Energy Economics – I Jeffrey Frankel Harpel Professor, Harvard University

1. Energy Economics – IJeffrey FrankelHarpel Professor, Harvard University ADA Summer School, Baku, Azerbaijan 7-9 July , 2010

2. (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?

3. To think about oil prices,a broad historical perspective is essential • From the vantage point of 2006, the last decade suggested a permanent upward trend. • Now, 2001-2009 looks like a classic bubble and crash.

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

5. Price of oil, 2001-2009Or was 2008 only a transitory spike?

6. (1) Long-term world oil price trend • (i) Determination of the price on world markets • (ii) The old “structuralist school” (Prebisch-Singer): • The hypothesis of a declining commodity price trend • (iii) Hypotheses of a rising price trend • Hotelling, non-renewable resources, & the interest rate • Malthusianism & the “peak oil” hypothesis • (iv) Empirical evidence • Statistical time series studies • Paul Ehrlich versus Julian Simon

7. (i) The determination of the export price on world markets • Developing countries tend to be smaller economically than major industrialized countries, and more likely to specialize in the exports of basic commodities like oil. • As a result, they are more likely to fit the small open economy model: • they can be regarded as price-takers, • not just for their import goods, • but for their export goods as well. • That is, the prices of their tradable goods are generally taken as given on world markets.

8. The determination of the export price on world marketscontinued • The price-taking assumption requires 3 conditions: • low monopoly power, • low trade barriers, • and intrinsic perfect substitutability in the commodity as between domestic and foreign producers – • a condition usually met by primary products • and usually not met by manufactured goods & services). • To be literal, not every barrel of oil is the same as every other and not all are traded in competitive markets. • But the assumption that most oil producers are price-takers holds relatively well.

9. A qualification: Monopoly power • Saudi Arabia does not satisfy the 1st condition, due to its large size in world oil markets. • If OPEC functioned effectively as a true cartel, then it would possess even more monopoly power in the aggregate. • However OPEC does not currently exercise much monopoly power beyond that of Saudi Arabia, • because so many non-members now produce oil and • because even OPEC members usually do not feel constrained to stay within assigned quotas.

10. The determination of the export price on world marketscontinued • To a first approximation, then, the local price of oil = ($ price on world markets) x (the exchange rate). • => a devaluation should push up the oil price quickly and in proportion • leaving aside pre-existing contracts • or export restrictions. • An upward revaluation of the currency should push down the price in proportion.

11. (ii) The old “structuralist school”Raul Prebisch (1950) & Hans Singer (1950) • The hypothesis: a declining long run trend inprices of mineral & agricultural products • relative to the prices of manufactured goods. • The theoretical reasoning: world demand for primary products is inelastic with respect to world income. • That is, for every 1 % increase in income, raw materials demand rises by less than 1%. • Engel’s Law, an (older) proposition: households spend a lower fraction of their income on basic necessities as they get richer. • Demand => P oil

12. Structuralists, continued • This hypothesis, if true, would imply that specializing in natural resources was a bad deal. • Mere “hewers of wood & drawers of water” would remain forever poor if they did not industrialize. • The policy implication of Prebisch: • developing countries should discourage international trade with tariffs, • to allow their domestic manufacturing sector to develop behind protective walls, • rather than exploiting their traditional comparative advantage in natural resources • as the classic theories of free trade would have it.

13. “Import Substitution Industrialization” policy (ISI) • was adopted in the 1950s, 60s and 70s • in most of Latin America and much of the rest of the developing world. • The fashion reverted in subsequent decades, however.

14. (iii) Hypotheses of rising trendsHotelling on depletable resources;Malthus on geometric population growth. • Persuasive theoretical arguments that we should expect oil prices to showan upward trend in the long run.

15. Assumptions for Hotelling model • (1) Non-perishable non-renewable resources: • Deposits in the earth’s crust are fixed in total supply and are gradually being depleted. • (2) Secure property rights: Whoever currently has claim to the resource can be confident that it will retain possession, • unless it sells to someone else, • who then has equally safe property rights. • This assumption excludes cases where warlords compete over physical possession of the resource. • It also excludes cases where private oil companies fear that their contracts might be abrogated or their holdings nationalized.

16. If property rights are not secure, • the current owner has a strong incentive to pump the oil quickly, • because it might never benefit if the oil is left in the ground. • That is one explanation for the sharp rise in oil prices from 1973 to 1979: • Western oil companies in the 1960s had anticipated that newly assertive developing countries would eventually nationalize the reserves within their borders, • and thus had kept prices low by pumping oil more quickly than if they been confident that their claims would remain valid indefinitely • until they indeed lost control in 1973.

17. Price of oil, 1900-2006Oil shocks 1 1973 Arab oil embargo 2. 1979 fall of Shah of Iran 3. 2008 spike

18. While we are on the subject of the 1970s oil shocks… • A more common explanation for the oil price increases of 1973-74 and 1979-80 is simply geopolitical disruptions: • Yom Kippur War and Arab Oil Embargo • Revolution in Iran and Fall of the Shah • Less common explanations: • Excessively easy monetary policy • coming from US Fed accommodation of Vietnam deficits • “The world is running out of oil.” • We consider both later.

