The Future of Oil Prices 2: Option Probabilities

A few days ago I showed a plot of oil futures prices, and Robin made the point that it would be useful to see information about variance as well. For each futures contract there are a set of options which can be used to deduce information about how much uncertainty the market sees in future prices. For example, the commodities price yesterday for December 2010 oil was $67 per barrel. But for $2 you could buy a call option with a strike price of $100. This will have a value of P – $100 if at the end of 2010 the oil price P is higher than $100 (and will have no value if the oil price is lower than $100). Therefore if oil goes up to $105 you will more than double your money; if it hits $122 you will make ten times your investment. Clearly the market does not view these possibilities as very likely, or the option would not be as cheap as $2. Below the fold I will describe and illustrate a simple technique for deriving probability estimates for price targets merely by glancing at tables of option values. I find it useful and practical in terms of getting a quick overview of how likely the market judges various possibilities.

To get more precise information from option prices, there are different methods you can use. One is to apply the Black-Scholes option valuation formula to deduce the market’s expectation for the volatility of the underlying commodity. You can then use this estimated volatility to model the commodity price as a random walk. In this way you can deduce a confidence interval for the market’s expectation of future prices at each time period.

I want to describe a lesser known but simpler approach that lets you read off the market’s confidence intervals almost at a glance. It works like this. Look at a table of option trading prices for a given commodity contract, for example December 2010 crude oil. Consider out-of-the-money options, such as call options for $80, $90 and on up. We want to get a picture of the market’s estimate that oil will exceed each of those prices on that December.

Let x be the option strike price and c(x) be the price of the corresponding call option. Now let us imagine that prices exist for every x value. This is not true in practice; oil option strike prices are typically separated by $1, sometimes only $0.50, in the center of the distribution, but get more widely spaced as we move out. But let us imagine an ideal contract where this is so.

Now consider setting up a trading position where we go long (i.e. we buy) an option contract at strike price x, and simultaneously go short (i.e. we sell) an option contract at price x+dx for some small dx. This will cost us c(x)-c(x+dx) which is a positive amount since c(x) is a decreasing function. The value of this option at expiration is, if the oil price P is greater than x+dx, (P-x) – (P-x-dx) = dx. If P is less than x, the value is zero. And for small dx we can neglect the case where P is between x and dx.

If the market’s estimate of the probability that the price will exceed x is p, then the expected value of the contract is therefore p*dx. And the cost ofthe contract must equal its expected value: c(x)-c(x+dx) = p*dx; divide by dx and we get (c(x)-c(x+dx))/dx = p. For small dx the left side approximates the negative of the derivative of the call option price with respect to the strike price, which we will call c’ (c-prime), producing the final result: -c'(x) = p.

In other words, you can determine the market’s estimate of the chance of exceeding a given price simply by evaluating the derivative of the call option. And since option prices are typically separated by simple values like 1, 5 or 10, this can be often be done by merely subtracting two values, sometimes with a simple shift of the decimal point or a small division. The same process and reasoning applies to put options, and again it is just a matter of subtracting two entries in the table and dividing if necessary by the difference in strike prices.

To show an example, here are some strike prices and values for December 2010 call options as of the close of trading December 26:

  • 70   7.41
  • 75   5.73
  • 80   4.37
  • 85   3.40
  • 90   2.73
  • 100 1.96
  • 110 1.49

To estimate the probability of oil closing above 75 on that date, take the entries for 70 and 80 and subtract: 7.41-4.37 = 3.04. Then divide by 10, the distance between 70 and 80, to get 30.4% as the estimate of this probability. For the probability of oil closing above 80, 5.73-3.40 = 2.43, divided by 10 is 24.3%. For oil closing above 85 it is similarly 16.4%. For oil closing above 100, the example considered at the top of this post, use 90 and 110: 2.73-1.49 = 1.24. And divide by 20 this time, the difference between 90 and 110, to get 6.2%. Those are the odds which market prices imply that traders perceive for oil being above $100 per barrel at the end of 2010.

Here’s a chart where I applied this process to the call options for this December 2010 contract, plotting the approximate derivative (Note that this term usually means something else in finance! This is really the derivative of a “derivative”) against the strike price (taken as the midpoint of the interval in the table). It effectively shows the market’s opinion of the probability of exceeding each price level at that date:
Oil_201012c_20061226
Relating this back to the controversy over Peak Oil, again we see that markets do not appear to foresee a significant chance that we will be experiencing severely high oil prices in the 2010 time frame, such as would be associated with a shortage. Even the chance of hitting 90 or above is only about 10%, and that would not even be an all time high, adjusting for inflation.

For completeness, here is the corresponding chart for put options. This indicates the probability of closing below the specified price at the end of 2010:

Oil_201012p_20061226

A couple of caveats in applying this technique: first, it works best with closing prices, because during the day there is too much variation as trading goes on, and taking the derivative magnifies the noise. And second, the most actively traded long term contracts are for December and, to a lesser extent, June, and those will generally have the most complete set of option prices. I hope you will find this, as I have, to be a practical and useful tool in getting a picture of market probability estimates, which I assume will generally be greatly superior to what I might come up with on my own.

[Update: the probability figures above are about 22% too low. Please see the comments for the corrected formula. Thanks to Perry Metzger for pointing out my error.]

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  • http://profile.typekey.com/robinhanson/ Robin Hanson

    This exercise gives what are called risk-neutral probabilities, as if traders didn’t care about risk. It would be more useful to use some estimates of risk-aversion to translate this into real probabilities.

    Also, I ask again, what does this tell us about how to overcome bias?

  • http://profile.typekey.com/sentience/ Eliezer Yudkowsky

    Robin, wouldn’t non-risk-neutrality on these prices create a market opportunity for anyone who knew about heuristics and biases? Surely there are plenty of traders who know by now?

  • http://profile.typekey.com/halfinney/ Hal Finney

    Robin, it is true that this reasoning, like the Black Scholes formula, assumes risk neutrality. As Eliezer points out, departing from this means the markets are leaving money on the table and allowing traders to take positions with expected profits. Of course in practice traders may refuse those positions if they are too risky. Nevertheless this approach has the advantage of providing concrete and simple estimates of the probabilities. It’s similar to interpreting Idea Futures claim prices as probabilities, a useful rule of thumb which may not be 100% correct. I would welcome postings on how to correct these estimates for bias due to risk.

    As far as the relevance to our topic of overcoming bias, believing market probability estimates appears to me to be a better policy than trying to compensate for one’s own internal biases. Particularly on emotional issues like Peak Oil where there are widespread difference of opinion, it should be helpful to have an outside, objective probability estimate.

  • Perry E. Metzger

    Much better analysis this time, Hal. The options market is indeed the place to try to extract this kind of data. However, you don’t seem to have accounted for the interest rate yield curve in computing your probabilities. (You certainly didn’t mention doing that.) Remember that the cost of money over the N years you are holding the option must be properly accounted for. Assuming I’m right and you didn’t incorporate interest rates, could you do an adjusted version with the yield curve properly incorporated? I suspect the difference will be significant, especially for the far contracts. (In theory, some other costs like the cost of storing oil could also alter the results but it will be harder to model that — the price curve off of the futures market might be used as a proxy in a really perfectionistic analysis.)

