11

Energy Economics – IEnergy Economics – I

Jeffrey FrankelJeffrey FrankelHarpel Professor, Harvard Harpel Professor, Harvard

UniversityUniversity

ADA Summer School, Baku, ADA Summer School, Baku, AzerbaijanAzerbaijan

7-9 July , 20107-9 July , 2010

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(1) Long-term trends: Are oil prices fated to rise as the world runs out?

(2) Shorter-term movements:

What causes swings such as the 2008 price spike?

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To think about oil prices,To think about oil prices, a broad historical perspective is a broad historical perspective is

essentialessential

From the vantage point of 2006, From the vantage point of 2006, the last decade suggested the last decade suggested a permanent upward trend.a permanent upward trend.

Now, 2001-2009 looks like Now, 2001-2009 looks like a classic bubble and crash.a classic bubble and crash.

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Price of oil, 1995-2006Price of oil, 1995-2006Permanent upward trend?Permanent upward trend?

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Price of oil, 2001-2009Price of oil, 2001-2009Or was 2008 only a transitory Or was 2008 only a transitory

spike?spike?

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(1) Long-term world oil price (1) Long-term world oil price trendtrend

(i) Determination of the price on world markets(i) Determination of the price on world markets

(ii) The old “structuralist school” (ii) The old “structuralist school” (Prebisch-Singer):(Prebisch-Singer): The hypothesis of a declining commodity price trend The hypothesis of a declining commodity price trend

(iii) Hypotheses of a rising price trend(iii) Hypotheses of a rising price trend Hotelling, non-renewable resources, & the interest Hotelling, non-renewable resources, & the interest

raterate Malthusianism & the “peak oil” hypothesisMalthusianism & the “peak oil” hypothesis

(iv) Empirical evidence(iv) Empirical evidence Statistical time series studiesStatistical time series studies Paul Ehrlich versus Julian SimonPaul Ehrlich versus Julian Simon

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(i) The determination of the (i) The determination of the export price on world export price on world

marketsmarkets Developing countries tend to be smaller Developing countries tend to be smaller

economically than major industrialized economically than major industrialized countries, and more likely to specialize in countries, and more likely to specialize in the exports of basic commodities like oil. the exports of basic commodities like oil.

As a result, they are more likely to fit As a result, they are more likely to fit the small open economy model: the small open economy model:

they can be regarded as price-takers, they can be regarded as price-takers, not just for their import goods, not just for their import goods, but for their export goods as well. but for their export goods as well.

That is, the prices of their tradable goods are That is, the prices of their tradable goods are generally taken as given on world markets. generally taken as given on world markets.

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The determination of the export price on world The determination of the export price on world marketsmarketscontinuedcontinued

The price-taking assumption requires 3 conditions: The price-taking assumption requires 3 conditions: low monopoly power, low monopoly power, low trade barriers, low trade barriers, and intrinsic perfect substitutability in the commodity as and intrinsic perfect substitutability in the commodity as

between domestic and foreign producers – between domestic and foreign producers – a condition usually met by primary products a condition usually met by primary products and usually not met by manufactured goods & services). and usually not met by manufactured goods & services).

To be literal, To be literal, not every barrel of oil is the same as every other not every barrel of oil is the same as every other and not all are traded in competitive markets.and not all are traded in competitive markets.

But the assumption that most oil producers But the assumption that most oil producers are price-takers holds relatively well. are price-takers holds relatively well.

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A qualification: Monopoly A qualification: Monopoly powerpower

Saudi Arabia does not satisfy the 1Saudi Arabia does not satisfy the 1stst condition, condition, due to its large size in world oil markets.due to its large size in world oil markets.

If OPEC functioned effectively as a true cartel, If OPEC functioned effectively as a true cartel, then it would possess even more monopoly then it would possess even more monopoly power in the aggregate.power in the aggregate.

However OPEC does not currently exercise However OPEC does not currently exercise much monopoly power beyond that of Saudi much monopoly power beyond that of Saudi Arabia, Arabia, because so many non-members now produce oil because so many non-members now produce oil

andand because even OPEC members usually do not feel because even OPEC members usually do not feel

constrained to stay within assigned quotas.constrained to stay within assigned quotas.

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To a first approximation, then, To a first approximation, then, the local price of oil = the local price of oil = ($ price on world markets) x (the exchange ($ price on world markets) x (the exchange rate).rate).

=> a devaluation should push up => a devaluation should push up the oil price quickly and in proportion the oil price quickly and in proportion leaving aside pre-existing contracts leaving aside pre-existing contracts or export restrictions. or export restrictions.

An upward revaluation of the currency An upward revaluation of the currency should push down the price in proportion.should push down the price in proportion.

The determination of the export price on world The determination of the export price on world marketsmarketscontinuedcontinued

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(ii) The old “structuralist (ii) The old “structuralist school”school”

Raul Prebisch Raul Prebisch (1950)(1950) & Hans Singer & Hans Singer (1950)(1950)

The hypothesis: a declining long run The hypothesis: a declining long run trend trend inin prices of mineral & agricultural products prices of mineral & agricultural products

relative to the prices of manufactured goods.relative to the prices of manufactured goods.

The theoretical reasoning: The theoretical reasoning: world demand for primary products is world demand for primary products is inelastic with respect to world income. inelastic with respect to world income.

