Oil prices have been climbing rapidly in the past few years, and especially in recent months. Some point to speculation, others suggest that the fundamentals justify high prices. In 2006 I wrote a couple of posts here about how you could predict
I don't know what Perry thinks about current oil prices, but here he is a month ago arguing for the reality of anthropogenic global warming. Maybe he's a bit more complex than you think.
nice to read the arrogant comments of a certain mr. perry metzger to a certain mr. david matthews from 2 years ago. i'd like to read again 2 years after, what he thinks of them.
Hal describes the surprising results of the Hotelling model of nonrenewable commodities: prices become much higher than the costs to produce the resource, the opposite situation from competitive markets in other kinds of commodities. Yet resource owners restrain production without the need for a cartel or any coordination.
This is because, under the Hotelling assumptions that the commodity is not renewable and cannot be substituted for (and of secure property rights, as David points out) the commodity producer can choose between producing today or keeping it in the ground to produce tommorrow, with no fear of permanently losing sales to some competitor. Any sales lost to a competitor today draws down the competitor's fixed stores and can be recouped at any time in the future.
What the Hotelling model does not properly account for is that these very characteristics also make these goods great substitutes or hedges for money. Hotelling looks at a "fixed" or "prevailing" interest rate, but we should really be looking at expectations of future interest rates, taking into account expectations of future inflation. And we should account for changes in these expectations. If we do so, I think we will find the model to have high explanatory power (albeit not high predictive power, since we can't outguess the market about future monetary conditions -- but the search for predictive as opposed to explanatory power in economic models is largely futile anyway).
Imagine a world with two currencies C1 and C2 and two nonrenewable minerals, M1 and M2. C1 money supply outstrips money demand by 10%/year, and for C2 by 5%/year (in other words, C1 "inflates" or "falls" by 10%/year and C2 by 5%/year). If the price has not properly increased to account for future expected inflation, people will prefer holding M1 and M2 to holding either of the currencies. They will play "hot potato" with the currencies: as soon as they obtain a currency in trade, they will try to purchase M1 or M2 with it. All holders of M1 or M2 will demand a stiff premium to exchange their minerals for falling currencies. What premium will they charge? In theory, the inflation premium is infinite: it is a "net present value" calculation of the depreciation of the currency into the infinite future. In practice, (as with the St. Petersburg paradox, and because no commodity is perfectly immune to substitution over the long term), the premium will just be very high: not only far higher than the cost of production, but also far higher than the Hotelling model under the assumption of no inflation. Inflation expectations will dominate the prices of G1 and G2 in C1 and C2.
Now imagine that inflation expectations change. If expectations of inflation in C2 to infinity go down from 5% to zero, we have in theory a change of net present value of revenue streams from G1 and G2 in currency C2 from infinity to zero, and in practice just a very high drop. It takes only a small change in inflation expectations to send the prices of G1 and G2 in C1 and C2 soaring or plummeting.
Since the standard Hotelling model predicts no abrubt price changes, and the monetary model does, the monetary model is a better choice for explaining the actual dramatic price movements in relatively nonrenewable commodities such as oil that we have observed.
Under imperfect information, since we have far better information about geology and technology than we do about future monetary conditions, and since uncertainty in monetary conditionsn produces far greater price changes than uncertainty about geology and technology, we can again conclude that abrupt changes such as we've seen are due almost entirely to changes in monetary expectations rather than in "fundamentals".
Furthermore, when we see dramatic changes across a wide variety of commodities, being led by the less renewable commodities like oil, Occam's Razor (or equivalently, basic probability) tells us that there are not 100 different explanations for why 100 different commodities have all gone up dramatically. Rather, we need only two quite related explanations: changes in inflation and inflation expectations for the currencies they are priced in.
Two commodities that come close to being Hotelling nonrenwable commodities are gold and oil. For gold, the above-ground stockpiles are far greater than the annual production. For oil, the below-ground stockpiles are far greater than the annual production. The price of gold has always historically been dominated by its role as money, monetary substitute, or hedge, or equivalent, and the price of oil is also coming to be so in an age of floating currencies and in the current decade of rising inflation expectations.
nuclear can substitute after that. But we can't yet put coal or uranium into our cars and planes.
Actually, nuclear-powered octane may very well become viable soon. It's the method of using nuclear power to store atmospheric CO2 in gasoline (basically, the chemical reverse of combustion), effectively making all cars carbon neutral, and thus killing 2+ birds with one stone.