19. One more assumption, to keep the Hotelling model simple: • (3) The fixed deposits are easily accessible: • the costs of exploration, development, & pumping are small compared to the value of the oil. • Hotelling (1931) deduced from these assumptions the theoretical principle: • the price of oil in the long run should rise at a rate equal to the interest rate.

20. King Abdullah of Saudi Arabia, with interest rates close to zero, apparently believes that the rate of return on oil reserves is higher if he doesn't pump than if he does: • "Let them remain in the ground for our children and grandchildren..." (April 12, 2008)

21. The Hotelling logic: • The owner chooses how much oil to pump • and how much to leave in the ground. • Whatever is pumped can be sold at today’s price (price-taker assumption) • and the proceeds invested in bank deposits • or US Treasury bills, which earn the current interest rate. • If the value of the oil in the ground is not expected to rise in the future, then the owner has an incentive to extract more of it today, so that he earns interest on the proceeds.

22. The Hotelling logic,continued: • As oil companies worldwide react in this way, they drive down the price of oil today, • below its perceived long-run level. • When the current price is below its long-run level, companies will expect the price to rise in the future. • Only when the expectation of future appreciation is sufficient to offset the interest rate will the oil market be in equilibrium. • Only then will oil companies be close to indifferent between pumping at a faster rate and a slower rate.

23. Hotelling,continued: • To say the oil price is expected to increase at the interest rate means that it should do so on average; • it does not mean that there won’t be price fluctuations above & below the trend. • The theory does imply that, averaging out short-term unexpected fluctuations, oil prices in the long term should rise at the interest rate.

24. If there are costs of extraction & storage?-- non-negligible costs (but assume constant) ? • then the trend in prices will be lower than the interest rate, by that amount. If there is a constant convenience yield from holding inventories? • then the trend in prices will be higher than the interest rate, by that amount. • The arbitrage equilibrium equation: E Δp oil = interest rate + costs – convenience yield

25. The upward trend idea is older than Hotelling. • It goes back to Thomas Malthus (1798)and the first fears of environmental scarcity: • Demand grows with population, • Supply does not. • What could be clearer in economics than the prediction that price will rise?

26. Over the two centuries since Malthus, • or the 70 years since Hotelling, • exploration & new technologies have increased the supply of oil at a pace that has roughly counteracted the increase in demand from growth in population & incomes.[1] [1]Krautkraemer(1998)andWright & Czelusta(2003, 2004, 2006).

27. Hubbert’s Peak – U.S. • Just because supply has always increased in the past does not necessarily mean it always will in the future. • In 1956, M. King Hubbert, an oil engineer, predicted that the flow supply of oil within the US would peak in the late 1960s and then decline permanently.

28. Hubbert’s Peak – U.S. • The prediction was based on a model • in which the fraction of the country’s reserves that has been discovered rises through time, • and data on the rates of discovery versus consumption are used to estimate the parameters in the model. • Unlike myriad other pessimistic forecasts, this one came true on schedule, • earning subsequent fame for its author: • U.S. oil output indeed peaked in the late 1960s.

29. Hubbert’s Peak – Global • Planet Earth is a much larger place than the USA, but it too is finite. • Some analysts have extrapolated Hubbert’s words & modeling approach to claim that the same pattern will follow for extraction of the world’s oil reserves. • Some claim the 2000-2008 run-up in oil prices confirmed a predicted global “Hubbert’s Peak.” [1] • It remains to be seen whether we are currently witnessing a peak in world oil production, • notwithstanding that forecasts of such peaks have proven erroneous in the past. [1] E.g., Deffeyes (2005).

30. Hubbert’s Peak – global HeatUSA.com blog

31. The complication: supply is not fixed. • True, at any point in time there is a certain stock of oil reserves that have been discovered. • But the historical pattern has long been that, as that stock is depleted, new reserves are found. • When the price goes up, it makes exploration & development profitable for deposits farther under the surface or underwater or in other hard-to-reach locations. • …especially as new technologies are developed for exploration & extraction.

32. The empirical evidence • With strong theoretical arguments on both sides, either for an upward trend or for a downward trend, it is an empirical question. • Terms of trade for commodity producers had • a slight up trend from 1870 to World War I, • a down trend in the inter-war period, • up in the 1970s, • down in the 1980s and 1990s, • and up in the first decade of the 21st century.

33. What is the overall statistical trend in commodity prices in the long run? • Some authors find a slight upward trend, • some a slight downward trend.[1] • The answer seems to depend, more than anything else, on the date of the end of the sample: • Studies written after the 1970s boom found an upward trend, • but those written after the 1980s found a downward trend, • even when both went back to the early 20th century. [1]Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington & Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Hadass & Williamson (2003), Reinhart & Wickham (1994), Kellard & Wohar (2005), Balagtas & Holt (2009) and Harvey, Kellard, Madsen & Wohar (2010).

34. What is the trend in the price of oil in particular? • 1869-1969: Downward • 1970-2010: Upward • The long run: Unclear ?

