Market power, asset allocation, and oil prices
In response to a (somewhat ridiculous) proposal that we “sue OPEC” over high oil prices, Mark Thoma writes:
[I]t’s unlikely that [monopoly power] is the factor behind the run-up in prices. Monopoly power explains the level of prices, i.e. why price is $8 rather than $5, but it doesn’t explain the change in prices, i.e. why the price would change from $8 to $12. There are ways to tell this story, e.g. a war or some other event giving a cartel the cover it needs to raise prices and blame it on external factors, but I don’t think that’s what’s going on in oil markets today, at least I don’t think this is a significant factor behind the oil price increases.
I think there may have been a change over the last few years in the market power of oil producers, for structural reasons. Traditionally, OPEC has suffered from the usual problem that makes large cartels unwieldy: Under agreements to restrain production, members individually have an incentive to cheat and sell larger-than-agreed upon quantities at still artificially high prices. But that assumes that the production quotas are significantly beneath the capacity of most members to produce. More subtly, it also assumes that each country gains by producing more rather than less oil, if cartel prices are maintained. Both of those assumptions may no longer hold.
As the global oil market has grown, demand may have outpaced individual countries’ capacity to supply, either because investment in new projects has not kept pace, or because nations have hit domestic “peak oil”. (See Indonesia for an extreme example.) Other countries may desperately need money in order to fund current spending, so it is widely known they will produce as much as they can, regardless of quotas. Ironically, as long as the total capacity of sure-fire cheaters and constrained suppliers is well below global demand at the cartel’s target price, the certainty of their output may enhance the ability of discretionary producers to control the quantity produced.
It’d always be easier for a cartel of five or six producers to exercise market power than a cartel of, say, thirteen. But that’s especially true when cartel members have little incentive to cheat. Normally, we think of governments as spendthrifts, always eager to spend an extra dime unless constrained by tax revenues or debt markets. That’s obviously a mischaracterization of today’s most important oil producers, whose governments spend far less than the oil revenue they receive. For Saudi Arabia, selling a barrel more of oil is a portfolio choice: revenue from the marginal barrel will be saved, not spent, so the question becomes whether it is wise to shift some of the Kingdom’s current allocation out of oil and into some asset that can be purchased with currency. For countries that have very little non-oil savings, mere diversification would encourage oil sales. It is unwise to have all ones eggs in one basket, and oil producers remember all too well that world prices can go down as well as up. They’d want to store their national wealth in an “efficient portfolio”, one that maximizes their return on risk by including a variety of investments.
But as oil producing nations have accumulated vast reserves of financial assets, switching from oil-in-the ground to stocks, bonds, or bank accounts is no longer so sure a bet. Real interest rates on “safe” dollar assets are currently negative, both in US and home country terms, and the outlook for safe euro assets is uncertain at best. Central banks and sovereign wealth funds of oil-producing nations already hold hundreds of billions of dollars worth of Western financial assets. They might already have reached or exceeded what they view as an optimal allocation of their national wealth into these securities. Of course, producers are still not well diversified, and it’s pretty clear that sovereign wealth funds are looking for alternative assets that might hedge their exposure both to oil and Western paper. But allocating into less liquid, unfamiliar categories of assets is slow work if you want to do it well. Perhaps current oil revenues outstrip oil producers’ capacity to find good investment opportunities, and they view oil-in-the-ground as a better second-best asset than dollars in the bank.
Ten years ago, oil producers did not have vast hoards of dollars and euros, and required oil revenue to meet budgetary needs. World demand was low enough that cheating by OPEC members could corrode producer pricing. It was hard to exercise market power. Now, cheaters don’t matter, and discretionary producers may be indifferent or worse to the prospect of selling a barrel more of oil at current prices.
(In a sense you might not call this market power at all, as price equals marginal cost, that is to oil producers, the assets they can buy for the dollar price of a barrel of oil are worth no more to them than a barrel of oil left in the ground.)
Brad Setser recently noted that…
[T]here are two clear paths that could end the current “oil up, dollar down” pattern.
Weakness in the US economy could drag down global oil demand, pulling both the dollar and oil down. Asia’s 1997-98 crisis led both Asian currencies and the price of oil.
Or a rebound in the US economy could push up the dollar while adding to oil demand. In 2000, a booming US pushed up oil prices and the dollar.
Ironically, a strong, healthy US economy might also push oil prices down, even while increasing US and world demand for oil! The price of oil to discretionary producers is not measured in dollars, but in the future purchasing power of the assets dollars can buy. If oil producers expected US financial assets to appreciate in value more quickly than oil (in terms of what they want to buy), President Bush wouldn’t have to look anyone in they eye to get the producers to invest in new wells. However, if that’s not the case, then the rate of production might be determined more by the political costs of failing to produce than by world demand or current-dollar prices.
But… for US dollar assets to appreciate faster in oil-producer purchasing power than oil itself, those assets would have to represent claims (direct or indirect) on future goods that producers want to buy, that is investment in tradable goods and services. Unfortunately, Brad is probably right to suggest that a “rebound” in the US economy would drive oil prices up, since we’ve come to believe that more GDP is always better, sectoral composition doesn’t matter, and producing tradables is for the little people. Federal stimulus checks might give a zetz to GDP, but in and of themselves they do nothing to make claims on American assets worth buying.
So the long-awaited trashing of the greenback because of America’s twin deficits is happening… ten years after I told my students it would.
Ross Perot has put up a presentation on the U.S. fiscal situation at perotcharts.com. I was surprised to see that, prior to the Iraq War, Federal spending as a share of GDP was declining. The budget was last balanced at about T=G=~20% of GDP, and could be so again, if the tax cuts lapse and the war winds down. The problem of course is the growth of entitlements. But a trade deficit is lot more paletable to the markets if one’s fiscal house is in order.
