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Some observers think that speculation is the cause of the escalating oil price – an escalation that, as I have pointed out in many lectures and publications (e.g. 2007), is capable of cutting the ground out from under the international macroeconomy. Put another way, these ‘pundits’ (= self-appointed experts) believe that we are dealing with a bubble, which is a price movement unsupported by fundamentals.
Among the gentlemen claiming that excessive speculation is responsible for the bad oil news being experienced by the buy side of that market, are the billionaire financier Mr George Soros (who admits that he is not an oil market expert, and that the oil price bubble has strong fundamental underpinnings), the influential television personality Mr Bill O’Reilly, and Lord Megnad Desai, who is a professor of economics at the London School of Economics. Many years ago Lord Desai and myself had a disagreement about the price of copper that terminated in the select learned journal Econometrica. I don’t recall how the referees ruled on that dispute, although I do remember that with copper – as at present with oil – I took great care to avoid making embarrassing mistakes.
Nor do I intend to make one here. The steadily rising oil price that we have witnessed of late is basically explained by the relation between ‘flow’ supply and ‘flow’ demand, where the term ‘flow’ will be explained in the next section: with or without speculation the result would be almost the same. What has happened – as you know as well as I – is that ‘normal’ demand is tending to outrun ‘normal’ supply, causing a fundamental supply-demand imbalance that is independent of speculative activities. This keeps inventories below the desired level, and leads to the earlier rather than later production of a certain quantity of oil, although later production could reduce the present value of intertemporal production costs by allowing a less intensive exploitation of high cost deposits. (Among other things, this might lower the rental rate for some production equipment, as well as reduce ‘overtime’ costs for employees.)
It should not be denied however that the financial market is now playing a more meaningful role than usual in the forming of (oil price) expectations, which is largely due to the price of this crucially important commodity rising higher and/or faster than the great majority of observers thought possible. The result is the oil price being observed and thought about much more intensely than before. This mention of very close observation brings to mind Werner Heisenberg’s uncertainty theory which, employed in financial economics rather than physics, means that false signals are often generated. For instance, when the influential oil investor T. Boone Pickens stated that oil could surge to $150/b, prices immediately moved higher. This display of respect for Mr Pickens’ acumen was impressive, although the term ‘over-reaction’ immediately flashed through my brain.
I don’t know if Lord Desai is familiar with enough academic energy economics to understand what is going on in and around the oil market today, but I am sure that George Soros has a superior insight, and Mr O’Reilly is probably ready to claim that he deserves to be honoured for merely taking an interest in the topic. For instance, in l992 Mr Soros was responsible for a magnificently correct bet that the British government would be forced to devalue sterling. Ostensibly, Soros’ Quantum Group of hedge funds had ten billion dollars on the table, and London wine-bar gossip then and later was prone to claim that a billion of the resulting windfall ended up in Mr Soros’ pocket.
Mr O’Reilly, of course, does not operate at those heights, but not too long ago he blamed “little guys in Las Vegas” for high oil (and motor fuel) prices. As Tina Turner might say, ‘what’s Las Vegas got to do with it’, in that he not only was completely wrong, but expressing himself in that carefree manner would hardly endear him to more sophisticated members of his congregation. Similarly, Senator Joseph Lieberman was considerably out of his depth when (in l990) he asserted that “It’s startling to think of oil prices being set by young guys on the floor of the exchange screaming at each other on the basis of rumours’. Actually, it is so non-startling that ten years later, when Lieberman was Senator Al Gore’s running mate in the U.S. presidential election, I forgot my allegiance to the Democratic Party and didn’t bother to exercise my franchise.
A more important person on the oil price scene is Abdullah el-Badri, secretary-general of the Organization of Petroleum Exporting Countries (OPEC), who last month summarized his thinking on the oil price by saying “The market is really crazy”. In a broad sense this is absolutely correct, because much of the craziness originates with politicians and civil servants in the oil importing countries, who until recently believed that OPEC would never get its act together, and as a result the oil price was destined to go south rather than north. If anything this incoherent behaviour has intensified, since as will argued below, there is a bizarre craving to believe that the OPEC countries would really and truly like to see lower oil prices. What they should believe is that very high oil prices provide these countries with the wherewithal to continue the diversification of their economies ‘out’ of the export of crude oil (and possibly gas).
The chairman of BP (British Petroleum) offered some quaint remarks on this state of affairs recently in Stockholm, saying that “the (present) oil price has an influence on the world economy that is not positive. To deny this is silly.” As Dave Cohen, who writes the weekly column for ASPO-USA (http.//www.aspo-usa.com) has pointed out though, the denial club still has many members.
WHAT THEY SHOULD AND COULD HAVE TAUGHT YOU IN ECON 101 ABOUT THE PRICING OF OIL
What I want to do now is to systematize, on a very elementary technical level, the most important aspect of short-run pricing in the oil market, even if it has been claimed that oil traders are altering their views and focus on the oil markets, shifting from short-term to long-term. This is not entirely false. You already know something about this topic if you are a careful reader of the financial press, or have watched BLOOMBERG and perhaps Fox News instead of the daytime soap operas. In elaborating on this matter the present section also contains an original diagram that I forced on first year economics and finance students in Sweden. It taught them something about short-term commodity pricing, which in some cases enabled them to feel a cut above their colleagues.