    By the way, the sorts of synthetic positions you are discussing here are called straddles, strangles, collars, etc.

    Also, it would be interesting to see a straight readout of the implied volatility, and compare that to the probability curves based on your technique. Assuming that the Black-Scholes model is correct, we would expect that the implied volatility and the region under the peak of the curve to coincide.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Eliezer, the issue is that, all else equal, money is worth more in a scenario where the overall market crashes than in a scenario where it grows big. Relative prices include both relative probabilities, *and* relative marginal value of money. In addition, as Perry points out, prices at different times are different due to interest rates.

    Hal, for most idea futures the value of money doesn’t vary that much between alternative scenarios considered.

  • http://profile.typekey.com/halfinney/ Hal Finney

    Perry, thanks, you’re right that I neglected interest rates. I think the correction would be that the future value of the contract is p*dx, and that should be discounted by exp(r*t) before equating to present day cost. This increases probability p to c’ * exp(rt). For these four-year-out contracts, assuming an interest rate of 5%, that increases my probability estimates by about 22%. Instead of a 6.2% chance of exceeding $100/bbl, it should be 7.6%.

    Robin, that’s true about risk differences in different scenarios; however it will apply to idea futures as well when we use them to evaluate Peak Oil!

  • http://www.sims.berkeley.edu/~hal Hal Varian

    Very neat post. For those who want to follow up on this, the relationship between state prices (aka risk-neutral probabilities) and the derivative of the call option was first derived by Breeden and Litzenberger,
    Prices of State Congingent Claims Implicit in Option Prices, Journal of Business, 1978.

    Here’s another argument for those who like calculus. Let C(k) be the value of a call option with strike price k, let s be possible values of the asset at expiration and let p(s) be the present value of a dollar delivered if the asset is worth s at time of expiration. Then the value of the call option is:

    C(k) = integral from k to infty of [s – k] p(s) ds

    Hence C'(k) = -integral from k to infty of p(s) ds and C”(k) = p(k)

    Hal Finney used the first derivative formula, but I think that the second derivative formula is even neater. The discrete version is
    ([c(k-ds) – c(k)]/ds – [c(k) – c(k+ds)]/ds)/ds
    which can be interpreted as a portfolio of 3 options with strike prices k-ds,k, and k+ds, holding long positions in c(k-ds) and c(k+ds) and 2 short positions in c(k). This is known as a “butterfly spread” — it pays off only if the asset price ends up in the interval (k-ds,k+ds).

  • http://www.sims.berkeley.edu/~hal Hal Varian

    Another useful references is Jackworth and Rubinstein, “Recovering probability distributions from option prices”, Journal of Finance, December 1996.

    Normally getting the risk neutral probabilities (aka “state prices”, “Arrow-Debreu prices”) is enough since these allow you to price any derivative security. You can get actual probabilities if you are willing to specify a particular utility function for the representative investor (e.g., constant relative risk aversion) and the correlation between aggregate consumption and the asset price (oil in this case).

  • Perry E. Metzger

    Hal (Finney, not Varian);

    Given that one is striving for accuracy here, I’d recommend using, for any given term, the current interest rate implied by the treasury bond yield curve, since the risk free rate of return will differ depending on the term. That curve is readily available (and is, as I’ve noted, the source of the peculiar shape of the oil futures curve).

    It would be interesting to see the full implied probability distribution for prices over time, perhaps with a 3D visualization of some sort. I’m guessing that the curve spreads out quite smoothly over time with the market assuming a fairly continuous increase in the price uncertainty as time increases, but it would be cool to see if that is true.

  • http://www.geocities.com/dmathew1 David Mathews

    “Clearly the market does not view these possibilities as very likely, or the option would not be as cheap as $2.”

    Unless the market possesses prophetic powers I would never place too much faith in what it views as either likely or unlikely in 2010. As a general rule, I assume most investors assume that “business-as-usual” (the present state of the market) will continue on forever without interruption or too much variation. For that reason the market assumes that the price of oil in 2010 will remain essentially the same as it is today.

    Does anyone really know what the world is going to look like in 2010? Only God knows, and He stopped speaking to humans a long time ago.

    Now there are several real-world threats to “business-as-usual” in the oil market between now and 2010. The world’s greatest oil patch — the Middle East — is poised to explode into international conflict at a moment’s notice. The United States of America is losing badly in Iraq and it appears very likely that America will have to surrender Baghdad in the same dishonorable manner as it left Saigon. Given these circumstances it is extremely likely that the flow of oil from the Middle East will become interrupted at some point over the next three – five years. If such were to occur the price of oil will undoubtedly skyrocket up to unprecedentedly high levels. $100 oil will look cheap within that environment.

    Another real-world threat to “business-as-usual” is the depletion of the world’s oil resources. Oil is a finite resource which humans are currently burning away at the rate of 85 million barrels a day. The Earth simply cannot support oil production at this rate forever. Oil fields become depleted and new oil fields cannot compensate for the depletion. How expensive must oil become when the Earth’s 6.5 billion humans have only 82 or 78 million barrels of oil to burn away each day?

    Finally, humankind’s insatiable demand for oil cannot help but have an impact upon the price over oil between now and 2010. China and India have acquired the automotive bug and their demand for oil is increasing every day. With more consumers competing for a finite resource the price of oil cannot help but go up. The United States of America will either have to outbid the Chinese and Indians or it will no choice except to make do with less than 25% of the world’s daily oil production.

    So who knows what is going to happen in 2010? The traders don’t know, I don’t know, only God knows. We’ll just have to wait around for several years and witness the future with our own eyes.

    We might live long enough to witness the collapse the United States of America. The Soviet Empire collapsed (suddenly and unexpectedly) so no one should dismiss the possibility of the American empire collapsing suddenly. There are a lot of sorrows awaiting us in the future. More than we can handle. Humankind’s future is a cosmic-scale tragedy. Too bad for humankind because we have brought all of these troubles upon our own species by our own foolish, destructive behaviors.

  • http://www.odograph.com odograph

    Prices for oil, futures, and options, are all good starting points for the question of oil scarcity. It’s fun, but as the above discussion shows, it can only be taken so far. Price in the real world seldom proves future-price, or scarcity. My house-flipper friend can tell you about that.

    FWIW, I think the next thing to consider is “where we go to get our oil.” To me it is an obvious signal that we go to monstrous efforts to haul and boil tar sands, or to develop robot drilling operations for the deepest seas.

    Are we in danger of lapping ourselves, going once around the planet and running out of places to look? Maybe. And maybe “the end of cheap oil” may be true (or at least obvious) before “peak oil” can be seriously measured.

  • http://www.odograph.com odograph

    By the way, I recommend this book, which does not use the words “peak oil” even once, but it does build a good (and in my opinion rational) case for looming scarcity:

    A Thousand Barrels A Second

    http://www.1000barrels.com/

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Since no one else has said it, let me at least mention the sign of the error that risk-aversion produces in these estimates. High oil prices would happen in a situation of lower world wealth, when money has a higher marginal value. Since these prices come from a product of probability and marginal value of money, this means the probability of high oil prices is *lower* than this graph suggests.