Reading Mark Thoma’s nice citation on income inequality confirms what personal observation has led me to believe: that it’s a club or class effect among corporate looters, I mean, management, and the financial cognoscenti who share privileged information, these being the the hedge fund and other Wall Street wealth-thieves, that has created the current inequality. Ben Stein has railed about this admirably in The New York Times.
What to do? If the privileged are going to hog information and resources, the poor huddled masses of stiffed voters need to commandeer some of the tax revenues in redistributive transfers (including health benefits, which can be viewed as an investment).
If you believe that investment demand is primarily a derived demand, this redistribution to higher APC citizens will prime the pump. The top 0.1% will still be fine, although they will whine. And if everyone starts to save again, the trade deficit will moderate.
What about entitlements? Where will that money come from? U.S. defense spending is 7-8 times that of its nearest competitors, China and Russia, both of whom are facing severe domestic social and economic problems. And we spend stupidly, in the “last war” way, as has recently been pointed out by senior military officials. At this point, if we as Americans are going to defend our nation-state, we have to reconstitute a domestic social contract and a sane pattern of domestic demand. Some, like John Robb (Global Guerillas), think the game is over, the state already “hollowed out”–it’s every person for him- or herself. Find your gated community, or if you can’t afford that, buy a gun.
There are very strong coalitions with entrenched interests in the way things are that will oppose such reforms. They in effect are content to let the majority be serfs and to extract their rents. This is the social environment that breeds alienation and terrorist opposition. The Old Testament is full of warnings about a society ruled by the greedy.
The Obama-McCain contest is very much between old style liberalism and the glitzy winner-take-all conservatism since Reagan.
Possible countermeasures to an Obama victory that in my view would be consistent with past actions: start a war (bomb Iran) before the election; stage another domestic terrorist event; assassination, of the bodily or personality type; out-and-out voter fraud; or pull the rug (money) out from under the yellow-bellied folks in Congress. What Obama has shown, however, is that if you make it easy to give, i.e., on the Internet, the little people can produce a lot of money. There are darker scenarios that come to mind that I’m not going to mention.
The Internet rivals the printing press as the social invention that spreads truth to the masses, and is also a vehicle for social self-organization. I hope someone solves the spam problem, but I’ll take it, in return for the benefits of being able to access so much more knowledge and to put my money where my mouth is so quickly.
Interesting times.
June 19th, 2008 at 10:34 pm PDT
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Thank you for an excellent analysis!
June 19th, 2008 at 11:54 pm PDT
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Steve,
in a comment to a previous thread I expressed similar views:
“As far as oil is concerned I don’t see how people expect GCC countries not to cut supply.
Right now they have a huge trade surplus that end up tied in US dollar denominated debt. So they are depleting their reserve of real, non-renewable, universally usefull resource exchanging that for monetary reserves hold in doubtful debt denominated in a devaluating currency.
If I had oil reserves and I felt the need to keep reserves, I’d keep oil. Why pump it out at all once you can’t exchange it for anything useful.”
If your post today is even remotely inspired by that comment that would be personal iron cross in economics :)
June 20th, 2008 at 2:24 am PDT
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Also a factor – increased oil revenues make it more and more difficult for oil exporters to maintain dollar pegged exchange rates – reserve buildup creates domestic inflation pressures.
Too much money for them to handle both in terms of future dollar purchasing power and negative effects on their own currencies.
But holding back production increases the price of oil and oil revenues, which ironically may have excacerbated this “problem”. Price elasticity may actually reduce revenue at higher production levels.
June 20th, 2008 at 4:01 am PDT
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Steve,
It is possible that OPEC countries are thinking that it’s more valuable to leave some barrels of oil in the ground than to sell them for $130, and use the $130 to buy western stocks, but this appears to be a huge mistake.
First, there’s a gigantic time value of money issue. I don’t have time to research this, but I recall seeing estimates of how long the world oil supply will last of like 40 to 50+ years. Suppose it’s 40 years, then if the Saudi’s leave a barrel of oil in the ground today, instead of running out 40 years later, they will have that extra barrel in the ground and can sell it.
Let’s compare the two alternatives:
A) Sell the barrel of oil now, and get $130. Then, invest that $130 for 40 years.
B) Sell it 40 years from now.
Which will make them wealthier? It depends on the rate of return, and on the price of oil in 40 years.
Without loss of generality, let’s talk in terms of real returns. Suppose they invest the money in a diversified U.S. stock portfolio and get the historic average real return of about 7%. After 40 years the $140 they got for the barrel of oil in 2008 would grow to $1,947. Do you think the real price of oil will be $1,947 in 2048, or anywhere near that.
From what I’ve read, it looks likely that inexpensive plug-in hybrids and pure electrics will be the norm long before then, and hooked up to electricity supplied almost exclusively from nuclear, solar, and other non-oil sources. Scientific American has a great article by a noted scientist on a solar grand plan that would “supply 69 percent of the U.S.’s electricity and 35 percent of its total energy by 2050” for “$420 billion in subsidies from 2011 to 2050”. That’s a fraction of the cost of the Bush tax cuts for the rich over that period, tax cuts that John McCain wants to make permanent – Yes, more and bigger yachts and mansions would be better for the economy and the globe than a vast solar network. – I’m not saying you’re for that Steve; that’s just a general comment about disastrous Republican policies.
Suppose the stock market did worse than its historic average. First, note that according to Wharton Financial Economist Jeremy Siegel’s data set, between 1802 and 2006, stocks have never had a non-positive 20 year return period (Stocks for the Long Run, 4th edition, page 24). But suppose that theeal return over the next 40 years was just 3%; still, by 2048, that $130 from selling a barrel in 2008 would grow to $424.
And stocks are a great inflation hedge because they are claims on real assets. Moreover, over a period of 40 years, I would certainly expect purchasing power parity to approximately hold, at least in tradable goods.