That is, for every 1 % increase in income, That is, for every 1 % increase in income, raw materials demand rises by raw materials demand rises by less thanless than 1%. 1%.

Engel’s Law, an (older) proposition: Engel’s Law, an (older) proposition: households spend a lower fraction of their income households spend a lower fraction of their income on basic necessities as they get richer.on basic necessities as they get richer.

Demand => PDemand => P oil oil

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StructuralistsStructuralists, continued, continued

This hypothesis, if true, would imply that This hypothesis, if true, would imply that specializing in natural resources was a bad deal. specializing in natural resources was a bad deal.

Mere “hewers of wood & drawers of water” would Mere “hewers of wood & drawers of water” would remain forever poor if they did not industrialize. remain forever poor if they did not industrialize.

The policy implication of Prebisch:The policy implication of Prebisch: developing countries should discourage international developing countries should discourage international

trade with tariffs, trade with tariffs, to allow their domestic manufacturing sector to to allow their domestic manufacturing sector to

develop behind protective walls, develop behind protective walls, rather than exploiting their traditional comparative rather than exploiting their traditional comparative

advantage in natural resources advantage in natural resources as the classic theories of free trade would have it. as the classic theories of free trade would have it.

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““Import Substitution Import Substitution Industrialization” policy (ISI)Industrialization” policy (ISI)

was adopted in the 1950s, 60s and was adopted in the 1950s, 60s and 70s70s in most of Latin America and much of in most of Latin America and much of

the rest of the developing world. the rest of the developing world.

The fashion reverted in subsequent The fashion reverted in subsequent decades, however.decades, however.

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(iii) Hypotheses of rising (iii) Hypotheses of rising trendstrends

Hotelling on depletable resources;Hotelling on depletable resources;Malthus on geometric population Malthus on geometric population

growth.growth. Persuasive theoretical arguments Persuasive theoretical arguments

that we should expect oil prices to showthat we should expect oil prices to showan an upward upward trend in the long run.trend in the long run.

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Assumptions for Hotelling Assumptions for Hotelling modelmodel

(1) Non-perishable non-renewable resources: (1) Non-perishable non-renewable resources: Deposits in the earth’s crust are fixed in total supply Deposits in the earth’s crust are fixed in total supply

and are gradually being depleted.and are gradually being depleted.

(2) Secure property rights:(2) Secure property rights:Whoever currently has claim to the resource Whoever currently has claim to the resource can be confident that it will retain possession,can be confident that it will retain possession, unless it sells to someone else, unless it sells to someone else,

who then has equally safe property rights. who then has equally safe property rights. This assumption excludes cases where warlords This assumption excludes cases where warlords

compete over physical possession of the resource. compete over physical possession of the resource. It also excludes cases where private oil companies fear It also excludes cases where private oil companies fear

that their contracts might be abrogated that their contracts might be abrogated or their holdings nationalized. or their holdings nationalized.

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If property rights are If property rights are notnot secure,secure,

the current owner has a strong the current owner has a strong incentive to pump the oil quickly, incentive to pump the oil quickly, because it might never benefit if the oil is left in the because it might never benefit if the oil is left in the

ground.ground.

That is one explanation for the sharp rise That is one explanation for the sharp rise in oil prices from 1973 to 1979:in oil prices from 1973 to 1979: Western oil companies in the 1960s had anticipated Western oil companies in the 1960s had anticipated

that newly assertive developing countries would that newly assertive developing countries would eventually nationalize the reserves within their eventually nationalize the reserves within their borders, borders,

and thus had kept prices low by pumping oil more and thus had kept prices low by pumping oil more quickly than if they been confident that their claims quickly than if they been confident that their claims would remain valid indefinitelywould remain valid indefinitely

until they indeed lost control in 1973.until they indeed lost control in 1973.

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Price of oil, 1900-2006Price of oil, 1900-2006Oil shocksOil shocks

1 1973 Arab oil embargo2. 1979 fall of Shah of Iran3. 2008 spike

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While we are on the subject While we are on the subject of the 1970s oil shocks…of the 1970s oil shocks…

A more common explanation for the oil price A more common explanation for the oil price increases of 1973-74 and 1979-80 is increases of 1973-74 and 1979-80 is simply geopolitical disruptions: simply geopolitical disruptions: Yom Kippur War and Arab Oil EmbargoYom Kippur War and Arab Oil Embargo Revolution in Iran and Fall of the ShahRevolution in Iran and Fall of the Shah

Less common explanations:Less common explanations: Excessively easy monetary policyExcessively easy monetary policy

coming from US Fed accommodation of Vietnam deficitscoming from US Fed accommodation of Vietnam deficits ““The world is running out of oil.”The world is running out of oil.” We consider both later.We consider both later.

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One more assumption, One more assumption, to keep the Hotelling model to keep the Hotelling model

simple:simple: (3) The fixed deposits are easily accessible: (3) The fixed deposits are easily accessible:

the costs of exploration, development, & the costs of exploration, development, & pumping pumping are small compared to the value of the oil.are small compared to the value of the oil.

Hotelling Hotelling (1931)(1931) deduced from these deduced from these assumptions the theoretical principle: assumptions the theoretical principle:

the price of oil in the long run should rise the price of oil in the long run should rise at a rate equal to the interest rate. at a rate equal to the interest rate.