A few years ago, in the Financial Times (November 4, 2004), the commodities page contained the following information. “Crude oil futures moved lower in volatile trade, following a large increase in U.S. commercial crude inventories, signalling that the oil market is well supplied.” Let’s put this statement in equation form: the change in price (?p) of physical oil is a function of the difference between desired inventories (DI), and actual inventories (AI). If that equation is linear, then we could write ?p = ?(DI – AI), where ? (or ‘lambda’) is a constant, and ?p (‘delta’ p) is the change in price. I wouldn’t be surprised if I could explain this simple relationship to the students at the secondary school I attended in Chicago – which, at that time, was one of the worst in the U.S.
Both CNN and Bloomberg – especially the latter – constantly mention inventories, but without explicitly referring to a relationship of the type presented above. That expression is also completely absent from mainstream microeconomics textbooks, and the same is true of most books on energy economics. This is one of the reasons why many academic discussions of the oil and gas markets are without any scientific value.
We are now going to work our way up to the above equation again, and in the course of doing so look at my diagram. This diagram, which at first glance may appear difficult, is actually extremely simple. It is so simple that it should be examined by all readers, but if they judge it too abstract they can go to the next section in this paper! I can mention that graduate students in my course in oil and gas economics in Bangkok who could not reproduce and thoroughly discuss this diagram in the final examination were assured of a failing grade, and a similar promise was made to my first term, first year (i.e. Econ 101) students at the universities of Stockholm and Uppsala.
To begin however, I slightly extend the above discussion. Oil inventories (i.e. oil stocks) are a stock concept : they are defined in e.g. barrels, and measured at a certain point in time, but they lack a time dimension. They have been designated AI and DI. On the other hand, current production (s) and demand (h) are flow concepts: they are defined and measured in terms of a certain unit of time (e.g. million barrels of oil per day (= mb/d). Microconomics 101 deals almost exclusively with flow variables.
Stocks and flows are closely related, since the change in stocks is determine by the net investment (or disinvestment) in stocks during a given period, or s – h: i.e. flow supply (s) minus flow demand (h). Moreover, in this model we define that famous concept equilibrium as the situation where desired stocks (DI) are equal to actual stocks (DI = AI), and the resulting ‘state of rest’ (i.e. equilibrium) is characterized by ?p = 0.
But if the stock market is out of equilibrium, e.g. DI > AI (because of expectations about present or future demand), then in the flow market we must have s > h in order to close the (DI – AI) gap. To obtain s > h, price must increase: the increased price raises flow supply (s) while decreasing flow demand (h). The size of (s – h) says something about how rapidly inventory holders want additional inventories. Hopefully, in the analysis, DI will eventually equal AI, and ?p = 0. Please note that the equation, ?p =?(DI – AI), or pt+1 – pt = ?(DI – AI), is a simple linear relationship between excess stock demand and the price change, assuming ? is a constant. Now let us look at the diagram.
The current (or flow) supply (s) goes into stocks (i.e. inventories) and current (i.e. flow) demand (h). Price is formed by the relation of actual stocks (AI) to desired stocks (DI), with the flows playing a secondary (but important) role. The equilibrium expression is AI = DI, and when this situation prevails, s = h, and price is constant (i.e. ?p = 0)! Put another way, a stock equilibrium implies a flow equilibrium, while a flow equilibrium does not imply a stock equilibrium. In this type of model expectations are very important because of their influence on desired stocks, and futures (i.e. paper) prices have some influence in forming price expectations in the physical market. Expected prices are undoubtedly more difficult to describe than via the simple implicit expression shown in the figure – i.e. pe = f(p) – but the main thing to recognize is the non-trivial role of expectations in determining the oil price, even if it was only when the oil price moved past $100/b that they received their true weight in the scheme of things.
Students of electrical engineering should immediately note that the diagram (with its feed-back ‘circuit’ p?DI) takes on the appearance of a servomechanism, in which case very high volatility is perfectly natural. This volatility is one of the reasons why futures and options markets for oil are so important, because they have permitted buyers and many sellers to hedge price uncertainty. For example, even though price spikes might be narrow, there are times when they can ruin unhedged buyers or sellers.
That immediately insinuates that a few comments about oil futures markets are justified. In l980 the volatility of physical oil prices became so large that a futures market became attractive to speculators as well as dealers in physical oil. For instance, , there was a decreased propensity by some categories of the latter to hold inventories as a precaution against having to buy in a rising market. Instead, individuals and firms requiring oil in the future bought a number of futures contracts, which (as explained in my textbooks) enabled them to lock in the existing oil price. Later they went into the spot market to buy their oil, while at the same time making an offsetting sale of futures contracts. The markets for oil options and oil futures-options also functioned well. Without going into detail, the presence of these derivative markets contributed to restraining rather than increasing the price of oil, since they reduced the risks faced by buyer and sellers. They upgrade market efficiency by providing an increase in the quality and quantity of information and, as noted once by Professor Lester Telser, “they facilitate trade among strangers”. Well, so do some of the bars near the university where he teaches, but perhaps that subject belongs in another scientific discussion.