So, if OPEC governments are savvy, it certainly doesn’t look like they would want to pump less than the amount of oil that maximizes revenue in the short term. It seems not qualitatively better than investing long term in gold instead than stocks. By the way, adjusting for inflation, a dollar invested in gold in 1802 grew to $1.95 in 2006. That same dollar invested in stocks grew to $755,163.00! (page 11 of Siegel’s book)
June 20th, 2008 at 4:51 am PDT
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People do what is in their best interest. American economist sometimes lose sight of this when they get too bogged down in their models.
We are scared to say it or admit in fear of increasing inflation expectations, but it is a monetary issue. We need to man up and admit it.
If you had all the dollars you wanted for current expenses and portfolio composition, what would be your bid for the next dollar? 0.1% barrel of Oil, 0.01% or 0.001%.
Very clear and timely post Steve.
June 20th, 2008 at 6:35 am PDT
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Steve:
I agree with you and have said so at my blog for months. If anyone believes buying 30-year US Treasury paper at 4.72% is a good deal, I have a nice bridge over the East River to sell him. Americans are myopic. Why should we believe the Saudis are stupid? Why should Saudis sell a real asset, oil, for a paper claim likely to repudiated? Does anyone remember Nixon’s embargo of soybean sales to Japan in 1973? I do.
June 20th, 2008 at 7:43 am PDT
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Interesting, thank you.
What do you think the impact of negative real rates is on the investment/portfolio preferences of the oil producers? I’d think it makes taking the stuff out of the ground in order to invest less attractive.
June 20th, 2008 at 7:54 am PDT
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Richard Serlin makes a good point about time value. But I suspect the relevant time interval is shorter than 40 years–the producers are waiting to see greenback “blood on the streets” before accepting any more. Once we have a new budget “vision” the dollar might bottom. Until then it’s like watching bank stocks, and wondering if the bottom is another 10% or 20% or 30% or 40% below today’s price (“feel my pain”)…. Let’s be honest: the only remedy our central bankers ever come up with for structural deficits is inflation….
June 20th, 2008 at 8:53 am PDT
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But Benign, the time interval is like 40 years. Voluntariliy keeping an extra barrel, or 1 billion barrels, in the ground now, has no effect on how much an OPEC country like Saudi Arabia could pull up and sell in 1 year, 5 years, 10 years, or 20 years. It only allows them to sell an extra barrel, or billion barrels, when they would otherwise have run out of oil in the ground, and the projections I have seen put that at like 40 years, maybe a lot more.
June 20th, 2008 at 10:48 am PDT
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Richard — If you believe that the world as described by Jeremy Siegel is a stable description of the future, regardless of how much anybody invests (and despite today’s monetary issues, the changing balance of international financial power, the changing structure of market, etc. etc.) then you’re absolutely right. By assumption, the best thing to do for any long-horizon investor is to put any dime she can scrounge into the stock market, QED.
I have lots of problems with Siegel’s story, even for less extreme cases than people with enough hundreds of billlions to invest that their pouring them in equities would impact expected equity returns. (I’ve been short broad US stock indices for years now, which Siegel would view as a kind of financial suicide.) I’ve gotta run, don’t have time to do a whole spiel on what I think is wrong with Siegel’s “Stocks for the Long Run” worldview. But… no one’s time horizon is 204 years long, institutional and geopolitical risks of stock investing have to be accounted for (yeah, stock markets that maintain continuity do well, but what if you’d invested in German, Japanese, Chinese markets in 1802, with a 1950 time horizon? Fixed time horizon analyses are always inaccurate, because they ignore the option value of discretion: that is long-time horizon exercises ought in general to show a premium, because you’d have to pay people to give up the right to withdraw early. Behaviorally, long time horizon investing through very extreme swings is implausible for human beings in aggregate. Some steel-bellied individual might have invested in 1920, held stoutly through the thirties, and come out better than bond investors etc by retirement in 1950. But the population of stock investors will not, we are leveraged financial (margin), operationally (we lose our jobs during the crash, and need to withdraw even though we know it’s bad timing), and behaviorally (a priori we were gonna buy and hold through anything, but I just can’t take it anymore!). Telling people they ought to invest as if they were the one steel-bellied investor capable of holding through the apocalypse when in fact most people will prove unable to hold through calamitous events is as bad as advising ordinary folks to choose undiversified portfolios, because if you are Warren Buffet it will make you rich.
I don’t think the case of oil producers is analogous to individual investors (they are not price takers, they are large enough to move markets), and I don’t think individual investors should be taking Jeremy Siegel’s advice right now.
The question of the time-horizon associated with a barrel of oil not taken today depends on the degree of discretion producers have in supply, given the rate at which they actually choose. As Richard points out, it’s implausible that this is perfect. If in general they plan to pump at the very maximum of their capacity to do so, a barrel not pumped today is effectively lost until the end of the life of the field. However, if in general producers do not pump full-throttle (and the premise of the piece is that some producers do not), then the time horizon becomes more flexible. If they are pumping at half capacity today and they forego a barrel of oil, then they absolutely can make it up next week. If they have opted to underdevelop a field, and are therefore foregoing half the output they could produce, they can time the extraction of barrels either by leaving it underdeveloped, or developing to the maximum technologically achievable capacity. In general, it’s inaccurate to say that producers have total discretion over the timing of extraction, but equally inaccurate to say they have no discretion in timing the extraction of foregone barrels. They face an optimization problem in terms of rate of extraction, in which the expected return on barrels extracted at any point in time would serve as a part of the “reward function”.
Alessandro — I get tons of valuable insights from commenters. I’m very fortunate to have you here. When I know I’m using an insight that I learned in comments (or anywhere else), I try to cite the source, but I read more than I remember what or where I’ve read, and am not as vigilant as I ought to be about tracking antecedents. You certainly have a gold medal (an iron cross sounds too harsh and martial) as far as I’m concerned, and my apologies if you felt underacknowledged. I really am lucky, and appreciate your thoughts and contributions.
