63 Comments

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.

Expand full comment

Well, it's May 30, 1998, and oil is $127 a barrel...

Expand full comment

Mrm, what do you disagree with my argument in http://www.typepad.com/t/co...

Expand full comment

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?

Expand full comment

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?

Expand full comment

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

Expand full comment

Hello Mr. Hertzlinger:

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

Expand full comment

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?

Expand full comment

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 priceshttp://www.bankofengland.co...Recent developments in extracting information from options marketshttp://www.bankofengland.co...

Expand full comment

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.

Expand full comment

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...

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.

Expand full comment

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?

Expand full comment

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.

Expand full comment

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.

Expand full comment

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.

Expand full comment

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."

Expand full comment