35. Price of oil, 1869-2009

36. Addendum 1: Malthusians vs. Cornucopians The wager of Paul Ehrlich against Julian Simon • Paul Ehrlich is a biologist, highly respected among scientists but with a history of sensationalist doomsday predictions regarding population, the environment, & resource scarcity. • Julian Simon was a libertarian economist, frustrated by the failure of the public to hold Malthusians accountable for the poor track record of their predictions. • In 1980, Simon publicly bet Ehrlich $1000 that the prices of 5 minerals would decline between then and 1990.

37. Malthusians vs. CornucopiansThe Ehrlich-Simon bet, continued • Ehrlich’s logic was Malthusian: • because supplies were fixed while growth of populations & economies would raise demand, the resulting scarcity would drive up prices. • He mentally extrapolated into the indefinite future what had been a strong rise in commodity prices over the preceding decade. • Simon’s logic is called cornucopian: • Yes, the future would repeat the past. • The relevant pattern from the past was not the ten-year trend, however, but rather a century of cycles: • resource scarcity does indeed drive up prices, whereupon supply, demand and, especially, technology, respond with a lag, driving the prices back down.

38. Malthusians vs. CornucopiansThe Ehrlich-Simon bet, continued • Simon won the bet handily: • Every one of the 5 real mineral prices in the basket declined over the next 10 years. • He was also right about the reasons: • In response to the high prices of 1980, new technologies came into use, buyers economized, and new producers entered the market.

39. The Ehrlic-vs.-Simon bet carries fascinating implications, • for Malthusians vs. Cornucopians, • environmentalists vs. economists, • extrapolationists versus contrarians, • and futurologists versus historians. • The main point: • Simple extrapolation of medium-term trends is foolish. • One must take a longer-term perspective. • Statisticians need as long a time series as possible.

40. However, one should avoid falling prey to either of two reductionist arguments at the philosophical poles of Mathusianism & cornucopianism. • On the one hand, the fact that the supply of minerals in the earth’s crust is a finite number, does not in itself justify the apocalyptic conclusion that we must necessarily run out. • As Sheik Yamani, the former Saudi oil minister, said, "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 oil.“ • Malthusians do not pay enough attention to the tendency for technological progress to ride to the rescue.

41. On the other hand, the fact that the Malthusian forecast has repeatedly been proven false in the past does not imply that it will always be so in the future. • One must seek, rather, a broad perspective, • in which all relevant reasoning & evidence are brought to bear in the balance.

42. (2) Short-term oil price volatilityand medium-term swings • Low short-run elasticities • Inventories moderate volatility • Cobweb cycle • Monetary influences • The 2008 spike • Speculators

43. Causes of Volatility • The market price of oil is volatile in the short run. • Because elasticities of supply & demand with respect to price are low, relatively small fluctuations in demand (due, for example, to weather) or in supply (due, for example, to disruptions) require a large change in price to re-equilibrate supply and demand. • Demand elasticities are low in the short run largely because the capital stock is designed to operate with a particular ratio of energy to output. • Supply elasticities are also often low in the short run because it takes time to adjust output.

44. High elasticities Low elasticities A given rise in demand causesa small price rise or a big price risewith with D D' S Poil Poil The increase in demand drives up the price D D' { S { Supply & demand for oil Supply & demand for oil

45. Volatility,continued • Inventories can cushion the short run impact of fluctuations, but they are limited in size. • There is a bit of scope to substitute across different fuels, even in the short run. • But this just means that the prices of oil, natural gas, and other fuels tend to experience their big medium-term swings together.

46. Volatility,continued • In the longer run, elasticities are far higher, bothon thedemand sideand thesupply side. • This dynamic was clearly at work in the oil price shocks of the 1970s – • quadrupling after the 1973 Arab oil embargo • doubling after the Iranian revolution of 1979, • which elicited relatively little consumer conservation or new supply sources in the short run, but a lot of both after a few years had passed.

47. Volatility,continued In the medium run, • people started insulating their houses and driving more fuel-efficient cars, • and oil deposits were discovered & developed in new countries. • This is a major reason why the real price of oil came back down in the 1980s-1990s.

48. Price of oil, 1970-2007

49. Volatility,continued In the medium term, oil may be subject to a cob-web cycle, due to the lags in response: • The initial market equilibrium is a high price; • the high price brings forth investment • and raises supply after some years, • which in turn leads to a new low price, • which discourages investment, • and thus reduces supply with a lag • and so on. • In theory, if people have rational expectations, they should look ahead to the next price cycle before making long-term investments in housing or drilling. • But the complete sequence of boom-bust-boom over the last 35 years looks suspiciously like a cobweb cycle nonetheless. 2 1 3 4

50. Monetary influences on oil prices • The same arbitrage equation that implies a positive long-run price trend also explains some shorter-run price swings. • The real price of oil should be unusually high during periods when real interest rates are low (e.g., due to easy monetary policy), • so that a poor expected future return to leaving the oil in the ground offsets the low interest rate. • By contrast, when real interest rates are high (e.g., due to tight monetary policy), current oil prices should lie below their long-run equilibrium, • because an expected future rate of price increase is needed in order to offset the high interest rate.