From the link:
"This plan has a minor hurdle, too; the electricity for driving the chemical processes, according to a white paper describing the overarching concept, would come from nuclear power. The proposal says it’d be worth it to have a payoff of steady, secure streams of methanol and gasoline with no carbon added to the atmosphere (and a price for gasoline at the pump of perhaps $4.60 a gallon — comparable to petroleum-based fuels as oil becomes harder to find)."
So, it doesn't require oil to get that much more expensive before this method is profitable. By my rough gas->oil reckoning, it only needs oil to hit $160/barrel. In much of the world, if you exempted such gasoline (as would be reasonable) from GW-related regulations, it's probably already profitable.
I predict this prediction will not be accurate. :)
Your backstop price is unrealistically high, and as other posters have commented, doesn't account for non-energy uses of oil. Look at other sources such as http://www.nytimes.com/2008... which shows a way to produce gasoline by re-capturing atmospheric CO2 using nuclear energy to power the endothermic reaction, which is supposed to be economical using current technology when gas hits $4.60/gallon at the pump.
Also, you're assuming rational economics. Humans, as we well know, are not rational. Confirmation bias encouraged treating oil as a renewable resource. Anchoring bias encourages purchasers and speculators to see a price near the current one as reasonable.
Oil prices are (currently) denominated in dollars, however the dollar itself has a value determined by supply and demand.
Why is Hotelling accepted as a model for price movements? Has it ever correctly predicted the price movements for any commodity? Is oil the first resource that the human race has ever been on the verge of using up? I guess we have to exclude carrier pigeons and sabertooth tigers because they were unpriced.
I'll admit that it's a nice clean model, but without some corroboration, it seems like an extreme move to base much planning on an argument that this forecast is reliable. It's possible, but so are lots of other outcomes.
Hal, thanks for the analysis, it was thought provoking for me.
I'm skeptical that future solar power cost will go down or even remain constant. You note that many estimates of future oil production oddly "do not take into consideration the increase in expenses due to higher energy costs, when estimating what price would allow producing certain resources." In a similar manner, much of the cost of creating solar power is tied up in the up-front energy needed to make the solar panels and other equipment. The cheapest current source of this energy is oil, or at least carbon-based power. As oil rises through, say, $400/barrel this will likely drive the overall cost of solar up.
I am surprised you didn't talk about the Hubbert's peak model in this context. The exploration-exploitation phenomenology of oil has a couple of other key features that need to be modeled. One is that oil isn't finite in the sense of a big pool sitting somewhere -- it is distributed in increasingly harder-to-pump locations, which begin to be economically exploitable as demand begins to sufficiently overtake supply. This moderates the shock dynamics somewhat. Also, substitution effects mess really badly with basic models, and the rudimentary discussion of substitution in your model is not enough. I like the Saudi Oil minister's quote, which goes "the stone age did not end because te world ran out of stone. The oil age will not end because the world runs out of oil."
i.e. the abstract recognition of resource finiteness plays into how energy markets behave, but the proximal drivers that ultimately change it will be other things.
I think that the majority of people know that oil isn't a renewable resource and that we do need to find a renewable one to replace it with but I think the mind set is "I'm on a budget and until its affordable I can't do anything about it." And I somewhat agree that oil should be higher for a few reasons but it is really hurting at the same time. Its kind of like a blessing, because its forcing us to find alternatives, in a really ugly disguise. And here is some more bad news this article I was reading called $225 Per Barrel - The New Gov't Standard for Oil talks about what the government is expecting to pay for oil eventually and how they're planning around it. Its very interesting and reminds me to plan carefully as I watch the gas pump price rise.
The difficult thing is that you also have to model the expected rate of return on every other asset, and not ignore price changes due to what an asset isn't as opposed to only what it is. This sort of Hegelian trick is very familiar to currency traders, and the energy as currency meme is seductive.
It's interesting but I think you're inflating the equivalent cost of solar power to favour oil use. Firstly I'd content that if you were going to build on a large scale you would not build in Germany, but in a desert, where there is a lot of sunshine - I would contend that a more accurate price for "barrel of electricity" is around $500.
Also it's not a like-for-like comparison, because burning petrol in a car only has a mechanical efficiency of 20-25%, whereas electric motors are close to 90% efficient or higher. On that measure you'd get parity with solar power at around $100-$150 per barrel (that's before refining costs etc). Even power stations are only around 33% efficient (though that is improving) which would equate to $166 per barrel if you just burned the oil for electricity.