Then why has the oil price been lingering around $130/b for the last few weeks? To begin, it is not “little guys” in Las Vegas or big guys at the New York Mercantile Exchange (Nymex) or the International Petroleum Exchange (in London) who are responsible, but changes that have taken place in the actual movement over time of (FLOW) supply and demand, as well as the expected movement (which is influenced to some extent by the price of futures – i.e. paper oil).. As we all are aware, expectations about the long run price are greatly influenced by the rapidly increasing demand of China and a few other countries, as well as the steadily increasing demand of many other countries (to include countries that are large producers and exporters of oil), and movements in short run prices. The latter now helps to emphasize the slow growth of readily accessible conventional and non-conventional oil supplies – the simple fact that the supply response is no longer as flexible/spontaneous as it once was.
Barbara Lewis, in the International Herald Tribune (May 23, 2008), says that the change has been indicated by “record-high oil prices for (futures) contracts stretching out to 2016”. This statement is incorrect, because anybody who possesses a practical knowledge of the futures market would make a point of avoiding contracts of that maturity (8 years), for which there is hardly any liquidity, and therefore the price of the contract might be very unfavourable when the position is closed. This matter of liquidity and maturities should never be overlooked by serious students.
SPECULATION OR FUNDAMENTALS?
Speculation means that there are some aspects of a bubble present. By way of broaching this subject it might be useful to consider three famous bubbles, of which two were all bubble, or ‘extreme’ phenomena, and the third largely but not entirely bubble. I am thinking of the South Sea Bubble (‘An unnamed venture that will bring great riches’), and the Tulip Bubble (‘Buying and selling simple tulips for fantastic prices’) for the first two, and the 1929 stock-market crash for the third. My international finance book (2001), and GOOGLE can tell you about these. The bottom line in all three was mass irrationality and excess greed that the market eventually identified and punished. This suggests that in the long run, on average, markets are more intelligent than individuals, and because of technological progress the long run is now much shorter.
What is going on in the oil market just now is no bubble, because if it was the market would have found out, and the bubble component of the oil price would have been liquidated. Instead, oil should be judged scarce on the basis of scientific predictions of the amount that will be demanded at both now and in the future, as well as the optimal behaviour of the major oil producers – by which I mean ‘Big Oil’ as well as big producers in e.g. the Middle East. It is easy to give the illusion of an unstoppable ‘bull’ market if there is a deluge of speculative buying at the right time, as Edward Morse (of Lehman Bros.) said took place recently, but if oil prices did not feature an extensive fundamental component (or ‘base’), then if this buying weakens, as occasionally takes place, the price should rapidly decline. This hasn’t happened, because in considering fundamentals, if buying slackens, the producers of oil in the Middle East have the means and probably the intention to keep the price up by ‘adjusting’ supply.
They definitely have the means, but suppose that in reality they do not have this intention. Speaking as a teacher of economics and finance, I would advise my political masters to always assume that they do have this intention until they obtain irrefutable proof that such is not the case, because the kind of economics that I study and teach leads me to insist that, theoretically, adjusting supply in such a manner as to keep the dollars rolling in makes all the sense in the world. For instance, at the Jeddah Summit that just ended, the oil minister of Saudi Arabia said that his country would not just raise output by several hundred thousand barrels per day, but achieve a total production of 12.5 mb/d by the end of next year. This may indeed be so, but it will not be sustainable production: instead, if it happens, 2 million (or more) of this will be due to surge capacity (that can only be maintained a short period of time).
In claiming that there is no predominant bubble or scam in the oil market, I am also claiming that there is no irregular amount of speculation in this market. There is instead an evolving supply crunch, that features a disappointing non-OPEC supply. But if this is so, why would people like George Soros and (Professor) Lord Desai come to another conclusion?
George Soros already has many billions of dollars, and if he makes the right bets on oil, he can easily pick up some extra lunch money. The right bet that I am thinking of is the one made after convincing other players that insightful speculation by high achievers (like themselves) could result in amassing more ‘green’ then, for example, the confused amateurs who rushed into Nymex a few weeks ago to buy long-term contracts for reasons that even a veteran psychologist would find it hard to comprehend. As most of those punters will soon discover, their net worth might never measure up to that of Mr Soros and his colleagues who, despite appearances, bet fundamentals rather than rumours or headlines.
What about Lord Desai? In a column written for the Financial Times, he informs his admirers that the oil market bubble must be “pricked” before it results in some ugly macroeconomic damage. His recipe for dealing with this issue is for the (futures) market’s clearing house to increase margin – or ‘security deposits’ – for all transactions in order to squeeze open interest, which he sees as a measure of speculation.
Normally I would hesitate before commenting on this suggestion, but not on the present occasion. It is theoretically possible – though unlikely – to have a very high open interest in a market without any speculation at all! Furthermore, ceteris paribus, squeezing open interest would reduce liquidity, and thus could make it more difficult for traders in physical commodities (i.e. non-speculators) to hedge price risk. Desai is also upset by the growing tendency to deal in contracts with a maturity of e.g. 8 years. I can’t understand why, because on the basis of the open interest statistics now available, a market with an 8 year maturity is almost totally illiquid, and therefore is strictly for chumps. The oil futures market was and is a short term hedging and speculation tool.