June 20th, 2008 at 11:52 am PDT
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Richard – not sure I believe that producers are hyperopic or geekish enough to think that way.
In the short run the producers’ output decisions have social and political consequences elsewhere. They are tired of being paid in depreciating dollars. They may withhold oil to motivate us to clean up our fiscal act and demand patterns (as the Chinese are now doing with their prices). With Ireland’s thumbs down to the EU, I have to think the producers still would rather be paid in stable value dollars than Euro’s or yen–but the ECB is certainly trying to make the Euro an attractive alternative with threatened rate increases.
There is a chance that the central banks, having reflated together, raise rates together and throw the world into a big Debt Deflation Depression…. I hope not.
June 20th, 2008 at 12:08 pm PDT
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– if i can believe BP, global consumption has been slowing.
– if i can believe the IEA and EIA, global production has risen nicely over the last year.
– if i can believe the folks at oxford institute for energy studies, price formation is ‘market related’, i.e. centered in the futures markets.
– one might wonder about the efficiency of such relatively recent price regime.
June 20th, 2008 at 7:27 pm PDT
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Steve,
I agree that if all they care about is maximizing their own wealth, then they will optimize current revenue as monopolists which usually means withholding some supply.
But they would do it only to increase current revenues, not to save the oil for later because they think it’s better to hold as an asset for like 40 years, then the stock or other conventional assets they could have purchased instead.
And, if they hold the oil in the ground as a form of saving it as an asset, the only possible time horizon for that would be like 40 years. What if they say, oh I’ll hold it in the ground as an investment for just 1 year, then sell it in a year? What return would they get? In a year they should just still sell the optimal amount for a monopolist to maximize revenue, and in a year they would still have way more than enough from other oil in the ground to do that or to sell any feasible quantity, so that unit that they held aside as an investment would just sit there.
It would do the same thing next year, and the year after, and the year after. It would only make a difference and actually be sold in about 40 years when they ran out of other oil in the ground. So it would just sit and make no money for 40 years and then make it’s selling price 40 years later.
For that selling price to make even a paltry 1% real return, the real price of oil would have to go from $130 today to $194. And the odds are great that in 40 years, the price of oil will collapse due to the advance of substitute and efficiency technology. From what I’ve read, reliable sources, plug-in hybrids and pure electrics should become inexpensive and common in only like 20 years or less, pushing average global mileage per gallon into the hundreds, if not thousands. And for electricity, there’s nuclear, solar (see the Scientific American article mentioned in my previous post), coal (hopefully with carbon sequestering), etc.
Investing the $130 in keeping the barrel in the ground is a terrible idea. Yes, there is risk to stocks, but it’s reasonable. The risk to, as an investment, keeping that barrel of oil in the ground for 40 years is much greater than with stocks, and the expected return is much lower. Any conventional investment is much better than this. If I had to, I would estimate that the marginal revenue from an additional barrel of oil would have to be way below $130 for keeping it in the ground to be a good investment, way lower than the price will ever get.
With regard to how good an investment a diversified stock portfolio is over the long run, I’d say it is the best for any single asset class, not just due to the historical performance and the arguments of Siegel (not all of which I agree with), but due to a tremendous amount of other evidence, theory, and other logic, which would take about 50 pages to really explain well even at a basic level.
I would add that If you follow a balanced money plan (see Elizabeth Warrens book, “All Your Worth) or my INDV 102 course syllabus, it’s not that hard to sock away a substantial amount in a well diversified stock portfolio each month. The modern stock markets of the U.S. and Western Europe are quite different than the ones of 1950 and earlier. The odds of a communist takeover and expropriation or anything like that are virtually zero the U.S. and Western Europe. The odds of something like the great depression happening are very tiny with the learning, track record, and resulting support of Keynesian-type policies.
June 20th, 2008 at 7:52 pm PDT
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Also, with regard to heavy investing by OPEC pushing up demand for stocks and risk-adjusted returns down. First note that the world stock market is vast even relative to OPEC money, but also I have a working paper on the issue of whether a substantial increase in stock demand would push down risk-adjusted returns, or push them down much.
The main idea is that mostly due to the high prevelence of constant returns to scale in many productive proceses and endeavors, the supply curve of investment opportunities may be very long and flat even for amounts of stock investment much higher than today’s level.
I submitted it to the Economists’ Voice and it got super edited down to a letter.
June 20th, 2008 at 9:28 pm PDT
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Richard — We agree that discretionary producers might not produce at full capacity, as this fails even to maximize current revenue given monopoly power. Therefore, producers do have the capacity to market time.
Here’s where we disagree:
If I were a Saudi Arabian sheik, I would be very concerned about the likelihood of a major devaluation of Western currencies relative to the price of commodities and tradable goods. They have just watched their dollar assets lose almost half its value in Euro terms (which correlates more closely to their consumption than USD as they import much more from Europe than America). They see the United States has little capacity to fund its continuing tradables deficit, including its energy deficit, by any means other than devaluaing paper. If I’d just watched 70% of my portfolio devalue by ~40% (or much more, if we measure in non-energy commodity terms rather than Euro), I’d be spooked. If the “fundamentals” that led to the loss had not much changed, I’d look for a different investment strategy. Add to that serious political risk — we don’t generally love Saudi Arabian sheiks in the US, and in difficult times, we might fail to respect their property rights. (The “sue OPEC” proposal that indirectly inspired this article is fundamentally an excuse for putting a legal veneer on freezing oil producer assets if they don’t do what we want.) These concerns are very reasonable.