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King Abdullah of Saudi Arabia, King Abdullah of Saudi Arabia, with interest rates close to zero,with interest rates close to zero,apparently believes that the rate of apparently believes that the rate of return on oil reserves is higher if he return on oil reserves is higher if he doesn't pump than if he does: doesn't pump than if he does:     

"Let them remain in the ground for "Let them remain in the ground for our children and grandchildren..." our children and grandchildren..." (April 12, 2008)(April 12, 2008)

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The Hotelling logic:The Hotelling logic:

The owner chooses how much oil to pump The owner chooses how much oil to pump and how much to leave in the ground. and how much to leave in the ground.

Whatever is pumped can be sold at today’s Whatever is pumped can be sold at today’s price (price-taker assumption)price (price-taker assumption) and the proceeds invested in bank deposits and the proceeds invested in bank deposits or US Treasury bills, which earn the current or US Treasury bills, which earn the current

interest rate. interest rate.

If the value of the oil in the ground is not If the value of the oil in the ground is not expected to rise in the future, then the owner expected to rise in the future, then the owner has an incentive to extract more of it today, has an incentive to extract more of it today, so so that he earns interest on the proceeds. that he earns interest on the proceeds.

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The Hotelling logic,The Hotelling logic, continued:continued:

As oil companies worldwide react in this way, As oil companies worldwide react in this way, they drive down the price of oil today, they drive down the price of oil today, below its perceived long-run level. below its perceived long-run level.

When the current price is below its long-run level, When the current price is below its long-run level, companies will expect the price tocompanies will expect the price to rise rise in the in the future.future.

Only when the expectation of future appreciation Only when the expectation of future appreciation is sufficient to offset the interest rate will the oil is sufficient to offset the interest rate will the oil market be in equilibrium. market be in equilibrium.

Only then will oil companies be close to Only then will oil companies be close to indifferent between pumping at a faster rate and indifferent between pumping at a faster rate and a slower rate. a slower rate.

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Hotelling,Hotelling, continued:continued:

To say the oil price is To say the oil price is expectedexpected to to increase at the interest rate means that increase at the interest rate means that it should do so on average; it should do so on average; it does not mean that there won’t be price it does not mean that there won’t be price

fluctuations above & below the trend. fluctuations above & below the trend. The theory does imply that, averaging out The theory does imply that, averaging out

short-term unexpected fluctuations, oil short-term unexpected fluctuations, oil prices in the long term should rise at the prices in the long term should rise at the interest rate. interest rate.

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If there are costs of extraction & If there are costs of extraction & storage?storage?

-- non-negligible costs -- non-negligible costs (but assume constant)(but assume constant) ? ?

then the trend in prices will be lower then the trend in prices will be lower than the interest rate, by that amount.than the interest rate, by that amount.

If there is a constant convenience yield If there is a constant convenience yield from holding inventories? from holding inventories?

then the trend in prices will be then the trend in prices will be higherhigher than the interest rate, by that amount.than the interest rate, by that amount.

The arbitrage equilibrium equation:The arbitrage equilibrium equation:

E E ΔΔp p oiloil = = interest rateinterest rate + + costscosts – – convenience convenience yieldyield

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The upward trend idea is older than The upward trend idea is older than Hotelling.Hotelling.

It goes back to Thomas Malthus It goes back to Thomas Malthus (1798)(1798) and the first fears of environmental scarcity:and the first fears of environmental scarcity: Demand grows with population,Demand grows with population, Supply does not.Supply does not. What could be clearer in economics What could be clearer in economics

than the prediction that price will rise? than the prediction that price will rise?

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Over the two centuries since Malthus, Over the two centuries since Malthus, or the 70 years since Hotelling, or the 70 years since Hotelling,

exploration & new technologies have exploration & new technologies have increased the supply of oil at a pace increased the supply of oil at a pace that has roughly counteracted the increase that has roughly counteracted the increase

in demand from growth in demand from growth in population & incomesin population & incomes..[1][1]

[1][1] KrautkraemerKrautkraemer (1998)(1998) andand Wright & CzelustaWright & Czelusta (2003, 2004, 2006).(2003, 2004, 2006).

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Hubbert’s Hubbert’s Peak – U.S.Peak – U.S.

Just because supply has always increased Just because supply has always increased in the past does not necessarily mean it in the past does not necessarily mean it always will in the future. always will in the future.

In 1956, M. King Hubbert, an oil engineer, In 1956, M. King Hubbert, an oil engineer,

predicted that the flow supply of oil within predicted that the flow supply of oil within

the US would peak in the late 1960s and the US would peak in the late 1960s and then decline permanently. then decline permanently.

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The The prediction was based on a model prediction was based on a model in which the fraction of the country’s reserves in which the fraction of the country’s reserves

that has been discovered rises through time, that has been discovered rises through time, and data on the rates of discovery versus and data on the rates of discovery versus

consumption are used to estimate the consumption are used to estimate the parameters in the model. parameters in the model.

Unlike myriad other pessimistic forecasts, Unlike myriad other pessimistic forecasts, this one came true on schedulethis one came true on schedule, , earning subsequent fame for its author:earning subsequent fame for its author: U.S. oil output indeed peaked in the late U.S. oil output indeed peaked in the late

1960s.1960s.

Hubbert’s Hubbert’s Peak – U.S.Peak – U.S.