  • Perry E. Metzger

    Mr. Mathews writes:

    “Unless the market possesses prophetic powers I would never place too much faith in what it views as either likely or unlikely in 2010. As a general rule, I assume most investors assume that “business-as-usual” (the present state of the market) will continue on forever without interruption or too much variation. For that reason the market assumes that the price of oil in 2010 will remain essentially the same as it is today.”

    I believe that Mr. Mathews has forgotten something rather important. Professional investors who are wrong too often go bankrupt. Those with unreasonable beliefs about the future cease to have money to invest, those with reasonable beliefs about the future continue to have money to invest. It is therefore often the case, in the long run at least, that markets tend to reflect a relatively objective distillation of the currently available information about the future.

    Mr. Mathews also states:

    “We might live long enough to witness the collapse the United States of America. The Soviet Empire collapsed (suddenly and unexpectedly) so no one should dismiss the possibility of the American empire collapsing suddenly. There are a lot of sorrows awaiting us in the future. More than we can handle. Humankind’s future is a cosmic-scale tragedy. Too bad for humankind because we have brought all of these troubles upon our own species by our own foolish, destructive behaviors.”

    Although I certainly agree that the United States will ultimately cease to exist (at latest, when the Sun expands past the current orbit of the Earth), and indeed, might cease to exist quite soon, Mr. Mathews appears to be under the impression that the economic state of the US is as fragile as that of the former Soviet Union. It is not. Although it is fashionable among certain individuals who are ignorant of economic theory to believe that communism is a perfectly viable economic system, the extreme poverty and near complete lack of basic necessities in the former Soviet Union ultimately doomed it. Resources cannot be created by magic, and in the end the Politburo could no longer even afford to pay for military equipment. The United States, by contrast, is in no imminent danger of the populace suddenly getting fed up with the lack of toilet paper or food because we have plenty of such items around.

    As for whether our future holds “cosmic-scale tragedy”, I have some doubts about that as well. Even were the entire human race to wipe itself out next Tuesday, the tragedy is unlikely to be noted even as much as a light year away, let alone at the extreme edges of our Hubble volume. Never the less, I suspect that the human race will not, in fact, off itself any time soon. Perhaps Mr. Mathews forgets the famous bet of Paul Erlich and Julian Simon, but I will remind him that Erlich did not win the bet. I will also point out that the dire predictions by the Club of Rome in the early 1970s have not come to pass either. To borrow a quote Robert Hettinga is fond of using:

    “… however it may deserve respect for its usefulness and antiquity, [predicting the end of the world] has not been found agreeable to experience.” — Edward Gibbon, ‘Decline and Fall of the Roman Empire’

  • Perry E. Metzger

    Odograph;

    As I’ve noted elsewhere, it is entirely necessary that oil pumping activities will peak at some point. After all, there is a limited amount in the ground, so we can’t continue pumping more forever.

    However, your references seem to believe this implies shortages of some sort. Nothing of the kind seems likely. At the point where energy from fossil oil becomes more expensive than energy from other sources, people will cease to use oil for that purpose. This is no more a looming tragedy than the fact that we ran out of natural cryolite deposits — the aluminum industry simply started using substitutes.

    The price of oil can’t go up too much in the very long term, because if it were to rise too far people would cease to use it for energy as it would become uneconomical. We should therefore expect that in the long run, oil prices will not rise without bound because demand is not boundless, and indeed we expect that when substitutes become more economically viable demand for oil would substantially drop.

    For those skeptical about the long term availability of cheap energy, I will point out that the sun pours out far more power every few moments into space than all the fossil fuel burning on our planet has ever generated or ever will generate. The universe is full of available power. Even without leaving our planet, there is enough uranium around that, properly husbanded, we could power a growing civilization far past the likely lifetime of the planet itself, and that is entirely ignoring the 1000W/m^2 of solar energy incident on the planet’s surface. There is no shortage of power in the long run.

  • http://www.odograph.com odograph

    Perry, someone upstream (in the previous entry) recalled the good old days. There was a time when all you had to do was drill a hole in Texas (or not so far from where I type in California).

    I’d say it is a sort of shortage, already, when those convenient land based opportunities move further and further away. I mean look at where ANWR sits! It is the most remote land based opportunity we have in the United States. And we discuss how soon to tap it … leaving us with?

    “A Thousand Barrels A Second” talks about supply chains, and the huge global effort that has been on-going (esp. since WWII) to keep them filled.

    Do you know what will fill them?

    Are you making a fact based and bias-free argument about where the energy will come from?

    FWIW, I think it ain’t over. I’m not joining what the peak oilers call either the “cornucopian” or the “doomer” camp. I just think there are interesting questions … questions that “blithe optimists” pass over just as quickly as “irrational pessimists.”

  • http://www.odograph.com odograph

    BTW, if we could run on “cheap solar” we would now. We wouldn’t have the “big if” of ultimate solar cell cost and efficiency hanging over our heads.

  • http://www.geocities.com/dmathew1 David Mathews

    Hello Mr. Metzger,

    You are correct in saying, “Professional investors who are wrong too often go bankrupt”. I suspect that if these same professional investors bet too much upon oil remaining cheap (circa $60 a barrel) in 2010 they will go bankrupt. But the financial troubles of failed investors is not my primary concern. Anyone who wants to bet that oil is going to remain less than $70 a barrel in 2010 can do so.

    Mr. Finney should perform this same sort of analysis on the path behavior of oil verses the oil futures probability distrubution regarding prices over the same period. For example, in 1999 what did the oil traders expect the price of oil to reach in 2003? In 2002 what did the traders predict the price of oil would reach in 2006?

    If the oil traders were correct in their future expectations in the past then I might take some comfort in their expectations regarding 2010.

    Mr. Metzger is in partial agreement with me about the future of the U.S. of A.: “I certainly agree that the United States will ultimately cease to exist (at latest, when the Sun expands past the current orbit of the Earth) …” Maybe engaging in a bit of hyperbole right there, though, because the United States of America certainly won’t exist for billions of years. Or millions of years. Or thousands of years. Or centuries. The U.S. of A. is a dying country. That much is certain but like any other terminally ill patient death need not occur immediately.

    Mr. Metzger has confidence in America as opposed to failed communism: “Resources cannot be created by magic, and in the end the Politburo could no longer even afford to pay for military equipment. The United States, by contrast, is in no imminent danger of the populace suddenly getting fed up with the lack of toilet paper or food because we have plenty of such items around.”

    Resources cannot be created by magic. Here is a very important point and in fact more important than any sort of argument about the timing of America’s collapse. The United States of America is in danger of resource deprivation in the form of oil and natural gas shortages and no amount of money or political rhetoric will make these resources materialize once they are either exhausted or unavailable to the American consumer. I wonder how quickly the American public will become fed up with a lack of gasoline at the gas station and a lack of natural gas to heat homes during winter and a lack of electricity because mining coal becomes prohibitively expensive once oil & natural gas become scarce?

    In other words: Those who bet that oil & natural gas will remain plentiful, cheap and available to the American consumer forever might discover that their bet bankrupts the country and leads to an economic collapse more horrendous than the Great Depression. Are you willing to make this sort of bet with the futures of 300 million Americans?