Even burning oil for domestic heating isn't a good use of oil either: A good heat pump can provide 3-5 kWh heating power for each kWh put in (depending on outside temperature), so again the break-even point for domestic heating is $166 at most. There are applications where oils cannot so easily be replaced
What I see a lot is the blinkered "let's wait until it all runs out before we figure out what to do" attitude, and of course the "oh, no these prices are killing us, someone has got to do something about it" from free-market non-interventionists, some very head-in-the-sand thinking.
The only certain thing is that oil will run out one day, and if we have a duty to the next generation, it is to provide them with the infrastructure to live an oil-free lifestyle, and do as much research as possible into this while we still can. One sure way of destroying the future generation's wealth is to put a lot of CO2 into the atmosphere and watch extremes of hot and cold weather make the planet less fertile and usable. I don't think they'd be thanking us for that.
But we can't yet put coal or uranium into our cars and planes
The Nazis used coal liquefaction 70 years ago. South Africa does it today, also having started under an oil embargo. So a backstop price of of $850 is way, way off.
Some evidence has been presented in this post. Weigh it appropriately and update. It isn't particularly rigorous, but it provides some direction for future individual inquiry. While the evidence may not be overwhelming, it's better than a coin toss. :)
Only in economics can someone begin an article by saying: "Unfortunately... my predictions were not accurate. Here is another approach to the problem."
What on earth could persuade anyone to believe that your next round of predictions will be any more accurate than the previous one; or, more pertinently, than a coin toss.
Solar power is not a substitute for oil. One is an energy, the other is a fuel. Currently, we have plenty of energy, coal alone is forecast to last 300 years and nuclear can substitute after that. But we can't yet put coal or uranium into our cars and planes. What we don't currently have is a good fuel substitute but Oil Shale, Biodiesel, Electric & Hydrogen seem to be the top contenders.
I don't know what Perry thinks about current oil prices, but here he is a month ago arguing for the reality of anthropogenic global warming. Maybe he's a bit more complex than you think.
http://toddseavey.com/2008/...
nice to read the arrogant comments of a certain mr. perry metzger to a certain mr. david matthews from 2 years ago. i'd like to read again 2 years after, what he thinks of them.
http://www.overcomingbias.c...
Hal describes the surprising results of the Hotelling model of nonrenewable commodities: prices become much higher than the costs to produce the resource, the opposite situation from competitive markets in other kinds of commodities. Yet resource owners restrain production without the need for a cartel or any coordination.
This is because, under the Hotelling assumptions that the commodity is not renewable and cannot be substituted for (and of secure property rights, as David points out) the commodity producer can choose between producing today or keeping it in the ground to produce tommorrow, with no fear of permanently losing sales to some competitor. Any sales lost to a competitor today draws down the competitor's fixed stores and can be recouped at any time in the future.
What the Hotelling model does not properly account for is that these very characteristics also make these goods great substitutes or hedges for money. Hotelling looks at a "fixed" or "prevailing" interest rate, but we should really be looking at expectations of future interest rates, taking into account expectations of future inflation. And we should account for changes in these expectations. If we do so, I think we will find the model to have high explanatory power (albeit not high predictive power, since we can't outguess the market about future monetary conditions -- but the search for predictive as opposed to explanatory power in economic models is largely futile anyway).
Imagine a world with two currencies C1 and C2 and two nonrenewable minerals, M1 and M2. C1 money supply outstrips money demand by 10%/year, and for C2 by 5%/year (in other words, C1 "inflates" or "falls" by 10%/year and C2 by 5%/year). If the price has not properly increased to account for future expected inflation, people will prefer holding M1 and M2 to holding either of the currencies. They will play "hot potato" with the currencies: as soon as they obtain a currency in trade, they will try to purchase M1 or M2 with it. All holders of M1 or M2 will demand a stiff premium to exchange their minerals for falling currencies. What premium will they charge? In theory, the inflation premium is infinite: it is a "net present value" calculation of the depreciation of the currency into the infinite future. In practice, (as with the St. Petersburg paradox, and because no commodity is perfectly immune to substitution over the long term), the premium will just be very high: not only far higher than the cost of production, but also far higher than the Hotelling model under the assumption of no inflation. Inflation expectations will dominate the prices of G1 and G2 in C1 and C2.