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Planet Earth is a much larger place Planet Earth is a much larger place than the USA, but it too is finite. than the USA, but it too is finite.

Some analysts have extrapolated Hubbert’s words Some analysts have extrapolated Hubbert’s words & modeling approach to claim that the same pattern & modeling approach to claim that the same pattern will follow for extraction of the will follow for extraction of the worldworld’s oil reserves. ’s oil reserves.

Some claim the 2000-2008 run-up in oil prices Some claim the 2000-2008 run-up in oil prices confirmed a predicted global “Hubbert’s Peak.” confirmed a predicted global “Hubbert’s Peak.” [1][1]

It remains to be seen whether we are currently It remains to be seen whether we are currently witnessing a peak in world oil production,witnessing a peak in world oil production, notwithstanding that forecasts of such peaks notwithstanding that forecasts of such peaks

have proven erroneous in the past.have proven erroneous in the past.

[1][1] E.g., Deffeyes E.g., Deffeyes (2005).(2005).

Hubbert’s Hubbert’s Peak – GlobalPeak – Global

3030HeatUSA.com blog

Hubbert’s Peak – Hubbert’s Peak – globalglobal

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The complication: supply is not The complication: supply is not

fixed.fixed. True, at any point in time there is a certain True, at any point in time there is a certain

stock of oil reserves that have been discovered. stock of oil reserves that have been discovered. But the historical pattern has long been that, But the historical pattern has long been that,

as that stock is depleted, new reserves are as that stock is depleted, new reserves are found.found.

When the price goes up, it makes exploration & When the price goes up, it makes exploration & development profitable for deposits farther development profitable for deposits farther under the surface or underwater under the surface or underwater or in other hard-to-reach locations. or in other hard-to-reach locations.

……especially as new technologies are especially as new technologies are developed for exploration & extraction.developed for exploration & extraction.

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The empirical evidenceThe empirical evidence

With strong theoretical arguments on both With strong theoretical arguments on both sides, either for an upward trend or for a sides, either for an upward trend or for a downward trend, it is an empirical question. downward trend, it is an empirical question.

Terms of trade for commodity producers had Terms of trade for commodity producers had a slight up trend from 1870 to World War I, a slight up trend from 1870 to World War I, a down trend in the inter-war period, a down trend in the inter-war period, up in the 1970s, up in the 1970s, down in the 1980s and 1990s, down in the 1980s and 1990s, and up in the first decade of the 21st century.and up in the first decade of the 21st century.

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What is the overall statistical trend What is the overall statistical trend

in commodity prices in the long in commodity prices in the long run?run?

Some authors find a slight upward trend, Some authors find a slight upward trend, some a slight downward trend.some a slight downward trend. [1][1]

The answer seems to depend, more than anything else, The answer seems to depend, more than anything else, on the date of the end of the sample: on the date of the end of the sample: Studies written after the 1970s boom found an upward trend,Studies written after the 1970s boom found an upward trend, but those written after the 1980s found a downward trend, but those written after the 1980s found a downward trend,

even when both went back to the early 20th century. even when both went back to the early 20th century.

[1][1] Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington & Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Hadass Cuddington & Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Hadass & Williamson (2003), Reinhart & Wickham (1994), Kellard & Wohar & Williamson (2003), Reinhart & Wickham (1994), Kellard & Wohar (2005), Balagtas & Holt (2009) and Harvey, Kellard, Madsen & Wohar (2005), Balagtas & Holt (2009) and Harvey, Kellard, Madsen & Wohar (2010).(2010).

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What is the trend in the price What is the trend in the price of oil in particular?of oil in particular?

1869-1969: Downward1869-1969: Downward

1970-2010: Upward1970-2010: Upward

The long run: Unclear The long run: Unclear ??

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Price of oil, 1869-2009Price of oil, 1869-2009

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Addendum 1: Addendum 1: Malthusians vs. CornucopiansMalthusians vs. Cornucopians

The wager of Paul Ehrlich against Julian SimonThe wager of Paul Ehrlich against Julian Simon

Paul Ehrlich is a biologist, highly respected among Paul Ehrlich is a biologist, highly respected among scientists but with a history of sensationalist doomsday scientists but with a history of sensationalist doomsday predictions regarding population, the environment, & predictions regarding population, the environment, & resource scarcity. resource scarcity.

Julian Simon was a libertarian economist, frustrated by Julian Simon was a libertarian economist, frustrated by the failure of the public to hold Malthusians accountable the failure of the public to hold Malthusians accountable for the poor track record of their predictions.for the poor track record of their predictions.

In 1980, Simon publicly bet Ehrlich $1000 that the In 1980, Simon publicly bet Ehrlich $1000 that the prices of 5 minerals would decline between then and prices of 5 minerals would decline between then and 1990.1990.

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Malthusians vs. CornucopiansMalthusians vs. CornucopiansThe Ehrlich-Simon betThe Ehrlich-Simon bet, , continuedcontinued

Ehrlich’s logic was Malthusian: Ehrlich’s logic was Malthusian: because supplies were fixed while growth of because supplies were fixed while growth of

populations & economies would raise demand, populations & economies would raise demand, the resulting scarcity would drive up prices. the resulting scarcity would drive up prices.

He mentally extrapolated into the indefinite future He mentally extrapolated into the indefinite future what had been a strong rise in commodity prices what had been a strong rise in commodity prices over the preceding decade. over the preceding decade.