In a Business Week article (January 21, 2008), it was stated that six Gulf States control sovereign wealth fund assets of about $1.7 trillion – or as much as all the hedge funds in the world. I consider the importance of hedge funds largely a dramatic myth where influencing the global macroeconomy is concerned, however I am prepared to admit that something that cannot be disregarded is the ability of money generated in that part of the world to influence the price of oil. This is not the place to provide a comprehensive resumé of that issue, although I will say again that (ceteris paribus) the higher the oil price, the greater will be the pace of diversification (into e.g. refining, petrochemicals and tourism) by the major oil and gas producers of the Gulf (and Russia); and the more rapid this diversification, the more modest will be the intentions and effort to produce and export larger amounts of oil and gas. For readers who intend to make a thorough study of oil market fundamentals, this should never be forgotten.
“I don’t think this is about financial investors,” the U.S. Treasury secretary said a few weeks ago. “It’s about long-term supply and demand.” Analysts at Barclays Capital and the Commodity Futures Trading Commission think likewise. And, as quoted by Barbara Lewis, Olivier Jacob of Petromax said that “The fundamentals rule, but the question is whether the futures market should reflect the fundamentals of the next few months or the next few years.” It may be a question to him but not to me: after six months, and often less, the decline in liquidity in a futures market is precipitous, and longer maturities should be avoided. But recklessness and ignorance aside, the fundamentals have always ruled in paper (i.e. futures) as well as physical markets. Let’s put it this way: the professionals – unless they have ulterior motives – say fundamentals, while the amateurs and conspiracy theorists say speculation.
Finally, in light of the above, I would like to get the peak oil issue off the table (again) by repeating something I once wrote, and replay in all my lectures on oil, to include this one, as well as any and every conversation touching on that subject, regardless of how inappropriate the occasion. Peak oil is not about the future – it’s about the past!. It’s about a (generally unspoken) strategy formulated many years ago by the most important countries in OPEC, which features a stagnation or decrease in the output of their invaluable oil (and probably also gas) when they get the opportunity. The present high oil price has given them the opportunity!. It’s not only about more money rather than less, but using that money to obtain the kind of future that the oil importers thought that they had an exclusive right to. Readers can take it from there.
Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory Textbook. World Scientific: Singapore, London and New York.
______ (2001). Global Finance and Financial Markets. World Scientific: Singapore, London, and New York.
______ (2000). Energy Economics: A Modern Introduction. Kluwer Academic Publishing: Boston, Dordrecht, and New York.
______ (1980). The Political Economy of Oil. Lexington Books: Lexington Massachusetts.
Hicks, John R. (1939). Value and Capital. Clarendon Press: Oxford.
Lindahl, Björn (2008). ‘Rekordpris trots fyllda oljelager’. Svenska Dagbladet (Feb. 21).
Sarkis, N. (2003). ’Les prévisions et les fictions’. Medenergie, No.5.
For information on purchasing reprints of this article, contact sales. Copyright 2013 CyberTech, Inc.
an excellent article. May I have your permission to copy it and circulate it to some of my colleagues (as opposed to simply sending them the link to Energy Pulse)
Joseph Somsel 7.1.08
One form of speculation not accounted for in the model is in-ground storage. That is, a producer withholding production in expectation that future production will fetch a higher price or that the non-price value to the producer will be higher then.
The current US constraints on production do have the unspoken rationale as speculation on future, higher value to the country. In that sense, the US Democratic Party can be considered speculators even though they are the ones railing against speculation!
Ferdinand E. Banks 7.2.08
Ed, I found that out before I was old enough to shave.
Adrian, circulate it far and wide, with my compliments.
Joseph, this business of in-ground storage is something I have always stayed away from because it has a taste of the Hotelling model of exhaustible resources about it. BUT, obviously you are correct, and obviously I was correct too, because what I had against the Hotelling model was the emphasis on the interest rate, while ignoring deposit pressure. Incidentally, I once met a couple of gentlemen from Norway who made the same point as you did. Obviously, Norway should have reduced their output by X barrels/day instead of allowing the oil price to fall as far as it did. I also want to emphasize that the only purpose of this 'model' is to discuss short-term pricing, only to do it in a more sophisticated manner than it is done in the Financial Times or on Bloomberg.
Len Gould 7.2.08
Just to add two small items of interest (to me) which seem to fit the discussion. First, I just had a discussion of oil and economic development in the mid-east with a friend recently inmigrated here from that part of the world. His emphatic position was "Ignore all that nonsense you hear about OPEC members making independent decisions on anything to do with oil production. That's all controlled by people in the US." Second is the relevance of the strong movement in the US to ban imported oil from Canadian oil sands on environmental grounds, which in the context of the above article seems to me counter-productive.
Carl Golightly 7.2.08
An excellent article! Thank you!
Ferdinand E. Banks 7.3.08
Well, Len, those countries in the Middle East have apparently come to the conclusion that they are not going to sell a barrel of oil for less than the price of a barrel of coca-cola, and that being the case it hardly matters who makes the decisions in that business. Something I didn't mention in this article is that not only is the price of motor fuel going to go up, but thanks to the increased price of oil, so is the price of food and a lot of other things ('inflation'). At the same time the price of your shares are going to go in the other direction. Of course, everybody knows about these things, but I think that it's a good thing to keep reminding them because I keep hearing something about the price of oil going to $200/b
Bob Amorosi 7.3.08
Another super writing from you, very well done. I love the math model in it, reminds me exactly of my electrical engineering control theory diagrams that I haven't seen much of in years (almost brought tears to my eyes).
