there is some clever commentator who can explain why it moved. But it is very hard to forecast oil prices over longer periods. That does not mean it is not a good investment, however. It could help diversify risk for many investors.

Now suppose you are an investor and you read that oil prices are likely to rise to $85 by 2010, as in this report from Bloomberg:

Commodities will rise as investors’ appetite for risk revives along with the global economy, Morgan Stanley analysts, led by Hussein Allidina, said in a report yesterday. At the same time, oil production will drop as much as 6.3 percent a year among suppliers outside the Organization of Petroleum Exporting Countries and by 3.5 percent within the group, the bank said.

Oil demand is expected to rise 1.4 million barrels a day, or 1.7 percent, in 2010, led by emerging markets outside the Organization for Economic Cooperation and Development, the International Energy Agency said on July 10. Crude prices have climbed 35 percent this year on optimism that government stimulus will overcome the worst recession in six decades.

Under such circumstances I think investing in oil might not be a bad idea when the current price is $60. And if producers read these articles they have less incentive to produce now. So it is hard for me to believe that it is just evil speculators who push the price up.

Let us suppose that without the speculators the price would fall today to $50. But in 2010 it will be $85 as the stories say. Then absence of speculation means a much larger price jump in the future. Won't that be more disruptive? If prices are lower today, then there will be less exploration so that when demand recovers the price increase will be even more severe.

So, by all means, lets shoot some speculators. Good entertainment. But I will bet that shooting regulators and even government officials would get higher TV ratings.

Speculators

Jim Hamilton has a good post on speculation and oil prices. It is tempting for politicians to blame high oil prices on speculators. They never seem to blame falling prices on speculators.

It is important to remember that the contracts that are being traded are for future oil deliveries. So it is important to think about how this could effect the current price. Think about tickets for a baseball game. If there is high demand for a future game does that cause the price of tonight's game to rise? That could happen if the owner reduced sales of tickets for tonight's game, but why would that happen? You cannot save unused seats!

With oil, of course, you can save it for future use. And that would raise the spot price. But then we would see inventories of oil increase. And as every economist has argued, we have not observed this as oil prices have risen. That is why it is hard to see how oil prices are being driven higher by speculation.

Energy Independence

Robert Higgs has a nice column on the folly of the notion of energy independence. Suppose we substitute bananas for energy:

If we were talking about bananas, everybody would see immediately the foolishness of seeking “banana independence.” Nobody would fall for half-baked arguments about our addiction to foreign bananas or our love affair with banana bread. It’s obviously uneconomic to grow millions of bananas in this country; it could be done, but doing it would entail much greater costs than buying them from producers in places better suited to their production (that is, places where they can be produced at lower opportunity cost).

The argument with regard to oil, or anything else, is identical.

Moreover, even if we produced all our own oil (or bananas) we would also have to erect a wall to prevent exports if we truly wanted to be insulated from what happens elsewhere. Oil is relatively easy to ship, so if prices rise elsewhere they are going to rise here as well unless exports are forbidden.

I think Higgs is wrong, however, when he writes:

The U.S. government may wish to exercise hegemony in the Persian Gulf so that politically well-connected big oil companies can reap a bigger share of the handling income from producing and transporting the Gulf oil (but if these companies didn’t perform these tasks, other companies would do so).

This confuses the source of oil company profits. Big profits arise when world oil prices rise because the companies produce oil as well as buy from OPEC. Hence, they earn rents on the oil that is produced at lower cost than what they must pay OPEC producers. They are the indirect beneficiaries of price increases because they have inventories of the commodity as well. Of course, if OPEC produced at full bore and drove prices down they would lose since most of their low cost oil was produced long ago.