Simon’s logic is called cornucopian:Simon’s logic is called cornucopian: Yes, the future would repeat the past. Yes, the future would repeat the past. The relevant pattern from the past was not the The relevant pattern from the past was not the

ten-year trend, however, but rather a century of ten-year trend, however, but rather a century of cycles: cycles:

resource scarcity does indeed drive up prices, resource scarcity does indeed drive up prices, whereupon supply, demand and, especially, technology, whereupon supply, demand and, especially, technology, respond with a lag, driving the prices back down. respond with a lag, driving the prices back down.

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Malthusians vs. CornucopiansMalthusians vs. CornucopiansThe Ehrlich-Simon betThe Ehrlich-Simon bet, , continuedcontinued

Simon won the bet handily: Simon won the bet handily: Every one of the 5 real mineral prices in Every one of the 5 real mineral prices in

the basket declined over the next 10 the basket declined over the next 10 years. years.

He was also right about the reasons: He was also right about the reasons: In response to the high prices of 1980, In response to the high prices of 1980,

new technologies came into use, buyers new technologies came into use, buyers economized, and new producers entered the economized, and new producers entered the market.market.

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The Ehrlic-vs.-Simon bet The Ehrlic-vs.-Simon bet carries fascinating implications,carries fascinating implications,

for Malthusians vs. Cornucopians, for Malthusians vs. Cornucopians, environmentalists vs. economists, environmentalists vs. economists, extrapolationists versus contrarians, extrapolationists versus contrarians, and futurologists versus historians. and futurologists versus historians.

The main point: The main point: Simple extrapolation of medium-term trends is Simple extrapolation of medium-term trends is

foolish. foolish. One must take a longer-term perspective. One must take a longer-term perspective. Statisticians need as long a time series as possible. Statisticians need as long a time series as possible.

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However, one should avoid falling prey to However, one should avoid falling prey to eithereither of of two reductionist arguments at the philosophical two reductionist arguments at the philosophical poles of Mathusianism & cornucopianism. poles of Mathusianism & cornucopianism.

On the one hand, the fact that the supply of On the one hand, the fact that the supply of minerals in the earth’s crust is a finite number, minerals in the earth’s crust is a finite number, does not in itself justify the apocalyptic conclusion does not in itself justify the apocalyptic conclusion that we must necessarily run out. that we must necessarily run out.

As Sheik Yamani, the former Saudi oil minister, As Sheik Yamani, the former Saudi oil minister, said, said, "The Stone Age came to an end not for a lack of "The Stone Age came to an end not for a lack of stones and the oil age will end, but not for a lack of stones and the oil age will end, but not for a lack of oil.“oil.“ Malthusians do not pay enough attention to the tendency Malthusians do not pay enough attention to the tendency

for technological progress to ride to the rescue. for technological progress to ride to the rescue.

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On the other hand, the fact that the Malthusian On the other hand, the fact that the Malthusian forecast has repeatedly been proven false in forecast has repeatedly been proven false in the past does not imply that it will always be so the past does not imply that it will always be so in the future.in the future.

One must seek, rather, a broad perspective, One must seek, rather, a broad perspective, in which all relevant reasoning & evidence in which all relevant reasoning & evidence

are brought to bear in the balance.are brought to bear in the balance.

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(2) Short-term (2) Short-term oil price volatilityoil price volatility and medium-term swingsand medium-term swings

Low short-run elasticitiesLow short-run elasticities Inventories moderate volatilityInventories moderate volatility Cobweb cycleCobweb cycle Monetary influencesMonetary influences The 2008 spikeThe 2008 spike SpeculatorsSpeculators

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Causes of VolatilityCauses of Volatility The market price of oil is volatile in the short run. The market price of oil is volatile in the short run. Because elasticities of supply & demand Because elasticities of supply & demand

with respect to price are low, with respect to price are low, relatively small fluctuations in demand relatively small fluctuations in demand (due, for example, to weather)(due, for example, to weather) or in supply or in supply (due, for example, to disruptions)(due, for example, to disruptions) require a large change require a large change in price to re-equilibrate supply and demand. in price to re-equilibrate supply and demand.

Demand elasticities are low in the short run largely Demand elasticities are low in the short run largely because the capital stock is designed to operate because the capital stock is designed to operate with a particular ratio of energy to output. with a particular ratio of energy to output.

Supply elasticities are also often low in the short Supply elasticities are also often low in the short run because it takes time to adjust output. run because it takes time to adjust output.

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A given rise in demand causesA given rise in demand causesa small price rise or a big price a small price rise or a big price

riserisewith withwith with High elasticitiesHigh elasticities Low elasticitiesLow elasticities

{ {

Poil Poil

Supply & demand for oil Supply & demand for oil

D

D

D'

D'

S

SThe increase

in demand drives up the price

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Volatility,Volatility, continuedcontinued

Inventories can cushion the short run impact Inventories can cushion the short run impact of fluctuations, but they are limited in size. of fluctuations, but they are limited in size.

There is a bit of scope to substitute across There is a bit of scope to substitute across different fuels, even in the short run. different fuels, even in the short run.

But this just means that the prices of oil, But this just means that the prices of oil, natural gas, and other fuels tend to experience natural gas, and other fuels tend to experience their big medium-term swings together.their big medium-term swings together.