They’re investing locally as much as they can, and increasing their share of investment in Europe, but it’s not like Europeans are immune to self-interested xenophobia and finding ways of expropriating assets. Plus, Europe is in danger of either following the US into a trade deficit or combatting the trend with some form of protectionism or capital controls, none of which improve the comfort level of foreign investors.
Emerging Asia is an option, but it’s opaque, lacks a track record, and doesn’t pretend to have an ideology that would put the sanctity of capital ahead of domestic interests. Japan has a reputation for giving home-bias a good name, by virtue of how poorly foreign investors tend to fare. Oil producers are trying to invest in Asia more, but it’s hard work.
Oil-in-the-ground is suboptimal. Everyone, I think, would prefer the world you think we live in, where the best possible investments are claims on future enterprise. But given the level of economic and political uncertainty in the world, now is a time when many investors, individuals as well as petrostates, are adopting a wait-and-see attitude and trying to avoid big commitments. Perhaps we are wrong, but I think the Saudis agree with me, not that US and European financial assets are toast, but that their prospects are unusually unsure, and the cost of slowing production today (and potentially increasing it later) are small relative to the risks associated with gambling wrong in a “diversified” portfolio of financial assets.
If we muddle through this without any further large dislocations, your position will be vindicated ex post, as the oil underperforms equity going forward like it historically has. But the cost of a couple of years’ underperformance may be worth avoiding the risks many of us perceive (especially for Saudi oil sheiks) in present markets.
If the dollar and euro continue to fall relative to oil producer purchasing power as they have for the past few years, they will be better off having held the oil. Obviously if something much worse happens, a general depression combined with devaluation, conflict that results in asset freezes or expropriation, etc., they will be doubly glad to have kept oil in the ground.
You might object that, even if dollar and euro assets continue to devalue, as long as they stabilize within a few years from now, the time value of money combined with a long recovery period for the foregone oil would still put them out ahead producing now. That’s a very quantitative question. Even if oil producers produce no more at any moment then the revenue-maximizing quantity of oil, that doesn’t imply that foregone oil is deferred 40 years out. Oil fields are projected to hit various peaks much earlier than that. There may come a time much earlier when producers cannot offer the revenue maximizing quantity. Then foregone oil now doesn’t substitute for the last barrels of oil 40 years from on, but for an increased ability in over a shorter term to maintain ever more difficult production targets. There are a lot of moving parts here. How long do liquid financials continue to devalue, and for how much? For how long do discretionary producers have spare capacity at revenue maximizing rates, if they forego production today or decide not to. What’s the likelihood of a “sharp” loss, due to assets frozen under terrorism pretexts, or an extraterritorial application of anti-trust law, or whatever. Putting all that aside, what is oil producers’ portfolio risk tolerance in more ordinary times? (If they are very risk averse, holding oil is a perfectly performant choice, since a scarce commodity in expectation will appreciate at the real risk free interest rate. Your time value of money argument implies a risk/return tradeoff producers might prefer not to make even in stable times, if James Hamilton is right that scarcity rents that previously were ignored are now priced into oil. (If oil does as well as Treasuries, and that’s the financial asset you would buy, why bother to make the trade?) If they would buy risk assets, we need to make assumptions about how well those risk assets perform. Do we use historical US/European baselines? Recent emerging market growth rates? A diminishing return rate, as markets mature and equity premia diminish? Jeremy Siegel’s straight lines in long log graphs hide so much more than they reveal.
On the other side, there are of course risks to holding oil. I fully expect we will at some point find technical solutions that will render oil optional or obsolete, and an oil withholder must consider that risk as well. I’m not claiming there is no scenario or reasonable case for producing revenue maximizing quantities of oil. I’m just saying that there are also perfectly reasonable alternative scenarios, under which it is optimal to withhold production. If I were the wise (hah!) economic planner in a Gulf petrostate, nervousness about shifting wealth into already swollen Western bank and investment accounts would play a large role in my decisionmaking.
June 21st, 2008 at 12:39 am PDT
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I see no reference to the fact that the dollar price of oil has been increasing as the dollar has been falling. In fact the both the real dollar price and the real Euro price of oil have increased. So producers are being compensated for the depreciation of the dollar on current production.
As far as oil producer dollar reserves are concerned, the dollar price of US assets such as real estate has declined, and stocks may follow. Most dollar denominated reserves are invested in relatively low risk bonds. There is nothing that stipulates these reserves must be converted into goods and services over some specified time frame. They can be reallocated to riskier investment categories as they get cheaper. If reserves are underweight risky assets, opportunities to buy US assets more cheaply in dollar terms offset dollar depreciation to some degree.
Also, at the macro level, oil producers are not interested in foregoing production to the point that spiking prices cause tipping point demand destruction and global recession or depression.
June 21st, 2008 at 7:49 am PDT
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SW:
I agree with you about the Saudis. They figure no matter what returns the S&P will make in nominal dollars, they will be minimal, if not negative in real dollars, inflation adjusted dollars, by whatever adjustment factor they use. Further, they should not forget the US 1973 soybean embargo. When measured US inflation rates get high enough, who knows what the US will do? Nationalize all Saudi holdings of US assets? Are the Saudis oblivious to the idiots in Congress talking about a new windfall profits tax? If the Saudis asked me, and they haven’t, I would tell them: leave it in the ground! If you want to sell it, buy gold bars with the proceeds.
June 21st, 2008 at 3:13 pm PDT
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anon — No mention was made that the dollar cost of oil is rising as the dollar falls, because no claim was made that present low (in real terms) oil prices are hindering production. Oil prices, in dollar, Euro, even gold or grain terms have very clearly risen. If you want to purchase something today with your oil, there has never been a better time to sell.
However, the dollar depreciation has eaten at the value of oil already converted to dollar portfolio assets in a way not easily recovered. The question is, for those who have no present use of funds, what is the best way to move present wealth forward in time? This is a hard problem. Despite what finance professors tell you (sorry Richard!), it is always a hard problem.