There are regular stories appearing every week lately in various news media from "amateurs and conspiracy theorists" claiming speculation is the evil behind oil prices, so it's refreshing to hear your article's valid arguments debunking them.
The economic pain has begun and is growing like a tidal wave here. With inflation threatening on the horizon too, the falling stock markets are finally showing their traditional predictive signs of what's to come. Ontario's large number of auto parts companies that supply GM, Ford, and Chrylser are dropping like flies almost daily now. Two Ontario companies making plastic dashboards and trim, Polywheels and Progressive Mouldings are the latest casualties, the latter one a half-billion-dollar-a-year sales American-owned company that was founded from a local Ontario garage tool shop 41 years ago, is throwing another 2000 plus out of work.
Ferdinand E. Banks 7.3.08
The logic behind the price increases and unemployment we are seeing now, and will probably see more of later, comes directly from Econ 201. Funny, isn't it, that all those high priced economists working for the big-wigs in North America and Europe couldn't tell their bosses what was bound to happen. Earlier tonight I was listening to the directors of the Swedish central bank explain their actions to the TV audience. 'Pitiful' is probably the best word to describe their ignorance.
Of course, the TV audience refuses to get the message, and so maybe it doesn't make any difference.
Joseph Somsel 7.3.08
I feel a little guilty that the job market for nuclear engineers is so contra-cyclical. it was great in the '70s and early '80s into the Carter years but my Silicon Valley neighbors were making the big bucks when the nuclear industry was scrapping by in the 90s.
Now, global economic gloom and doom is making nuclear a hot career field again.
A little guilty, yes, but I'll cry all the way to the bank.
As to in-ground storage, part of the problem is that governments use economics as only one input to their decision-making and most of the remaining reserves are under government control.
Andres Lucas 7.8.08
It all boils down to the Balance of Power.. and politics.. p*,r driven by world politics which drives DI... This alters the equilibrium.. Also need to measure which players have historically maintained DI > AI .. meaning that having greater power, at times where oil proces were low, were able to maintained an unbalanced position where DI>AI.. in order to relax current prices. maybe its time for these players to actually let AI=DI.
bill payne 7.8.08
We're a bit worried about the possibility of an attack on Iran.
Oil prices may be low on our worry list if an attack occurs.
While oil appears to be a current problem, electric generation capacity may be a problem in about 2012.
PNM is making demand and supply predictions for the next 20 years. http://www.prosefights.org/pnmelectric/pnmelectric.htm
No matter what the middle east countries think the price of oil can not rise furthur- in fact it should now be getting lower any day. Reason the substituites will soon enter market and in fact the shift is already taking place.electric cars/ hybrid vehicle production will shoot up very soon anf this offfcourse is bad news for major auto makers. Cars like nano will take over the market with thweir electric variant and in fact I believe the Tatas might be even working on it.Solar energy technology that produce electricity at five cents are very much on the anvil . I belive expectations that massive oil flows can be expected out of Iraq has proved false becuse of war there and In NIgeria repeated attacks has effected the oil flow. But the elections in Us is going to change the scenario in Iraq and war in Nigeria may not be able to continue. End of this year shoukld see this oil bubble going bust in massive way.The world would have learnt a lesson and the shift from this energy source will be permanent. The gas finds are increasing by the day but there are not enough resources to take out the gas. All this will change in six months time at the best. The world is not going to be held captive by middle east countries who spend lavishly on luxury goods and have nothing else but oil to show!
Jeff Presley 7.8.08
Glad to see this article in print and thanks again for the sneak preview. I never have had the chance to talk to T. again, but have your name in mind for that conversation. A certain Mr. Feldstein from Harvard posted this which aligns largely with most of your thoughts above. However, you of all people should be scared when the folks at Harvard start agreeing with you eh?
He does of course blow an otherwise cogent article with his last sentence. See if you can spot the flaw: Any steps that can be taken now to increase the future supply of oil, or reduce the future demand for oil in the U.S. or elsewhere, can therefore lead both to lower prices and increased consumption today.
Ferdinand E. Banks 7.9.08
Thanks Andres. All of my students must show me that they understand my diagram if they want a passing grade, but precious few others do me that favor.
Bill, you say that oil prices might be low on your worry list if an attack on Iran takes place. Well, if the oil price jumps to $200/b the day after an attack you might reassess your priorities.
Alok, the techological improvements that you are talking about, and/or others, will definitely come about. The question is will they be in time for a few hundred million of us. As for the oil price collapsing, I am a humble teacher of economics and finance, and my position on this topic is non-negotiable: it might fall to the $5/b that Milton Friedman said would happen, but not unless the OPEC countries fall asleep at the switch - which of course could happen.
Jeff, of course Mr Feldstein's thoughts align with mine, and yours too, and almost all of the persons who contribute to this forum in one form or another. Of course, a few of his colleagues at Harvard may have a problem adding 2 + 2, but this is hardly the place to offer names.
Ferdinand E. Banks 7.9.08
Sorry, but I reread this article again just now, and I see that instead of 'DELTA' there are some 'QUESTION MARKS'. Well, the diagram tells the story, and the 'math' is mostly an aside.
Yasser Al-Saleh 7.9.08
Another masterpiece of a great intellectual
James Curry 7.9.08
Prof Banks thank you very much for this!