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Volatility,Volatility, continuedcontinued

In the longer run, elasticities are far In the longer run, elasticities are far higher, higher, bothboth on theon the demand sidedemand side and theand the supply side. supply side.

This dynamic was clearly at work in This dynamic was clearly at work in the oil price shocks of the 1970s – the oil price shocks of the 1970s –

quadrupling after the 1973 Arab oil quadrupling after the 1973 Arab oil embargo embargo

doubling after the Iranian revolution of doubling after the Iranian revolution of 1979,1979,

which elicited relatively little consumer which elicited relatively little consumer conservation or new supply sources conservation or new supply sources in the short in the short runrun, but a lot of both after a few years had , but a lot of both after a few years had passed. passed.

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Volatility,Volatility, continuedcontinued

In the medium run,In the medium run, people started insulating their houses and people started insulating their houses and

driving more fuel-efficient cars, driving more fuel-efficient cars, and oil deposits were discovered and oil deposits were discovered & developed in new countries. & developed in new countries.

This is a major reason why the real price This is a major reason why the real price of oil came back down in the 1980s-of oil came back down in the 1980s-1990s.1990s.

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Price of oil, 1970-2007Price of oil, 1970-2007

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Volatility,Volatility, continuedcontinued

In the medium term, oil may be subject to In the medium term, oil may be subject to a cob-web cycle, due to the lags in a cob-web cycle, due to the lags in response:response: The initial market equilibrium is a high price;The initial market equilibrium is a high price; the high price brings forth investmentthe high price brings forth investment

and raises supply after some years, and raises supply after some years, which in turn leads to a new low price, which in turn leads to a new low price, which discourages investment, which discourages investment,

and thus reduces supply with a lagand thus reduces supply with a lag and so on. and so on.

In theory, if people have rational expectations, In theory, if people have rational expectations, they should look ahead to the next price cycle before they should look ahead to the next price cycle before making long-term investments in housing or drilling. making long-term investments in housing or drilling.

But the complete sequence of boom-bust-boom over the last But the complete sequence of boom-bust-boom over the last 35 years looks suspiciously like a cobweb cycle nonetheless.35 years looks suspiciously like a cobweb cycle nonetheless.

1 2

34

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Monetary influences on oil Monetary influences on oil pricesprices

The same arbitrage equation that implies a positive The same arbitrage equation that implies a positive long-run price trend also explains some shorter-run long-run price trend also explains some shorter-run price swings. price swings.

The real price of oil should be unusually high during The real price of oil should be unusually high during periods when real interest rates are low (e.g., due to periods when real interest rates are low (e.g., due to easy monetary policy), easy monetary policy), so that a poor expected future return to leaving so that a poor expected future return to leaving

the oil in the ground offsets the low interest rate. the oil in the ground offsets the low interest rate.

By contrast, when real interest rates are high (e.g., By contrast, when real interest rates are high (e.g., due to tight monetary policy), current oil prices due to tight monetary policy), current oil prices should lie below their long-run equilibrium, should lie below their long-run equilibrium, because an expected future rate of price increase because an expected future rate of price increase

is needed in order to offset the high interest rate. is needed in order to offset the high interest rate.

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The mechanism?The mechanism?

High interest rates reduce the demand for oil, High interest rates reduce the demand for oil, or increase the supply, through 3 channels: or increase the supply, through 3 channels:

¤¤  by increasing the incentive for extraction   by increasing the incentive for extraction today rather than tomorrow; today rather than tomorrow; ¤¤  by decreasing firms' desire to carry   by decreasing firms' desire to carry inventories (oil stocks held in tanks or tankers) inventories (oil stocks held in tanks or tankers) ¤  ¤  by encouraging speculators to shift out by encouraging speculators to shift out of spot oil contracts, and into treasury bills.of spot oil contracts, and into treasury bills.

All 3 mechanisms work to reduce the market price of All 3 mechanisms work to reduce the market price of oil, as when real interest rates where high in the early oil, as when real interest rates where high in the early 1980s. 1980s.

A decrease in real interest rates has the opposite effect, A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising oil lowering the cost of carrying inventories, and raising oil prices, as happened from Aug. 2007 to Sept. 2008.  prices, as happened from Aug. 2007 to Sept. 2008. 

Call it an example of the “carry trade.”Call it an example of the “carry trade.”

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The monetary overshooting theory The monetary overshooting theory summarizedsummarized

Monetary contraction temporarily raises Monetary contraction temporarily raises thethe real interest real interest raterate whether via rise in nominal interest rate, fall in expected inflation, or both.whether via rise in nominal interest rate, fall in expected inflation, or both.

Inventory demand falls. Oil prices fall. Inventory demand falls. Oil prices fall. How far? How far? Until oil is widely considered "undervalued" Until oil is widely considered "undervalued"

-- so undervalued that there is an expectation of future appreciation-- so undervalued that there is an expectation of future appreciation together with other advantage of holding inventories: the "convenience yield“together with other advantage of holding inventories: the "convenience yield“

that it is sufficient to offset the higher interest rate that it is sufficient to offset the higher interest rate and other costs of carrying inventories: storage costs plus any risk premium. and other costs of carrying inventories: storage costs plus any risk premium.

Only then are firms willing to hold the inventories Only then are firms willing to hold the inventories despite the high carrying cost.despite the high carrying cost.