Oil producers have absorbed great losses on portfolio assets by putting them into “safe” bonds. You implicitly suggest that oil producers could convert oil to cash to make themselves ready for opportunities in US real-estate or other assets. No argument. Perhaps there is a “convenience yield” to holding liquid dollar assets that offsets past and expected depreciation of the dollar. Perhaps not. It’s a reasonable, risky, active investing strategy, what you suggest. It might work. It might not. It requires a lot of investment skill to distinguish opportunities from scams while investing great quantities of money. Some oil producers might fancy themselves talented investors and look forward to profitable risks, others might be more concerned with safety. The latter would find little comfort in accumulating financial assets right now.
Non-liquidity constrained oil producers may have little to worry, from an economic perspective, from a global depression. If I’m right, and their existing menu of savings assets is unappetizing, a world depression might offer attractive opportunities of the sort that you describe, while oil in the ground serves as a reasonable store of value through the period. They wouldn’t dare, but from an economic perspective (and unrealistically in assuming no asset protectionism), a bear raid on the global economy might be a decent strategy. The Saudis absolutely do not need our demand right now. They have plenty of the dollars they could get from oil sales, more than they know what to do with. I’d argue the political costs of a worldwide depression, of potentially incurring the wrath of their American security sponsor, weigh on their minds far more than the economics of demand destruction.
The long-term risk to discretionary oil producers is technological change that permanently devalues oil-in-the-ground. That is what should, and probably does, keep those guys awake at night. As soon as they perceive new technologies might economically supplant oil, they’ll have every incentive to pump like there’s no tomorrow. Because, of course, then that will be true.
June 21st, 2008 at 3:51 pm PDT
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Steve,
Sorry, no time to comment on this. I’ve basically contemplated the question, To Blog or not to Blog, and found that it really takes up way too much time. At least for the next few years it’s probably better that I spend that kind of time on learning (more directly, certainly there’s some learning in blogging), research, papers, business, etc.
I was glad to learn about it and really enjoyed it, but now’s not the time for spending more than a small amount of occasional time on it. So you may not hear from me much, but if you’re ever in Tucson, please email me.
A parting note, Kruggie has some great posts today on oil speculation.
June 21st, 2008 at 5:58 pm PDT
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You’ve addressed the problem of strategy for oil producers in converting their oil reserves into financial reserves over time. Important variables include the expected dollar price of oil, the expected dollar return on financial assets, and the expected appreciation or depreciation of the dollar itself. Additional considerations include the effect of any strategy on the value of financial assets already accumulated and those projected for the future. Other questions include appropriate time horizon as well as the management of risk around all of these issues.
I think there is an additional and overarching dimension. This relates to the fact that most oil producers have pegged their currencies to the US dollar. Brad Setser has written that it makes little sense for oil producers to peg their currencies to the country with the world’s largest current account deficit. There are a number of alternatives; among those he has examined is the intriguing idea of pegging oil currencies to the price of oil. In the current environment, this and other alternatives would dampen the internal inflation pressures that have arisen from oil producers pegging to the dollar and encourage their current account adjustment by making dollar denominated imports considerably cheaper. It would assist with the global rebalancing Setser envisages as ultimately necessary.
So the overarching dimension to which I refer is broader current account adjustment amongst the oil exporters. You’ve essentially described current account adjustment in the limited but very deep sense of controlling the annuitization of oil reserves into exports of oil over time, thereby affecting the revenue side of the current account and the corresponding build up in financial assets over time. The build up of financial assets is the problematic question that opens up to the possibility of holding back oil in the ground instead of continuing to build financials at the current pace.
But the current account imbalance and the corresponding capital account build up is only partly determined by oil strategy. And the restriction of the problem to an examination of oil exports is incomplete in terms of addressing the guts of the US dollar asset glut problem. The other part is the pace at which the current account imbalance and the financial asset build up may be controlled by encouraging more imports of real goods and services.
So I’m saying that a Brad Setser type lens on the larger international balance of payments imbalances question as it applies to the oil exporters should really be included in the framework for your discussion about the release and export of oil reserves over time. This gives the problem solving process the full degrees of freedom it warrants. If the Gulf countries were to de-peg from the dollar, this would allow adjustment of their own currencies to encourage more imports and alleviate some of the pressure on the build up of additional (questionable) dollar assets over time.
I’m also saying that both the Gulf and China have contributed substantially to the dilemma they face with regards to the value of past and future accumulations of dollar assets by pegging their currencies to the dollar. This has impeded US current adjustment and contributed to the depreciation of the dollar. It should come as no surprise that the solution to the build up of dollar assets in the Gulf and elsewhere should include the macro escape valve of de-pegging from the dollar, as China has begun to do. This will allow for more orderly adjustment in the case of oil exporters and others, and in the case of the Gulf offers a more comprehensive economic platform from which to design strategy for the trade-off between current and future oil production as it affects current and capital account patterns for the future.
I also think your analysis has been most creative and fascinating. I’m just saying it might be expanded further by including this dimension within your overall framework. Then again, maybe you have already, and I’ve missed it.
June 21st, 2008 at 6:41 pm PDT
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“The long-term risk to discretionary oil producers is technological change that permanently devalues oil-in-the-ground. That is what should, and probably does, keep those guys awake at night. As soon as they perceive new technologies might economically supplant oil, they’ll have every incentive to pump like there’s no tomorrow. Because, of course, then that will be true.”
Steve, I have 1 word for you….PLASTICS
June 21st, 2008 at 7:07 pm PDT
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anon & Richard — I fear my responses may have been overly sharp, not in the sense of smart, but unnecessarily argumentative… I really appreciate the comments (the quality of people’s comments continually astonishes me), but tend to reply in quick bursts of overwhelming verbiage. That’s a conscious time-budgeting strategy on my part (I don’t much edit comments, it’s scrawl-and-post), but I fear I’ll piss of people whose conversation I enjoy.