With the House P.U.M.P. Act and the Senate Commerce Transportation & Science committee's attention now focused on regulating the ICE, do you think that (potentially) three democrat branches of the government will bring about an oil market crash or will international supply and demand still prevail as the market drivers?
I believe that Obama will cave to the House and Senate and ratify legislation that would close the Dubai and London loopholes on the ICE. Whereas McCain, strongly advised by former Senator Phil Gramm, will most likely veto any legislation that regulates the ICE- an action that will place more emphasis on increasing domestic oil production, which is a familiar but ill-fated initiative given our current political climate.
captainjohann samuhanand 7.9.08
Sir, The descision makers in USA have found out that Stored oil in Arabian sands is more risky than in undegraound tanks in USA. This price rise is direct result of US increasing its strategic reserve from 350 billion barrels to 700 barrels. Also as Iran shifted oil trade from dollars to other currencies, the wise men of US have printed more green packs which china and India are holding while americans are holding the Crude!!!The price should increase more to may be 200 even and only importing countries like India(75%) china(25%) are going to pay through their basmathi rice and electronic goods and cheap clothes.
Mark McClurkin 7.9.08
You most undoubtedly covered some of my discussion below in earlier articles, but I would appreciate hearing your comments. What differences are there now compared to the the early 1980's oil price bubble that eventually led to prices falling from about $40/bbl to around $10/bbl in the mid 1980s? Is it simply that the demand is higher and more globally spread? Why didn't OPEC cut back production to a point of supporting $40/bbl oil then? As I recall Saudi was producing upwards of 10+M bbl/day back then and now they are in the 9M range with about 2M in reserve capacity. I suppose the US going into a deep recession in the early 80's helped to reduce demand. It appears that this is in the works now, which will also help to feed a world wide recession. Hard for me to see oil plunging by 75% this time around, though. Before I even read your article, I was arguing the same basic point with one of my friends; why would any oil producer domestic or foreign want to increase production dramatically and suffer what happened in the mid 80's. Also if I was a large producer and I had a large reserve of oil that the public did not know anything about, what would prompt me to advertise that and possibly dampen current prices?
Richard Vesel 7.9.08
As one of my fellow engineers noted above, the model you draw is reminiscent of electrical models we have encountered in past lives.
What is missing from it, I feel, is the influence of market "emotion", which can tend to drive such systems into "thermal runaway" (an electrical engineering term!). The only tangential reference to this emotional content, which goes unquantified, is "desired stocks", yes? What influences this "desire", and causes its actual quantity to increase? I offer you the economic fundamental terms "greed" and "fear" as the influences...
At this time, supply flow and demand flow are within about 0.1% of each other, at about 86 mbbl/day, with supply being 100k bbl over demand. Meanwhile, on the NYMEX, three times that amount of "paper oil" is being traded daily. So this is not just your ordinary futures market, with suppliers and consumers hedging their positions.
As I commented regarding your previous (excellent) article, I personally would be a lot happier if there could be no speculation in "lifeblood" commodities, in this case, petroleum. Others I would pre-emptively add to the list would be: water, grid-delivered electric power, and possibly natural gas as well.
I would be interested in a model, which when applied to historical data, can reflect past bubble growth and bursting behaviors, using hard input data, as well as historically-derived coefficients that would not require event by event tuning. Is there such a thing, by any chance?
Peter Platell 7.9.08
Dear Ferdinand, It is good that you try to make people aware about the implications of finite resources. Do you have some comments about peak uranium and peak coal scheme Peter Platell
Ryan Ferris 7.9.08
This discussion is interesting and Dr. Banks arguments might be shown to be technically correct in relation to abstract economic models. But most of such modeling fails when it attempts to describe world energy prices, which is a market so politicized and interdependent with the economic health and currency of all sovereign nations that any prediction of supply and demand in nearly impossible to guarantee. Nor do I suspect that it is possible to guarantee the accuracy or usefulness of data surrounding current oil supplies and oil demand. The data itself would be politicized.
I think it is entirely possible that high prices will decrease demand in developed nations and that such decreased demand will increase price for the entire world. Thus, gasoline could skyrocket to $11.50/gal in the U.S. (the rumoured price in Turkey), and the oil majors could still break profit records on greatly reduced world demand. There was a "boss talk" with David O'Reilly (CEO Chevron) in the WSJ awhile back. In response to the question of whether reduced demand in the U.S. would reduce price, he talked about Turkey having $11/gallon gas and selling a record number of automobiles!
Jeff Presley 7.9.08
Richard, Asked and answered, I'd recommend this book
Ryan, The "official" price of gas in Turkey is $11/gal, but let's not forget the vast underground economy there, avoiding the government taxes and enjoying the bounty of smuggled Iraqi oil from south of the border. I don't have the conversions handy, but suspect something on the order of sub dollar a gallon for the smuggled stuff.
Len Gould 7.9.08
Jeff: No blackmarket in the Netherlands, fuel > $11
Jeff Presley 7.9.08
Len, are the Netherlands experiencing record automobile purchases as well?
Ferdinand E. Banks 7.10.08
You are really too kind, Yassar.
Anyway, kindness aside, there are a number of questions above to answer, and I will take them one at at time, though not today. Just now however the one by Richard Vesel deserves a reply.