In the long run, the general price level adjusts In the long run, the general price level adjusts to the change in the money supply.to the change in the money supply.

As a result, the real money supply, real interest rate, and real commodity price eventually return to where they As a result, the real money supply, real interest rate, and real commodity price eventually return to where they werewere

Frankel "Expectations and Commodity Price Dynamics: The Overshooting Model," Frankel "Expectations and Commodity Price Dynamics: The Overshooting Model," American J. of Ag. EconomicsAmerican J. of Ag. Economics

(1986).(1986). __ & Hardouvelis, "Commodity Prices, Money Surprises, and Fed Credibility" __ & Hardouvelis, "Commodity Prices, Money Surprises, and Fed Credibility" J. of Money, Credit & BankingJ. of Money, Credit & Banking (1985). (1985).

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Monetary influences on oil prices,Monetary influences on oil prices, continuedcontinued

Very low US real interest rates boosted Very low US real interest rates boosted commodity prices toward the end of the 1970s, commodity prices toward the end of the 1970s, especially in $ terms;especially in $ terms;

high US interest rates drove them down high US interest rates drove them down in thein the 1980s, 1980s, especially in $.especially in $.

In the years 2003-2010, low interest rates may again In the years 2003-2010, low interest rates may again have been a source of high commodity prices.have been a source of high commodity prices.

References by the author include Frankel, 1986, 2008a,b; Frankel & References by the author include Frankel, 1986, 2008a,b; Frankel & Hardouvelis, 1985; Frankel & Rose, 2009; and "Real Interest Rates Cast a Hardouvelis, 1985; Frankel & Rose, 2009; and "Real Interest Rates Cast a Shadow Over Oil," Shadow Over Oil," FTimes,FTimes, April 15, 2005. April 15, 2005.

Also Barsky & Summers, 1988; and Also Barsky & Summers, 1988; and Caballero, Farhi & Gourinchas, 2008Caballero, Farhi & Gourinchas, 2008.. Barsky & Killian (2002) and Killian (2009) believe that many big oil price Barsky & Killian (2002) and Killian (2009) believe that many big oil price

“shocks” have in reality been endogenous with respect to monetary policy.“shocks” have in reality been endogenous with respect to monetary policy.

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Influences on oil inventories

Regressors Real interest rate Standard Significant coefficient error at 10%

1. Real rate -5.96 0.29 *

2. Real rate -0.69 0.35 * & linear trend

The spot-futures spread, risk & Industrial Production The spot-futures spread, risk & Industrial Production also appear significant in variants of the inventories also appear significant in variants of the inventories equation.equation.

Source: Source: Table 4, Frankel, “The Effect of Monetary Policy on Real Commodity Table 4, Frankel, “The Effect of Monetary Policy on Real Commodity Prices,” in Prices,” in Asset Prices and Monetary Policy,Asset Prices and Monetary Policy, edited by John Campbell edited by John Campbell (University of Chicago Press), 2008, pp.291-327(University of Chicago Press), 2008, pp.291-327

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Real interest Spot- IP Δ IP Risk Δ risk Lagged rate futures inventories

-0.394* -0.821* 0.397* -0.002* 0.089 0.041 0.062 0.001

-0.056 -0.079* 0.052* 0.000 0.931* 0.032 0.013 0.020 0.000 0.009

-0.211* -0.727* 0.131 -0.005* 0.085 0.040 0.126 0.001

-0.017 -0.071* 0.009 0.000 0.937* 0.032 0.012 0.045 0.000 0.009 * Asterisks indicate significance at the 5% level of significance. • Non-stationary variables detrended by including quadratic terms in each regression• Source: Frankel (2008)

Influences on oil inventories, continued

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Reasons for the oil price rise,Reasons for the oil price rise,culminating in the 2008 spikeculminating in the 2008 spike

As Jim Hamilton points out, it differed As Jim Hamilton points out, it differed from the previous big oil price from the previous big oil price increases which arose in geopolitical increases which arose in geopolitical disruptions to disruptions to supplysupply..

Rather, there was a combination Rather, there was a combination of rapidly growing of rapidly growing demanddemand, , with stagnant supply.with stagnant supply.

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Past oil price shocks arose in Past oil price shocks arose in geopolitical supply disruptionsgeopolitical supply disruptions

Exogenous disruptions in world petroleum supply.––––––––––––––––––––––––––––––––––––—

Date Event Drop in world Drop in U.S. oil production real GDP

Nov.1956 Suez Crisis 10.1% -2.5%Nov.1973 Arab-Israel War 7.8% -3.2%Nov.1978 Iran Revolution 8.9% -0.6%Oct.1980 Iran-Iraq War 7.2% -0.5%Aug.1990 Persian Gulf War 8.8% -0.1%––––––––––––––––––––––––––––––––––––—Source: Hamilton (2003, p.11).

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Price of oil, 1940-2008Price of oil, 1940-2008

March 2008

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Reasons for the 2007-08 oil price spike, Reasons for the 2007-08 oil price spike, continuedcontinued

Instability among oil producers; fear of US-Iran Instability among oil producers; fear of US-Iran conflict; misguided US ethanol subsidies; etc., conflict; misguided US ethanol subsidies; etc.,   

But the solution must be But the solution must be macroeconomicmacroeconomic:: Prices of other minerals & agricultural products Prices of other minerals & agricultural products

increased at the same time.increased at the same time.