    I think it wisest and most humane to hedge against that bet by encouraging Americans to abandon the gluttonous hyperconsumer lifestyle now while it still remains a voluntary option. Americans ought to give up their SUVs and materialistic obsessions now. By doing so Americans will save some resources for essential future needs rather than consume them on frivolous present-day wants and waste.

    Mr. Metzger is correct in saying, “Never the less, I suspect that the human race will not, in fact, off itself any time soon”. Of course, “soon” is a relativistic term based upon the context. If “soon” is placed within the context of 2006 – 2010, I am certainly in agreement. And if “soon” is placed within the context of the next ten thousand years, I am in uncertain agreement. But when placed within the context of geological time — the Earth is 4.5 billion years old, remember — it is an absolute and inevitable and inescapable certainty that Homo sapiens will go extinct from the Earth and leave only fossils and a brief episode of pollution to testify of our existence in the Universe.

    I also agree that the extinction of Homo sapiens won’t be noticed by the cosmos or the sun or the Earth or even by Nature itself. Homo sapiens are not vital in any sense. We exist for a moment and then are gone forever and soon enough the Earth forget that we ever existed. That’s why it is vitally important for humankind to cease all of the self-destructive activities which serve to accelerate humankind’s extinction. An objective observer looking upon the Earth would probably conclude that Homo sapiens are a uniquely suicidal species by virtue of our pollution of the Earth, degradation of the environment, depletion of the Earth’s resources, and devotion to violence and warfare.

    Homo sapiens are an endangered species in spite of all appearances to the contrary. The species has already entered its terminal phase. The path to extinction is slow and extremely painful. You should thank God that you were born here and now because over the next several centuries the entire Earth is going to become a hellish place. The climate will change and technology will fail and humans will have no choice except to face the harshness of Nature without any of the protections that we take for granted.

  • http://profile.typekey.com/sentience/ Eliezer Yudkowsky

    Dear David: this is not an ordinary blog where talk is cheap. If you aren’t taking advantage of this huge market opportunity to buy those incredibly underpriced options for $100 oil in 2010, don’t expect anyone here to pay attention.

  • http://www.geocities.com/dmathew1 David Mathews

    Hello Mr. Yudkowsky:

    I do not have any desire to invest in the oil market or profit in any sense from the massive suffering which must result from the coming oil catastrophe. 150,000 people (Iraqi civilians) and 3,000 American soldiers have already died on behalf of oil, how then can I obsess over money or income or wealth or possessions?

    Don’t you understand that when oil costs over $100 a barrel and the United States of America collapses money won’t mean much? We are speaking here about a catastrophe which could very easily kill thousands or millions of people. Should I (or anyone else) seek to profit from massive human suffering?

    You people are placing a bet on the future of 300 million Americans when you assume that oil will remain abundant & cheap forever. Don’t you understand this is a matter which transcends greedy personal financial concerns?

    If you have children, aren’t you concerned about what sort of world they are going to live in twenty years from now? If your children have children, aren’t you concerned about what sort of world they will inherit fifty years from now?

    You people are placing a bet on the lives of your own children and grandchildren. If your bet fails they will suffer in a terrible manner. We are here dealing with life and death, not profits and losses.

  • http://www.geocities.com/dmathew1 David Mathews

    Dear Mr. Metzger:

    I note in your reply to odograph you claim:

    “For those skeptical about the long term availability of cheap energy, I will point out that the sun pours out far more power every few moments into space than all the fossil fuel burning on our planet has ever generated or ever will generate. The universe is full of available power. Even without leaving our planet, there is enough uranium around that, properly husbanded, we could power a growing civilization far past the likely lifetime of the planet itself, and that is entirely ignoring the 1000W/m^2 of solar energy incident on the planet’s surface. There is no shortage of power in the long run.”

    It appears that you are here engaging in a context fallacy. You must assume that just because energy is cheap in America that means that it is cheap everywhere. I regret to inform you that America and the prosperous West constitute a minority of the world’s population. There are 6.5 billion humans on the planet and a large number of these people are impoverished, deprived, and lacking even the most basic necessities of life.

    For example, the United States of America (a country of 300 million) consumes 25% of the world’s daily oil production. This is possibly only because billions of humans are deprived of oil altogether.

    If the Muslims consumed oil at the same gluttonous pace as the American consumer they would have no oil left over to export. If Mexico, Nigeria and Venezuela consumed oil at the same gluttonous rate as the American hyperconsumer these countries would have no oil to export to America.

    In other words: Cheap, abundant energy is not available to humankind. Cheap, abundant energy is a luxury which is available only the wealthy & fortunate.

    The world — that is, the 6.5 billion Homo sapiens of the Earth — is desperately in need of cheap energy right now. Billions of humans are suffering right now. Millions of people are dying needlessly because of a lack of the basic necessities of life.

    Shall we allow these people to continue to die while the West continues to party like there is no tomorrow?

    There is a fundamental injustice in the behavior of the West. Not only is the West unjust to the impoverished resource-rich nations of the world but it is also unjust towards its own children. When these resources are depleted life on the Earth is going to become very difficult for everyone.

    By encouraging Americans to consume ever-increasing quantities of oil what you are doing essentially is killing future generations of Americans. Don’t you understand that trade and commerce and most American jobs will evaporate once the oil becomes depleted and the gas stations run out of gasoline?

    I am talking here not about today or tomorrow but about the fast-approaching future several decades from now. I am talking about an event that we all might witness with our own eyes.

    You are making a pretty big bet here. If you win the bet life will continue along pretty much as-normal but if you lose death might result. America could easily become as poor as Mexico or Nigeria should our country exhaust its oil supplies and lose its oil imports. Do you know what could happen in a nation of 300 – 400 million people when the oil runs dry?

    We are speaking here about horrors which are too terrible to contemplate, not profits and losses.

  • http://profile.typekey.com/sentience/ Eliezer Yudkowsky

    I suggest that the good David Matthews be banned from this blog and his comments deleted. He does not appear to understand what this blog is about.

  • http://www.odograph.com odograph

    For what it’s worth, I think Perry and David provide a little drama of the biases involved in simple optimist/pessimist divides on energy.

    I wouldn’t want to ban either one of them. They both name plausible futures based on their world-views (though I think David peppers a few more current-facts).

    If we are serious, we have to think about where the biases creep in to extend the facts (or when biases are offered simply in place of facts!).

  • http://www.geocities.com/dmathew1 David Mathews

    Hello Odograph,

    The current-facts are: “Five million African children under age 5 died last year — 40 percent of deaths worldwide — and malnutrition was a major contributor to half of those deaths. Sub-Saharan children under 5 died not only at 22 times the rate of children in wealthy nations, but also at twice the rate for the entire developing world.”
    (http://www.nytimes.com/2006/12/28/world/africa/28malnutrition.html)

    How much oil do you suppose that these starving Africans consume? How much oil do they export? To what extent is the Western, prosperous, cheap & abundant energy lifestyle made possible by their suffering?