Yes, the model I constructed looks like the kind we studied in electrical engineering, and as I have noted many times one of the circuits takes on the appearance of a first degree servomechanism. My comment here is that this set-up helps to explain the instability of the oil price. I have a differential equation for this system, but I don't deal in differential equations any longer unless snot-nosed students get above themselves. The point of this model is to show the influence of inventories on the SHORT-RUN pricing of oil, and if you look at it very closely you will see tht it is a very simple construction. Even so, you unfortunately don't get this in economics 101, or 901 either for that matter. HOWEVER, the basic idea for this model came from some other people, even though the diagram is mine all mine.
Long run pricing is something else. This is explained by the relation of flow supply to flow demand, where flow supply has an economic explanation that you will find in my textbook and various articles, while flow demand is largely a function of economic growth in the large oil using/importing countries. At the present time, and in the forseeable future, flow demand is outrunning flow supply, and as far as I can tell, the oil suppliers like that arrangement, hope that it will continue, and if the world economy doesn't crash, will do what is necessary to make sure that it continues...I think. WOULDN'T YOU IF YOU WERE IN THEIR PLACE, and I'm sure that you and most of the other people contributing to this forum know how.
You say that on NYMEX three times as much paper oil as physical oil is traded. Thank you, because I thought it was much more. However, that situation is necessary in order to supply the liquidity needed for suppliers and demanders of physical oil to hedge price risk. THIS IS A GOOD THING, because it is a good thing that transactors in physical oil can hedge price risk. Good in the sense that if they couldn't, the oil price MIGHT be even higher. Despite what you said, this is very definately an "ordinary" futures market, where speculation is as important as hedging price risk.
I don't know if there is a model of the kind you asked about at the end of your article, however, personally, I would not be interested in it. What is happening now is something that I predicted 25 years ago, because it was obvious to me - as well as many other persons - that technology could only do so much where finding and producing (conventional) oil is concerned. Of couse, some of the colleagues thought (and still think) that technology can find oil even where none existed, but I didn't buy that concept.
What about speculation DETERMINING price? Speculation might 'influence' price as shown in my diagram, but I won't say how much or how little, even though I have some ideas on that subject. But where the determination of price is concerned that is brought about by flow supply and flow demand.
Warren Reynolds 7.10.08
Just outlaw and remove the speculators from the price loop and let "supply and demand" curve take over. Then oil would drop to around $100/barrel.
I am glad to see oil price gouging and price increases; it will drive us quickly to the Solar-Hydrogen Economy. Then, a kg. of hydrogen would sell for $2.78/gallon-equivalent and get you 24 miles. There would be no difference between Shell hydrogen and Chevron hydrogen; it is all the same. Supply would be generated locally at each station via solar power and the speculators would be out of work.
Roger Arnold 7.10.08
Thanks, Fred, for another great article.
For the sake of fellow naif's like myself, I think it's worth stating the mechanism that links futures prices and spot prices. It's a form of arbitrage, conditioned on the availability of physical storage capacity. Specifically, if the futures price is "too high" relative to the current spot market price, traders can make a risk-free profit by buying on the spot market and holding for future delivery. That has the effect of increasing actual inventories -- your 'AI' parameter. Conversely, if the futures price is "too low", those who hold actual inventories can profit by selling into the spot market from inventories, and buying on a low-priced futures market to rebuild inventories later.
I'm sure all that is obvious to you as well as many other readers here. It wasn't obvious to me, however, until I did a little research on the futures market. I was trying to get some grip on exactly the question you addressed here, of the effect of speculation on oil prices.
There's still a great deal of devil in the details that I've yet to comprehend. One is the value of "lamda" in your equation (and the factors that influence it), another is the nature of "f" in your "P* = f(p)". The "DI" parameter plays a crucial role in determination of price movement, but it seems to be a very "soft" parameter.
What I'm concerned about is the potential for manipulation. It's obvious that long term prices are determined -- as you say -- by the flow variables 's' and 'h', and that speculative activity has limited power to move prices away from the values determined by "fundamentals". But how limited is "limited"?
Given the natural linkage between futures prices and spot market prices, it's obvious that an institution with sufficient funds behind it can create a great deal of price movement in the sort term. All it has to do is switch its betting from the short side to the long side of futures contracts, or vs. vs.. Since futures prices have a strong tendency toward self-fulfilling prophecy, it doesn't actually cost the institution all that much to drive prices one way or the other. The question is, can it arrange to make more from pumping the market than it costs it to do the pumping?
Even if the answer is no, that the positions that would be required to profit from the pumping would themselves nullify the pumping attempt, there remains the question: how honest are the fund managers? The money they are playing with is predominantly "other people's money". If the managers leak word to silent confederates of what moves they are going to induce in the market (and when), those confederates can profit enormously. They just have to be clever enough to keep their roles in driving the moves somewhat hidden, and the ties to their silent confederates (and the kickback channels) well concealed. (Say, in offshore numbered back accounts.)
That type of deliberate manipulation and passing of inside information is strictly illegal. But with the current regulatory atmosphere in Washington and the preference to cover up white collar crime by wealthy political donors, how confident can we be that it's not rampant? It's not just the Bush administration, either. Clinton's blatent farewell pardon of financier Marc Rich has never -- AFAIK -- been adequately explained.
Malcolm Rawlingson 7.10.08
Well Fred - you blow apart the speculator myth that is being trotted out by the political elitists and explain what is really going on. Excellent job as usual.