Now imagine that inflation expectations change. If expectations of inflation in C2 to infinity go down from 5% to zero, we have in theory a change of net present value of revenue streams from G1 and G2 in currency C2 from infinity to zero, and in practice just a very high drop. It takes only a small change in inflation expectations to send the prices of G1 and G2 in C1 and C2 soaring or plummeting.
Since the standard Hotelling model predicts no abrubt price changes, and the monetary model does, the monetary model is a better choice for explaining the actual dramatic price movements in relatively nonrenewable commodities such as oil that we have observed.
Under imperfect information, since we have far better information about geology and technology than we do about future monetary conditions, and since uncertainty in monetary conditionsn produces far greater price changes than uncertainty about geology and technology, we can again conclude that abrupt changes such as we've seen are due almost entirely to changes in monetary expectations rather than in "fundamentals".
Furthermore, when we see dramatic changes across a wide variety of commodities, being led by the less renewable commodities like oil, Occam's Razor (or equivalently, basic probability) tells us that there are not 100 different explanations for why 100 different commodities have all gone up dramatically. Rather, we need only two quite related explanations: changes in inflation and inflation expectations for the currencies they are priced in.
Two commodities that come close to being Hotelling nonrenwable commodities are gold and oil. For gold, the above-ground stockpiles are far greater than the annual production. For oil, the below-ground stockpiles are far greater than the annual production. The price of gold has always historically been dominated by its role as money, monetary substitute, or hedge, or equivalent, and the price of oil is also coming to be so in an age of floating currencies and in the current decade of rising inflation expectations.
Neat coincidence there, LeBleu ;-)
nuclear can substitute after that. But we can't yet put coal or uranium into our cars and planes.
Actually, nuclear-powered octane may very well become viable soon. It's the method of using nuclear power to store atmospheric CO2 in gasoline (basically, the chemical reverse of combustion), effectively making all cars carbon neutral, and thus killing 2+ birds with one stone.
From the link:
"This plan has a minor hurdle, too; the electricity for driving the chemical processes, according to a white paper describing the overarching concept, would come from nuclear power. The proposal says it’d be worth it to have a payoff of steady, secure streams of methanol and gasoline with no carbon added to the atmosphere (and a price for gasoline at the pump of perhaps $4.60 a gallon — comparable to petroleum-based fuels as oil becomes harder to find)."
So, it doesn't require oil to get that much more expensive before this method is profitable. By my rough gas->oil reckoning, it only needs oil to hit $160/barrel. In much of the world, if you exempted such gasoline (as would be reasonable) from GW-related regulations, it's probably already profitable.
I wouldn't worry.
I predict this prediction will not be accurate. :)
Your backstop price is unrealistically high, and as other posters have commented, doesn't account for non-energy uses of oil. Look at other sources such as http://www.nytimes.com/2008... which shows a way to produce gasoline by re-capturing atmospheric CO2 using nuclear energy to power the endothermic reaction, which is supposed to be economical using current technology when gas hits $4.60/gallon at the pump.
Also, you're assuming rational economics. Humans, as we well know, are not rational. Confirmation bias encouraged treating oil as a renewable resource. Anchoring bias encourages purchasers and speculators to see a price near the current one as reasonable.
Oil prices are (currently) denominated in dollars, however the dollar itself has a value determined by supply and demand.
Why is Hotelling accepted as a model for price movements? Has it ever correctly predicted the price movements for any commodity? Is oil the first resource that the human race has ever been on the verge of using up? I guess we have to exclude carrier pigeons and sabertooth tigers because they were unpriced.
I'll admit that it's a nice clean model, but without some corroboration, it seems like an extreme move to base much planning on an argument that this forecast is reliable. It's possible, but so are lots of other outcomes.
Hal, thanks for the analysis, it was thought provoking for me.
I'm skeptical that future solar power cost will go down or even remain constant. You note that many estimates of future oil production oddly "do not take into consideration the increase in expenses due to higher energy costs, when estimating what price would allow producing certain resources." In a similar manner, much of the cost of creating solar power is tied up in the up-front energy needed to make the solar panels and other equipment. The cheapest current source of this energy is oil, or at least carbon-based power. As oil rises through, say, $400/barrel this will likely drive the overall cost of solar up.