Richard — I’ll do my best to goad you back into argument, but you’re right that blog-participation is a major time sink. I’ve found the benefits to be worth the cost, but the cost has been very large (and I periodically drop off the blogosphere in a crisis of things left undone, and sometimes neglect or drop out of comment threads).
JKH — I’m a huge Brad Setser fan, and agree that a broad balance-of-payments perspective gives an important and different view of the glut of petrostate financial assets. It’s interesting to compare, say the Gulf petrostates and China — Brad S follows on both, but they are quite different, I’d argue that China has a great deal more to close from demand destruction than petrostates do, because production foregone does not translates to nonperishahable assets retained, and because of social, political, and development expectations in China. A serious economic downturn without an international political dimension (if such a thing is possible) would be manageable for the petrostates, but might provoke a severe crisis in China.
Re Brad Setser’s suggestion that petrostates depeg, and potentially peg to a basket that includes oil, I wholly endorse it in theory, but am cynical it will happen prior to a crisis, for distributional reasons. As Brad has pointed out, there are distributional implications to depegging: the purchasing power that is eroding Gulf state workers’ buying power in the form of inflation is currently captured by the state and those who run it. Plus, the United States prefer the pegs be maintained, and petrostate rulers spend upon a US security guarantee. I don’t see an incentive to change, except an internal crisis (that would probably have to include unrest among imported workers, who I think get the rawest end of the deal, taking payment in local currency or dollars but not receiving any of the sinecures available to citizens).
In terms of what I’ve written above, pegging local currency to oil, or otherwise provoking an appreciation re the dollar simply amounts in a shift from aggregate savings to aggregate spending. That is, workers whose real wages have suffered would gain purchasing power, and these being poorer people, they would probably use that purchasing power to buy stuff. As Brad hopes, this should help bring petrostate surpluses towards balance (as workers purchase imports). That spending would reduce the funds available for investing, and might thereby undo the logic of my argument above. As the sums the state has to invest converges towards the scale of investment opportunities managers expect will outperform oil (risk adjusted, as additions to their existing portfolio), the state has more incentive to pump and less reason to hold back. In other words, as Brad suggests, things would become more normal: prosperity would be broadly shared, more people would live better, and state oil cos would have incentive to produce.
Everyone would be happier, if the petrostates depegged, except the US Treasury secretary (who wants continued funding for the US current account deficit), and the rulers of Gulf states, who would give wealth away to citizens and foreign workers that currently they are able to keep. If the world had listened to Brad in 2005, we’d be in a much better place today. But Brad’s achilles heel, I think, has always been the politics: he gets the the “global good” exactly right every time, but can’t persuade politicians that they’re incentives are aligned with that global good.
Brad DeLong once referred to Setser &Roubini as “false Cassandras” (on a syllabus he posted). I think history will look back on them (and especially Brad, who has been tireless, datacentric, and measured throughout a years-long quixotic enterprise) as true Cassandras, as people who warned of very real dangers, people who desperately ought to have been listened to, but were not, to all of our peril.
June 21st, 2008 at 7:56 pm PDT
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SW:
I haven’t read anything by Brad DeLong in a year. Why? I think he’s another guy with a PhD who has nothing to say.
June 22nd, 2008 at 8:09 am PDT
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«the historic average real return of about 7%.»
Please please don’t joke. Has the stock market in the USA been growing faster than GNP for a couple hundred years? That would be miraculous.
7% is ridiculous, it means a doubling in real terms in 10 years. Let’s say that the best real returns you can get are around 3% per year over several decades (considering real inflation level, survivor bias, …).
«But suppose that theeal return over the next 40 years was just 3%; still, by 2048, that $130 from selling a barrel in 2008 would grow to $424.»
Looks pretty good here.
«But Benign, the time interval is like 40 years. Voluntariliy keeping an extra barrel, or 1 billion barrels, in the ground now, has no effect on how much an OPEC country like Saudi Arabia could pull up and sell in 1 year, 5 years, 10 years, or 20 years. It only allows them to sell an extra barrel, or billion barrels, when they would otherwise have run out of oil in the ground, and the projections I have seen put that at like 40 years, maybe a lot more.»
Here this argument disregards three important subjects:
* That some OPEC members seem to have rather inflated for political reasons their reserve figures, They know that they did though, but we can only guess.
* That many oil producing countries have built substantial infrastructures based on oil, and the time period over which to depreciate them matters. Even if the world switched to a hydrogen economy in 20 years time, it may very well be worthwhile for the Saudis to keep their oil based system, as they got oil for “free”, and invested quite a bit in an oil based economy.
Overall the best strategy for the oil producers is to sell as little oil as possible to increase its scarcity at any one point, but not to the point that developing and installing a non-oil based infrastructure is obviously profitable for their clients.
I would think that right now the price is high but not yet over the critical threshold, so the oil producers should not pump faster.
June 22nd, 2008 at 11:43 am PDT
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groucho — Ha!
More seriously, petrochemicals are an important part of the picture (in my youth I studied organic chemistry, and it struck me as sacrilege somehow that we burned so much of the raw material from which every cool chemical was made). But, new energy technologies would be sufficient to seriously devalue current oil reserves.
Eventually, the human species will have to take responsibility for the whole carbon cycle. CO2 is convertible to petrochemicals, for plastics, drugs, or fuel. Whether by augmenting natural photosynthesis (e.g. culturing algae in vast petrie dishes built in deserts) or by finding other energy producing processes, we can reduce carbon from CO2 and carbonates back to useful organics. If our collective future is bright (a big if, sure, but I’m hopeful), we’ll find both new energy sources and means of actively managing the full carbon cycle.