    There is a bias here which is related to assuming that Western people and Western economies are all that matters. In a world of 6.5 billion people the only valid context is global. From a global perspective Homo sapiens are not doing well. The species is transforming the Earth into a sewer and depleting the Earth’s resources at an ever-increasing and ever-accelerating pace. The present generation’s greed & gluttony are destroying the basic necessities of life vital to the future survival of future generations. By living large on the Earth the present generation is killing future generations of humans.

    But in this case, death & suffering are not merely speculative future outcomes of present behaviors. Millions of people are dying right now, right under our nose, while the DOW is rising and oil is hovering in the low $60s and the price of gasoline is $2.29 a gallon. Oil is cheap but blood is free.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    David is not (yet) banned, but I did delete his last very long comment. Posting a series of very long comments abuses the open comments feature of this web forum. David, and everyone, please keep your comments short and on topic.

  • http://www.odograph.com odograph

    David, I agree with you on the facts that many in our world find energy to be cruelly expensive, and I think you are onto something when you suggest that living in a cheap-energy economy might lead to a bias.

    But what is the question at hand? Is it how soon oil will peak in world industrial production?

    If we define oil (not a simple problem, when things like tar sands and sometimes coal are reformed into oil), we can look at that.

    If we look at energy costs and futures in industrial (or marginalized) nations, we can define those questions as well.

    (Note to Robin, I think the discussion would have been much more shallow without David’s comments. He’s right, that a superficial look at prices, and price expectations in the privileged west, are not going to give us an unbiased view.)

  • http://www.geocities.com/dmathew1 David Mathews

    Hello Robin,

    Do you engage in censorship based upon the length of the post or because you simply don’t want to hear the message? Generally speaking, people censor messages that they don’t want to hear. I believe that is the only reason why you removed my post.

    If I am lying, say that I am lying. But don’t engage in censorship and then justify your act by claiming that a post was “too long”. We are here dealing with a serious subject matter which does not resolve itself in a few sentences or paragraphs.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    David I said I deleted your comment because it was too long, in a rapid sequence of too long posts, and that is what I meant. If you cannot explain yourself in a short comment, then make a long web page somewhere else and link to that in your comment.

  • http://www.odograph.com odograph

    Shorter:

    The only bias-free answer on “peak oil” or “the future of oil prices” is to say you don’t know. The only way to begin a definite answer is to layer assumptions – assumptions about the future strength of your nation’s economy, assumptions about future fossil fuel discoveries, assumptions about future technologies, assumptions about future patterns of consumption, assumptions about future international relations, assumptions about global warming and global warming responses, and on and on.

    And:

    The converse of “peak oil cannot be proven” is not “cheap energy is therefore guaranteed.”

    Energy prices become an unknown, in which current trend provide clues, but not a “final answer.”

  • http://www.geocities.com/dmathew1 David Mathews

    Hello Robin,

    I cannot possibly engage in any sort of reasoned discussion with people who practice censorship. You compromise your intellectual honesty by engaging in censorship and removing posts which contain messages contrary to your own viewpoint.

    Certainly you cannot help but win an argument when you prevent the expression of all contrary viewpoints. So I abandon the argument to the censor.

  • http://www.odograph.com odograph

    I found this blog, as it was forming, after being steeped for a couple years in the “peak oil” stew. It came at a perfect time for me, as I moved past what I felt were the limited clues to our energy situation, and came to examine how so many people could form hard and fast expectations.

    “Doomers” or people who believed in imminent catastrophe were my usual foil (I enjoyed directing them to your post on Time on Risk), but they were by no means the only people working from their gut. We all do. (Am I right in thinking a “status quo bias” is broadly measured in human populations?)

    I think this is a prefect petri dish for questions of bias and expectations.

    I hope you’ll continue, though perhaps the question is too broad to be easily digested in short pithy posts.

  • Perry E. Metzger

    I’ll ignore Mr. Mathews’ recent comments, but I will briefly comment on one from Odograph, who said:

    “BTW, if we could run on “cheap solar” we would now.”

    I am sorry to say that that seems a rather strange comment. Imagine if, in 1930, someone had ridiculed Penicilin, saying “well, if it could be manufactured in bulk, we would do that now”, or if someone had ridiculed the idea of mass production of computers in 1950, saying “if we could do that, we would do it now”, or if someone had said, in 1985, “if it were possible to connect people’s homes to the internet, we would do it now.”

    Well, the simple answer to “why hasn’t it been done already” is that we are in the middle of developing the technology needed. Right now, we’re producing something like ten thousand metric tons of monocrystaline Si wafers per year by the Czochralski process. (It might be up to twenty thousand metric tons, don’t hold me to the figure.) We need to scale that up to a few million metric tons per year to satisfy even replacement needs were we to get a substantial fraction of our power from solar, and I’d say ten million metric tons a year is a reasonable goal in the near term. Such an increase in scale would also produce a dramatic reduction in price. Is such a scale-up realistic? Quite realistic — in fact, such a scale up and price reduction happened a century ago with aluminum, which is now produced on the order of tens of millions of metric tons per year. Do we have to worry about shortages of Si itself? No, because silicon is just about the most common element in the earth’s crust. Is this scale up happening right now? Indeed, so far as I can tell, it is, but it will take a decade or more complete, as you would expect when we are talking about a factor of 1000 scale up in production. We’ll similarly need to scale up production of low Fe glass for facing the solar panels, scale up the production of frames to put the panels in, figure out automated ways of doing the packaging, automated or low-labor ways of cleaning panels in order to keep power output up in spite of dust, etc. Lots of practical work has to be done, much as happened a century and a half to a century ago when the oil industry was in its infancy.

    Some claim the price of photovoltaic solar will never be competitive, but I think that is because they haven’t studied the matter. PV cells have already fallen a factor of a few hundred over three decades. Another half order of magnitude fall in price is all that is really needed, and I can easily see the price falling an order of magnitude in a decade.

    So, Odograph’s comment as to “if it straightforward to use solar, why aren’t we doing it already” is easily answered — for the same reason we didn’t use antibiotics in 1930 even though we knew about Penicilin already, and for the same reason we didn’t have home computers in 1950, and for the same reason most people weren’t using the Internet in 1985. The basic knowledge is already in place, but the technology is not yet mature. Give it a little time, though, and a bit of investment, and that problem will fix itself.

  • http://www.odograph.com odograph

    BTW, my take after reading Nassim Taleb’s Fooled by Randomness was that most people overestimate the predictability of markets, and misuse measures of past volatility as stronger indicators of future performance than they may in fact be. Black Scholes is an excellent formula, but it ain’t going to spot a student revolution in Iran (run it again with pre-1979 data, and it won’t).

    Is Black Scholes “good enough” to anticipate the rate of future oil discovery? I’d think that hinges on how good we think market players are at anticipatin the rate of future oil discovery, correcting for their status quo bias, etc.

  • http://www.odograph.com odograph

    Hi Perry, I missed your last post while writing mine.

    Wouldn’t my friend Taleb suggest that you are drafting a history with “hindsight bias”?

    We can easily count the things we have, we miscount the things we missed (flying cars?), and … how the heck to we translate that into things we wish for?

    How do we know cheap energy is Penicilin and not a flying car?