I am surprised you didn't talk about the Hubbert's peak model in this context. The exploration-exploitation phenomenology of oil has a couple of other key features that need to be modeled. One is that oil isn't finite in the sense of a big pool sitting somewhere -- it is distributed in increasingly harder-to-pump locations, which begin to be economically exploitable as demand begins to sufficiently overtake supply. This moderates the shock dynamics somewhat. Also, substitution effects mess really badly with basic models, and the rudimentary discussion of substitution in your model is not enough. I like the Saudi Oil minister's quote, which goes "the stone age did not end because te world ran out of stone. The oil age will not end because the world runs out of oil."
i.e. the abstract recognition of resource finiteness plays into how energy markets behave, but the proximal drivers that ultimately change it will be other things.
@ Thomas Ryan:
I think that the majority of people know that oil isn't a renewable resource and that we do need to find a renewable one to replace it with but I think the mind set is "I'm on a budget and until its affordable I can't do anything about it." And I somewhat agree that oil should be higher for a few reasons but it is really hurting at the same time. Its kind of like a blessing, because its forcing us to find alternatives, in a really ugly disguise. And here is some more bad news this article I was reading called $225 Per Barrel - The New Gov't Standard for Oil talks about what the government is expecting to pay for oil eventually and how they're planning around it. Its very interesting and reminds me to plan carefully as I watch the gas pump price rise.
The difficult thing is that you also have to model the expected rate of return on every other asset, and not ignore price changes due to what an asset isn't as opposed to only what it is. This sort of Hegelian trick is very familiar to currency traders, and the energy as currency meme is seductive.
It's interesting but I think you're inflating the equivalent cost of solar power to favour oil use. Firstly I'd content that if you were going to build on a large scale you would not build in Germany, but in a desert, where there is a lot of sunshine - I would contend that a more accurate price for "barrel of electricity" is around $500.
Also it's not a like-for-like comparison, because burning petrol in a car only has a mechanical efficiency of 20-25%, whereas electric motors are close to 90% efficient or higher. On that measure you'd get parity with solar power at around $100-$150 per barrel (that's before refining costs etc). Even power stations are only around 33% efficient (though that is improving) which would equate to $166 per barrel if you just burned the oil for electricity.
Even burning oil for domestic heating isn't a good use of oil either: A good heat pump can provide 3-5 kWh heating power for each kWh put in (depending on outside temperature), so again the break-even point for domestic heating is $166 at most. There are applications where oils cannot so easily be replaced
What I see a lot is the blinkered "let's wait until it all runs out before we figure out what to do" attitude, and of course the "oh, no these prices are killing us, someone has got to do something about it" from free-market non-interventionists, some very head-in-the-sand thinking.
The only certain thing is that oil will run out one day, and if we have a duty to the next generation, it is to provide them with the infrastructure to live an oil-free lifestyle, and do as much research as possible into this while we still can. One sure way of destroying the future generation's wealth is to put a lot of CO2 into the atmosphere and watch extremes of hot and cold weather make the planet less fertile and usable. I don't think they'd be thanking us for that.
But we can't yet put coal or uranium into our cars and planes
The Nazis used coal liquefaction 70 years ago. South Africa does it today, also having started under an oil embargo. So a backstop price of of $850 is way, way off.
Saifedean - I suggest starting at the beginning of Overcoming Bias and working upwards. Your question would be answered.
But here are some links to help:
As for admitting to errors:
"The Importance of Saying Oops"http://www.overcomingbias.c...
"Tsuyoku Naritai"http://www.overcomingbias.c...
I'm sure there are others.
And for the coin toss:
http://www.overcomingbias.c...
Some evidence has been presented in this post. Weigh it appropriately and update. It isn't particularly rigorous, but it provides some direction for future individual inquiry. While the evidence may not be overwhelming, it's better than a coin toss. :)
Only in economics can someone begin an article by saying: "Unfortunately... my predictions were not accurate. Here is another approach to the problem."
What on earth could persuade anyone to believe that your next round of predictions will be any more accurate than the previous one; or, more pertinently, than a coin toss.
Solar power is not a substitute for oil. One is an energy, the other is a fuel. Currently, we have plenty of energy, coal alone is forecast to last 300 years and nuclear can substitute after that. But we can't yet put coal or uranium into our cars and planes. What we don't currently have is a good fuel substitute but Oil Shale, Biodiesel, Electric & Hydrogen seem to be the top contenders.