June 22nd, 2008 at 11:50 am PDT
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IA — I wonder if oil producers are buying gold bars with the proceeds, or metals or other long-term-storable commodities. They’d have to buy physical — exposure through futures markets leaves them exposed to risks correlated with their financial portfolio. And they’d have to be quiet about it — “hoarding” commodities (especially industrial rather than merely monetary commodities) is often seen as impolitic, and invites confiscation by force over the longer term.
Blissex — I think you’ve got it right. The main threat to oil producers from hardship among consumers are political (you know, oil politics have contributed to wars getting started) and structural (consumers could find alternatives to oil). Those are the forces that push production levels higher. Conditional on success in preventing the emergence of a competitive technology, portfolio considerations currently put a damper on production, at least relative to the recent past (not long ago, producers really needed to pump to support current consumption), and quite possibly in absolute terms. It’s still a tricky dance for them.
(I would prefer they overreach by underproducing than that they be persuaded to maximize output, and yet again undermine the market for alternatives.)
June 22nd, 2008 at 12:04 pm PDT
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«I haven’t read anything by Brad DeLong in a year. Why? I think he’s another guy with a PhD who has nothing to say.»
Probably he has a lot to say probably, and sometimes he betrays himself :-). But I guess that he has learned that if he wants to have a public career (and he seems determined) he had better not say excessively controversial things and go with the flow. Just like the Democratic leadership, who realize that the culture wars have been won by the Republicans as the irish-american and italian-american communities have become fully-vested conservatives.
June 22nd, 2008 at 12:09 pm PDT
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«I think you’ve got it right. The main threat to oil producers from hardship among consumers are political (you know, oil politics have contributed to wars getting started) and structural (consumers could find alternatives to oil).»
As to the political side, as someone else I think pointed out, at 3% over 40 years oil at $424 is entirely in their political and military control (in the sense of asset denial: they can blow up the oilfields if threatened with loss of control), and they can trust that, a few trillions dollars of foreign IOUs are not equally safe under their control.
If I was a Saudi ruler I would weight pretty heavily my chances with keeping oil under ground in my absolute control versus having a stack of IOUs from foreign governments and business… Sovereign risk is a big deal, and black swans happen.
June 22nd, 2008 at 12:18 pm PDT
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«I wonder if oil producers are buying gold bars with the proceeds, or metals or other long-term-storable commodities. They’d have to buy physical — exposure through futures markets leaves them exposed to risks correlated with their financial portfolio.»
Well, converting one commodity under the ground to another may just be a bit of hedging on the possible fortunes of the two commodities, but does not make a lot of difference.
Usually the best thing that commodity producers can do is to convert most of money from sales of commodities to capital investment in their own human and physical infrastructure, as those are long term investments that depreciate slowly. Their own human and physical infrastructure is also directly under their political and military control, eliminating a large amount of political risk.
It is a bit sad that instead the Saudi princes have invested such a large part of their country’s oil revenues in current expenditure to finance a colossal population explosion, to buy the political acquiescence of all those proud male family heads. I suspect that will cause a lot of trouble in the next century, and not just for Saudi Arabia.
June 22nd, 2008 at 12:25 pm PDT
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Steve, thanks for filling in some of the steps in my hurried comments (depreciating assets vs. depreciating currency).
Richard, a depression could happen in the USA. On major dimensions the economy resembles 1929’s: large debt overhang, great wealth and income inequality, falling standards of living for most households. I know (as a former college professor) that this is politically incorrect to say… but never say never.
While an oil price in a currency basket is appealing intellectually, in the short run the euro and greenback will probably jockey for reserve currency status, which confers benefits. I read that the markets are pricing in rate increases for both. Then contraction… then hyperinflation? Who knows.
Finally, it’s clear that the issues we all enjoy ventilating about at such length are multi-dimensional, and I’ll again refer those interested in a larger perspective written by a couple of Beltway economists to Strauss &Howe’s The Fourth Turning. In the mid-Nineties, they forecast a transition into a Crisis generation in the early 2000s, with a probable depression after 2010, and the risk of world war in 2020.
I do think the petrostates learned in the 1970s crisis that they are critically dependent on the economic health of their customer states, so I am optimistic that they would provide oil as cheaply as is reasonable in a gathering depression.
The physicists have been writing about the transition at end of “the growth era” of human history. See arXiv:cond-mat/0002075v4 , which deals with a singularity in human history forecast to occur within the next few decades (not the AI singularity). I dig the econophysics literature.
Humankind must learn to live in a more stable state, resource-wise. The current rates of growth are unsustainable (actually lead to a mathematical singularity).
We can make this transition peacefully or not.
June 22nd, 2008 at 9:54 pm PDT
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Here’s the link to Johannson and Sornette, Finite-time singularity in the dynamics of the world population, economic and financial indices
June 23rd, 2008 at 10:19 am PDT
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I agree with Blissex…the only reason the Suadis are going to pump more oil is to ease pressure for us to find alternatives. I think the dye has been cast and it’s too late though. Everyone is talking about alternatives or drilling our own reserves. It’s almost like their greed was there own undoing.
For their sake I hope the’re invested in something other than oil in the ground. They have no agriculture or other natural resources except sand. What are they going to do in 40 years when their oil is run out? Hah I say what are they going to do in 10-15 years when we’re not dependant on there oil and there’s a world surplus.
June 23rd, 2008 at 2:18 pm PDT
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Blissex, real stock market total returns in the US were about 6.3% per annum from 1900-2005 (geometric average, from ABN Amro global investment yearbook). About half of this is capital growth and half reinvested dividends. It’s not at all implausible that your portfolio grows faster than the overall economy if you reinvest all your earnings instead of consuming them. Of course, you’ll have to avoid paying any tax to do this.
June 25th, 2008 at 11:31 pm PDT
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