  • Perry E. Metzger

    Flying cars were never a practical idea given the materials and fuels available without “strong” molecular manufacturing. If you study the problem extensively, you quickly conclude that they are not a practical proposition. (I am referring here only to things that are approximately the same size as current cars and that are expected to have operating costs reasonably close to that of current cars — clearly things like helicopters are practical, but they meet neither criterion.)

    However, if you study the photovoltaics problem extensively, you come to the conclusion that the only real problem is getting the manufacturing cost down, and there are obvious ways to do that even without major technological breakthroughs. Indeed, the PV industry has a long history of reducing manufacturing costs — it has dropped orders of magnitude in thirty years. The transition from specialty product to very large scale mass produced product can only reduce costs further.

    Clearly, though, the only way to convince yourself of this would be to study the matter for yourself. You should not take my word for it.

  • http://www.odograph.com odograph

    Actually, I’ve looked at this for a couple years, and even joined the American Solar Society to support them in my small way.

    If we look at the trends for solar technology in $/w we see an unfortunate decline in the rate of advancement:

    http://www.solarbuzz.com/Moduleprices.htm

    and

    http://www.solarbuzz.com/StatsCosts.htm

    We fell rapidly in $/W in the first decade of solar research/application, but have been at a $5/W plateau for some time now.

    How do you make a bias-free argument that we will break through that plateau?

    I think it is possible, but it is a “counting chickens before they are hatched” problem. Optimists want us to count all eggs as chickens. Pessimists want us to count no eggs as chickens.

    I think rational observers have to wait …

  • Perry E. Metzger

    Actually, manufacturing costs have been continuing to drop. However, demand currently is growing faster than supply, and there is a substantial shortage of monocrystaline Si out there, so retail prices have been steady or even going up while manufacturing costs go down. Having seen such things happen in the semiconductor industry, I’m reasonably confident the situation cannot continue — more production capacity will come on line because a profit is to be made in doing so, and ultimately that increased production capacity will lower retail costs as well.

  • http://www.odograph.com odograph

    Here is a graph that shows the plateau much more clearly:

    http://www.eia.doe.gov/cneaf/solar.renewables/rea_issues/fig1s.html

    from:

    http://www.eia.doe.gov/cneaf/solar.renewables/rea_issues/solar.html

    Really Perry, if you want to make an assurance that “costs” are lower … how do you do that?

  • Perry E. Metzger

    SunPower and other public companies in the solar cell business release reports to their investors. Said reports detail things like their manufacturing capacities and costs. The only thing that hasn’t gone down of late is the price of monocrystaline Si, and that is because, as I’ve noted, there has been less capacity than demand of late. There are relatively few specialty firms making wafers these days, and their main customers used to be the semi industry, not the PV industry. Now, of course, that is changing fast.

    A bunch of new plants are being constructed, and I’m expecting that there will be more capacity on line soon, and that said capacity will continue to grow steadily for many, many years. Will this lower retail prices much? Probably not. As I’ve said, we are on a long curve from tens of thousands of tons per year to tens of millions of tons per year, and it will be some time before manufacturing capacity gets large enough to drive down retail prices.

    Some time in ten to twenty years, though, I expect solar cells to become an “overnight success”, just as the Arpanet/Internet had almost 25 years of steady exponential growth before suddenly, overnight, “it appeared out of nowhere”. (It is remarkable how many “overnight successes” start with decades of hard work…)

  • http://www.odograph.com odograph

    I hope that is true Perry, but the technological parallels you allude to did not hit their own plateaus in 1987, as solar cells did.

    I think we are core on topic here with bias and expectations. I hope the blog owners are following and will take this further with their special expertise.

    You are making assurances to me about a future. You are drawing parallels from other technologies that have marched on. There are also, unfortunately many examples of technologies which have not. Are you familiar with the data that (a) the Ford Model A got “between 20 and 30 mpg (US)” in 1927, and (b) that the US “Total fleet fuel economy peaked in 1987 at 26.2 mpg.”

    It is easy for someone coming from the information processing field to think that energy will be “like” megahertz or megaflops … but is that a rational connection or is that bias?

    Or is it perhaps more insidiously a sticky combination of rational projection and bias at the same time?

    References:

    http://www.answers.com/topic/ford-model-a-1927

    http://uspolitics.about.com/od/energy/i/cafe_standards.htm

  • http://www.odograph.com odograph

    BTW, I think the future will hold many wonderful inventions and advancements.

    Unfortunately I think it is a logical fallacy to take that general idea and translate into a specific guarantee – that one of those wonderful inventions and advancements will bring a cheap replacement for declining oil production.

    It may be true, or false, and it cannot be predicted.

  • http://profile.typekey.com/halfinney/ Hal Finney

    I agree with Odograph that Peak Oil makes a good test case for techniques for getting at the truth. It’s an area with widespread disagreement, emotional biases, and potentially great importance as the apocalyptic scenarios suggest. Yet we have considerable information that can be brought to bear. Oil geography has been intensively studied for decades. Likewise resource economics. So we have substantial academic resources which are relevant to the problem. Market information is also plentiful and relevant, as I have tried to suggest in my last two postings. In addition it is possible for the layman to study these issues for himself and to try to weigh the evidence on each side in order to determine the truth of the matter.

    I am trying to approach this issue here both at the meta level and at the substantive level. The meta question is, how do we learn the truth in controversies? The substantial question is, what is the truth of Peak Oil theory? The goal is to discuss meta issues and illustrate them by applying them to the Peak Oil question. I have started by discussing market information and showing that financial markets are not behaving as if they expect serious oil shortages in the next few years. This does not prove that Peak Oil is false, because markets are frequently wrong. But it does show what is in the minds of market participants: it reflects the “wisdom of crowds”. As I have argued in earlier posts, there is evidence that using this kind of information is likely to be superior to trying to determine the truth on your own by studying the facts of the matter.

    I may not have met the burden of establishing that this is an issue worth paying attention to: of setting out a prima facie case that Peak Oil may indeed be real and may have serious negative impact on our lives in the next few years. For those who have not looked into it closely, Peak Oil may seem a no more serious threat than the Christian Rapture, asteroid impacts, or other low-probability events. Perhaps I should post a message laying out the case for Peak Oil in order to justify it as a good test case for the issues we discuss here.

  • Perry E. Metzger

    Just a quick point, Hal. The theory that we have or will hit a peak in oil production does not in any way imply that we will hit shortages or a dramatic rise in price. The latter is only implied if no substitutes are found for the good. I agree that the market is behaving as though there may be further increases in energy prices but not (or at least not with high probability) dramatic increases. This could simply be a belief that substitutes for fossil fuel energy sources will be found, rather than faith that fossil fuel production will continue forever.

    I’ve seen far too few people discussing the fact that Peak Oil might be true but have no obvious bad effects on society.

  • http://www.geocities.com/dmathew1 David Mathews

    Hello Mr. Metzger:

    > “I’ve seen far too few people discussing the fact that Peak Oil might be true but have no obvious bad effects on society.”

    The Council of Foreign Relations has an entirely different opinion about this matter. But what do they know?

    I’ll trust you if you say everything is going to be ok. Certainly the Market would never allow Americans to suffer.

  • Perry E. Metzger

    David Mathews asks, “The Council of Foreign Relations has an entirely different opinion about this matter. But what do they know?”