Many said speculators were driving up the price.Many said speculators were driving up the price.

Two macroeconomic fundamentals could explain Two macroeconomic fundamentals could explain the decade’s boom in commodity markets:  the decade’s boom in commodity markets:  Low interest rates in the US; Low interest rates in the US; rapid growth worldwide, rapid growth worldwide,

especially in China & India.especially in China & India.

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The rapid growth in world demand, The rapid growth in world demand, especially from Asia, is obviously part of itespecially from Asia, is obviously part of it 2003-20072003-2007 and now back again since mid-2009.and now back again since mid-2009.

But what explains the accelerated But what explains the accelerated price rise in 2008?price rise in 2008? All forecasts for growth in Asia & the world All forecasts for growth in Asia & the world

had been downgraded by then.had been downgraded by then. Only the easing of US monetary policy fits.Only the easing of US monetary policy fits.

Reasons for the 2007-08 oil price Reasons for the 2007-08 oil price

spike,spike, continuedcontinued

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Don Kohn and Paul Krugman: low interest rates or speculation could not be the causes, because oil inventories were low. It is true that low interest rates or speculation, other things equal, should in theory increase firms’ desire to hold inventories.

                                                                                                             US crude oil inventories did not appear especially low or high in the graph above, showing June 1998-June 2008 (from Bloomberg).                                  

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World markets are relatively integrated, so it is world inventories that should matter most. Oil inventories in developed countries were above average during most of the year, as the graph shows.

They rose in January 2008, when the Fed aggressively cut interest rates. These numbers are far from conclusive…     

Source: Oil Market Report: International Energy Agency

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Conclusion: Causes of 2008 Oil Conclusion: Causes of 2008 Oil SpikeSpike

Hamilton Hamilton (2009)(2009) Primary causes:Primary causes:

Booming demand and stagnant productionBooming demand and stagnant production

Possible secondary factors:Possible secondary factors: Low interest ratesLow interest rates SpeculationSpeculation

When the global recession is over, When the global recession is over, the fundamental imbalance will return.the fundamental imbalance will return.

Thus the long-term and short-term may be linked:Thus the long-term and short-term may be linked: Malthus/Hotelling/Hubbert prediction of global scarcityMalthus/Hotelling/Hubbert prediction of global scarcity The 2008 price spikeThe 2008 price spike

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Addendum:Addendum:Are speculators bad?Are speculators bad?

Sure, speculators are important Sure, speculators are important in commodities markets.  in commodities markets.   The spot price of oil especially on a day-to-The spot price of oil especially on a day-to-

day basis, is determined in markets where day basis, is determined in markets where participants typically base their supply and participants typically base their supply and demand in part on their expectations of demand in part on their expectations of future increases or decreases in the price.    future increases or decreases in the price.   

That is speculation.  That is speculation.  But it need not imply But it need not imply

bubbles or destabilizing behavior.bubbles or destabilizing behavior.

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Are speculators bad?Are speculators bad? continuedcontinued

Speculators often fulfill useful functions:Speculators often fulfill useful functions: If they know the price is temporarily high, they If they know the price is temporarily high, they

sell short, thereby moderating today’s high price.sell short, thereby moderating today’s high price. If they have reason to think there will be a future If they have reason to think there will be a future

increase in demand, they go long, increase in demand, they go long, thereby driving up today’s low price and sending thereby driving up today’s low price and sending the market signal needed to spur investment.the market signal needed to spur investment.

In these cases they are the messenger delivering In these cases they are the messenger delivering the news about economics fundamentals.the news about economics fundamentals.

Admittedly, there are sometimes speculative Admittedly, there are sometimes speculative bubbles, a self-confirming movement of bubbles, a self-confirming movement of the market price away from fundamentals.the market price away from fundamentals.

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A story from the 1955 movie A story from the 1955 movie East of East of

Eden:Eden: The legendary James Dean plays Cal.  The legendary James Dean plays Cal.  Cal “goes long” in the market for beans, anticipating an Cal “goes long” in the market for beans, anticipating an

increase in demand if the USA enters World War I.  increase in demand if the USA enters World War I.  Sure enough, the price of beans goes sky high, Sure enough, the price of beans goes sky high,

Cal makes a bundle, and offers it to his father.  Cal makes a bundle, and offers it to his father.  But the father is morally offended by Cal’s speculation, But the father is morally offended by Cal’s speculation,

not wanting to profit from others’ misfortunes, and angrily not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.” tells him that he will have to “give the money back.” 

Cal has been the agent of Adam Smith’s famous invisible Cal has been the agent of Adam Smith’s famous invisible hand:   By betting on his hunch about the future, he has hand:   By betting on his hunch about the future, he has helped raise the price of beans in the present, thereby helped raise the price of beans in the present, thereby increasing the supply so that more is available increasing the supply so that more is available precisely when needed (by the British Army).  precisely when needed (by the British Army). 

The movie even treats us to a scene The movie even treats us to a scene in which Cal watches the beans grow, in which Cal watches the beans grow, which real-life speculators seldom get to do.which real-life speculators seldom get to do.

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In In GiantGiant, it’s oil that James , it’s oil that James Dean invests in, before World Dean invests in, before World War II again raises demandWar II again raises demand

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