    Generally speaking, I avoid reasoning on the basis of authority. I think the reasonable man examines arguments, not who is making said arguments. I could bandy about the names of all sorts of people, some of them with Nobel prizes, who agree with my position, but that is not a reason to believe my arguments any more than mentioning the CFR is a reason to believe your arguments.

    I will, however, mention that if we had irrefutable proof that all the oil and coal would vanish within a decade, we could pretty much preserve our current society without any real loss in standard of living by building nuclear plants starting now. (Nuclear power costs under 3 cents per kilowatt hour, less than almost any other source of energy we have today.) It would require a serious commitment to accepting things like waste vitrification and storage, and accepting fuel reprocessing and the use of plutonium in civilian reactors, but we could do it, and if we did, we would not all suddenly start starving. Given that we already have technologies capable of replacing oil, and that I have yet to see any really persuasive arguments to the contrary, I must say that I don’t find your claims that the human race is doomed in the near term terribly credible.

    If I might stray a bit, such beliefs often seem to me to have the same flavor as militant christian faith. The central message is “The human race is sinful and thus will be punished”, but instead of being judged by God it is to be judged by Mother Gaia, which doesn’t seem (to me at least) to be much more than a relabeling. As a rationalist, I find it difficult to understand why others find such spiritual and quasi-spiritual belief systems comforting, especially when they predict (over and over) that the world must end because people are so bad, but I must accept the obvious fact that such beliefs do indeed appear to have an appeal to many people, and that they certainly are a strong influence in the political process, for good or ill.

    Anyway, Mr. Mathews, straying perhaps even further, may I note that knee-jerk attacks on market mechanisms aren’t much more likely to give you credibility than knee-jerk attacks on evolutionary theory, the germ theory of disease, etc.? Although markets are certainly not benevolent mechanisms (they are in fact utterly indifferent to our fate, since they lack consciousness), their characteristics are reasonably well understood at this point by lots of people who have spent lots of time examining them in great detail. Thus economists (like Dr. Hanson and others here) generally have reason to believe that they can make reasonable predictions about their behavior, and past experience has tended to confirm that this belief is reasonable. You would do better to try to make compact, reasoned arguments than to simply make it sound as though you had a personal bias against economists.

  • http://www.geocities.com/dmathew1 David Mathews

    Dear Mr. Metzger:

    Well, the CFR is not just any organization worthy of name-dropping for authority. But if you insist that they are mistaken in their fears, I’ll have to argree with you. Economists are different from everyone else because they are experts in every field. The laws of science cannot compete with the laws of economics.

    As to the question of nuclear power’s ability to save our economy and our God-given right to economic growth, I hate to tell you but the CFR is aware of this theory and it is skeptical. Scientists of various sorts are also skeptical of nuclear power’s ability to solve the West’s energy problems. Environmentalists have their objections to nuclear power, too, but economists and environmentalists seldom get along well enough to communicate reasonably with each other.

    As to humankind’s ultimate and inevitable fate — that is, humankind’s extinction — we need not argue about that subject because it is already settled. There is a historical record of life on this planet which confirms that extinction is the fate of all species. Humans are not exempt. Those who argue against humankind’s extinction might as well argue against death.

    The time scale involved in humankind going extinct is a subject worthy of debate but as it involved future events it is by necessity speculative. I can only tell you my opinion about this matter: Homo sapiens won’t persist for a geologically significant period of time. Homo sapiens will likely go extinct within one hundred thousand years. But who really knows what will happen tomorrow?

    I do not say that Homo sapiens must go extinct because humans are bad. No, not at all. I am saying that Homo sapiens must go extinct because the species is an animal and must suffer the same fate as all other animals. Humankind is not exempt from the laws of biology. Nor can the laws of economics defeat the laws of biology, either.

    You make a request: “You would do better to try to make compact, reasoned arguments than to simply make it sound as though you had a personal bias against economists.” Why would I lie to you? I do have a personal bias against economists. As far as I can tell, economists are utterly and absolutely ignorant about the physical realities which govern and limit human activity upon the Earth. Economists are also so focused upon money that they entirely lose sight of the human element, i.e. there are 6.5 billion humans on the Earth and more than a billion of these are suffering horrendously.

    As far as I can tell, economists speaking about the future are about as reliable as psychics but far more expensive.

  • http://www.odograph.com odograph

    Hal (Finney), regarding your 03:37 PM comment. Sound great and I’ll look forward to it all. For what it’s worth, I do think “markets” have some of the best guesses about the future … but sometimes “best” doesn’t mean likely. There might even be an extra tension here when we are looking for a break from the status quo. That might (?) be the kind of thing which it is hardest for markets to predict.

    Perry, I agree almost completely with your 04:08 PM comment ;-). For what it’s worth, I think the degree of “badness” that comes with peak oil depends on a single number … but it is a number that nobody knows. That is the rate of production decline post-peak. This is usually represented as a year-over-year percentage, but might vary over time.

    To get ahead of myself, I think low percentages (a point or two?) might be mild and lead me to a worldview much like your own. I’m more concerned with steep (high single digit?) declines year after year. They will lead to a scramble. But … we can leave that for later.

    It is hard enough to discuss if-peak, before engaging the near-impossible (IMO) what-decline.

  • http://www.odograph.com odograph

    BTW, my current answer to “overcoming bias” in this is not to take my own projections too seriously. Everything in my 9:35 PM comment that looked like a prediction might be wrong. It is my “best guess” but it was made with “low confidence.”

  • Jon

    Fascinating thread….esp from my viewpoint as a commerical hedger….

    One small item – there seems to be some confusion as to what “prices are telling us” – simply this: probabilities given what we know NOW. As information changes constantly, the aggregate knowledge – or price – changes constantly. Thus, the disconnect between current futures price – and ultimate price in the future.

    And Odo – good to see you again. JDH would like this thread.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Hal, it would be well worth doing this analysis more carefully, and then publishing it. Imagine a web page which always showed the current estimates, let you browse through previous estimates, and let you vary a risk-aversion parameter to see how the predictions depend on that.

  • http://profile.typepad.com/robinhanson Robin Hanson

    MrM, even risk-averse traders will want normalized probabilities, so if they assign higher probabilities to some events, they must assign lower probabilities to other events.

  • ChrisA

    This is more of a question really. I am assuming that the natural sellers of long term horizon options are oil producers (i.e. those long in oil) who are looking to hedge their long position. But who would be the buyers? Most day to day buyers of oil are intermediaries, (oil refiners, chemical companies, airlines) who can expect (in the long term) that they will be able to pass on any high prices to their ultimate customers in a high price environment. So the ones who should be hedging their short position are the customers, generally individuals like you and me. But individuals are much less sophisticated and heterogeneous than the sellers of options. The risk to any one person is also small compared with the concentrated risk faced by the sellers. Could this all work to artificially lower the option prices?

  • http://profile.typepad.com/halfinney Hal Finney

    ChrisA, I think there are some large buyers who hedge. I read last year that Southwest Airlines had benefited from oil purchase hedging contracts it had entered into several years earlier when oil was much cheaper. Of course SWA does not actually buy oil, they buy jet fuel, but the prices tend to move together, so they had basically locked in year 2001 prices up through 2005 or so. The commentary was that this had helped the airline with its competitive position in the past but that it was losing that advantage now as the contracts were expiring, and that it was far from clear that setting up new such hedges with today’s historically high prices would be a good idea.

    Here’s a great article which discusses the oil trading market, from the Bank of England:
    http://www.bankofengland.co.uk/publications/quarterlybulletin/qb060105.pdf

    They explain that oil companies tend not to sell oil via long term commodities contracts, because that would insulate them from the vagaries of price changes, but their investors are intentionally exposing themselves to such swings and want oil stocks to reflect oil prices. They also say that government oil ministries face similarly counterintuitive motivations: if they hedge their oil sales and the price rises, they lose the excess profits and look bad; while if the price falls, they’ve saved the government money, but in fact it would have been OK if they had lost money in that situation because everyone else was losing too. Basically the reward for doing well is less than the punishment for doing poorly, so they don’t hedge much. Most hedging is apparently off the markets and is done in private over the counter deals, customized for each pair of buyers and sellers. Some of these contracts can extend even further than the six years of the public markets.

  • ChrisA

    Thanks Hal

    The BOE report is a very good summary. It confirms my suspicion that most institutions are betting on the oil price by using oil company shares, so the fact that oil company shares are at a discount to the market in general suggests that the weight of market participants are not expecting higher prices.

    As you said the report says that oil ministries and large oil companies tend not to hedge (supposedly at the request of their shareholders). I can see why agents don’t like to hedge, the upside goes to the owner, but the agent shares in the downside. Could this structure be bringing some distortion to the market though? The agents are the ones that know about the supply part of the picture best. (How many hedge funds can analyse seismic logs?). So the agents might assign quite a large probability to the possibility of high prices as a result of this knowledge, but, since they gain no advantage if they are right but take a considerable part of the downside, the evidence has to be very strong in order for them to act by withholding oil from the market place to sell at the probable future high prices.

  • http://profile.typepad.com/jckommer jck

    Talking about the BOE,they have been using pdfs,implied by prices of traded options,for awhile.Two papers of interest below:
    Using option prices to measure financial market views about balances of risk to future asset prices
    http://www.bankofengland.co.uk/publications/quarterlybulletin/qb040403.pdf
    Recent developments in extracting information from options markets
    http://www.bankofengland.co.uk/publications/quarterlybulletin/qb000101.pdf

  • http://profile.typepad.com/jhertzli Joseph Hertzlinger

    As far as I can tell, economists are utterly and absolutely ignorant about the physical realities which govern and limit human activity upon the Earth.

    Okay. What are those limits?

  • http://www.geocities.com/dmathew1 David Mathews

    Hello Mr. Hertzlinger:

    The Earth is finite, hence all of its resources are finite.

  • MrM

    Robin Hanson: Yes, of course, sometimes “real” (=risk-averse) probabilities are higher than risk-neutral ones, and sometimes they are lower (e.g., credit default probabilities implied by CDS). In the case of call options I’d think that real probs are higher

  • http://profile.typepad.com/jhertzli Joseph Hertzlinger

    Didn’t economics start out by analyzing the collision between finite resources and infinite wants?

    As others have mentioned, economists take finite resources into account via commodities prices. The fact that such prices have not been rising as much as you think they should just might reflect that other people think they are more abundant than you do.

    As for how abundant resources are: Resources, in the sense they are finite, consist of atoms and energy. We don’t use up most types of atoms at all and, at any given time, use only a minute fraction of the Earth. Similarly, we use only a minute fraction of the solar energy hitting the Earth.

    There’s also the rest of the Universe…

    BTW, have you taken a survey of economists that shows them to be ignorant of the size of the Earth?

  • http://www.geocities.com/dmathew1 David Mathews

    Hello Mr. Hertzlinger:

    > “Resources, in the sense they are finite, consist of atoms and energy. We don’t use up most types of atoms at all and, at any given time, use only a minute fraction of the Earth. Similarly, we use only a minute fraction of the solar energy hitting the Earth.

    > “There’s also the rest of the Universe…”

    If you are building economic forecasts based upon the fantasy that the rest of the Universe is available for human consumption no wonder why they are so substantially wrong. Humans have the Earth, and only the Earth, and only temporarily.

    Secondarily: It is true that humans have only used “only a minute fraction of the Earth”. The minute fraction that we have used, however, is the only part of the Earth which is available for human consumption. By way of analogy: If you happen to find yourself on a liferaft in the middle of the ocean with a bottle of water it is altogether true that by consuming that bottle you have only used a minute fraction of the water in your environment. You’ll still die from dehydration in spite of the millions of gallons of (sea)water which surrounds you.

    Finally, about the solar energy hitting the Earth: Yes, humans only use a small fraction of this power. Do economists take it on faith that in the future humans will possess the ability to utilize more solar power because humans will absolutely need that power to survive? I’ve got bad news for you: Plenty of humans have died waiting desperately for some new technology to solve their problem(s). In the future, plenty of humans will die because these promised desperately-needed technologies will fail to materialize.

    > “The fact that such prices have not been rising as much as you think they should just might reflect that other people think they are more abundant than you do.”

    Prices reflect a subjective opinion regarding a resource’s abundance within the short-term timeframe which is meaningful to the market. Abundance leads to scarcity when billions of humans consume the resource as quickly as technology and gluttony allows. When scarcity appears future generations will have no choice except to live and die without.

    Oil is cheap only because future generations won’t have any oil to consume. The present generation is stealing from the future on behalf of ego, horsepower, technology, luxury, convenience and obesity. Do you care about the future, Mr. Hertzlinger?

  • http://profile.typepad.com/robinhanson Robin Hanson

    Mrm, what do you disagree with my argument in http://www.typepad.com/t/comments?__mode=red&id=27005327

  • Doug S.

    Well, it’s May 30, 1998, and oil is $127 a barrel…

  • http://profile.typepad.com/halfinney Hal Finney

    That’s true, Doug, something the market judged a low-probability event has occurred. Indeed, oil prices have consistently surprised the market for most of the past decade.

    Ironically this very day I saw an article about how Southwest Airlines has managed to get a leg up over its competitors by using hedges to lock in favorable oil prices:

    The airline, one of the largest at Los Angeles International Airport, locked in more than 70% of the fuel it expected to consume this year at about $51 a barrel, far below Thursday’s closing crude price of $126.62 a barrel.

    I posted about the same kind of hedging by the same airline above, a year and a half ago. At that time, SWA was benefiting from hedges created years earlier. Ironically, oil prices at the time I wrote were a seemingly high $60, and SWA was effectively paying far less. It seemed then that the hedging strategy had run its course, but now we see that the airline was in fact setting up new hedges, locking in those “high” prices and looking very smart now that oil has doubled.

    The question is whether the spin on the new article, the same spin we heard before, is correct this time:

    The advantage won’t last forever because oil prices could plummet, and even if they stayed high the amount of fuel Southwest has been able to hedge in future years diminishes considerably from 55% next year to 30% in 2010.

    I wonder if Southwest is defying the skeptics and eagerly locking in $120 oil for use in 2009-2012? Nobody seems to consider this as a possible strategy, but then nobody was talking about locking in $50 oil back in 2006.