I considered going into politics in the late 70's....for about thirty seconds..after which I dismissed the idea on the grounds that I would not be able to tell the truth ever again.
And for Joseph Somsel - a great onservation my friend - I just delight in telling all those folks who informed me earnestly that the nuclear industry is dead - that they were wrong - plain wrong. US has plans for 34 new nuclear plants, 100 in China, and the list goes on and on and grows daily. As you say with a dearth of nuclear engineers we are laughing all the way to the bank.
Professor DC Leslie (sadly now deceased) former Head of Nuclear Engineering at Queen Mary College, University of London, a man respected and admired for his nuclear engineering vision one told a young graduate who could not find a job that things would be mediochre to bad until about the turn of the century and then there would be a huge expansion as the world struggled to meet its energy needs - nuclear energy he said would surge and engineers would just name their price.
That graduate was me and he was exactly right. I only wish he was alive to see it.
Malcolm Rawlingson 7.10.08
Warren, Nice idea to go to hydrogen and get out of oil except we use oil for lots of other things besides transport fuels.
Not sure how one runs an aeroplane on hydrogen or make polyethylene or polypropylene or lubricants. The problem is much bigger than simply motor fuels. Oil is the petrochemical feedstock for the economy not just a fuel.
Not sure how you generate that much hydrogen using solar power either. Presumable one would no longer to be able to fill up at night unless some kind of large capacity cryogenic hydrogen plant was located at each filling station. The solar panels for the gas station would take up a few city blocks.
Producing the hydrogen with nuclear generated electricity would work but suggest it's better to convert that to methane at the nuclear site and then feed it into the existing gas mains. Use the methane to fill up your car directly out of the gas main. That is practical.
I like the idea of using hydrogen as the energy transporter but doing it from just solar is a bit of a stretch. Nice thought but numbers are off by a couple of orders of magnitude.
Roger Arnold 7.10.08
A bit more on reserves and potential price manipulation...
Captainjohann above greatly misstates the capacity of the SPR. It's a bit over 700 million barrels, not 350 billion, and while increases in the SPR's capacity are indeed planned, it's nothing close to a doubling. Not from anything I found in a quick search. But the SPR apparently does represent more than twice the total amount of private capacity within the US for oil inventories. It's also very cheap storage capacity.
There have been proposals that the government should convert the SPR from a "dead resource" to a "live resource" that is actively used to stabilize and moderate oil prices. It would operate in a similar manner to how a central bank operates to stabilize a national currency. There's an article here, on the Cato Institute's web site, advancing that idea. I don't agree with many positions that the Cato Institute takes, but this one seems to make a lot of sense.
I'm interested in what Fred or others here have to say about the proposal, pro or con. It would certainly be an easy policy change for one of the presidential candidates to propose, and should bring quick results--if, that is, there's anything to the claim that current oil prices are caused by speculation.
Jeff Presley 7.10.08
Roger, Glad to see you back again. I believe the Strategic Petroleum Reserve needs to be just that, STRATEGIC. Using it to moderate prices isn't going to do us any good if it is 80% empty and we have a shooting war in the Strait of Hormuz (for example). People like to claim it is only a few month's worth at today's usage, but if there were an emergency, I'd expect even our most moronic politicians will vote in favor of rationing, so instead of depleting the supply at 21M bbls/day it will last considerably longer if consumption were moderated.
The high prices are pinching pocketbooks, but also doing their job in demand destruction. If this continues, I'd expect US consumption to drop to something like 17-18M bbls/day. Unfortunately, I'm convinced the Chinese are FILLING their strategic reserve at this moment, so they are grabbing the bbls that the US doesn't consume, with ~$1.7 trillion American greenbacks they've been saving for a rainy day, like today.
The OPEC nations are dancing a merry dance, they enjoy the revenues, but are concerned about the tipping point into worldwide recession, which will create a whole new level of demand destruction. Should that happen, the BRIC nations (except Russia) will stop consuming at the rates they've been, G8 consumption might drop by 30-40% and OPEC will be forced to dump oil on the market just to keep paying the bills and keep their malcontent populations reasonably satisfied. Since many of them have no GDP per se, oil revenues are almost the only thing filling the government coffers.
Todd McKissick 7.11.08
Roger, Who would control this new live SPR inflow and outflow? Given the abuse of power by the FED and other 'central bank' entities and the magnification of those problems, why add those problems to the oil market?
Jeff, For one, UAE is definitely ramping up national growth. They have, by far, the most ambitious infrastructure projects which include skyscrapers, 100% self sustainable cities, entertainment mega-complexes and quiet RPS goals that would make a California Democrat ashamed. Either they don't trust putting their money in the bank or they know something.
Malcolm, "Not sure..." just means your research is incomplete.
Ferdinand E. Banks 7.11.08
Warren, I agree with you that the outcome of higher oil prices might be the new energy economy that is absolutely necessary for our survival. This, incidentally, is the reason that I have accepted most of the talk about global warming, even if some of the deductions by the global warming booster club strike me as fruitcake. Of course, where a solar-hydrogen economy is concerned I am positive, as long as it is not overdone, and nuclear gets to play a large part in the program. Let me say though that I am NOT as qualified to participate in that debate as I would like to be.
And Todd, thanks for pointing out what they are doing in the UAE. Saudi Arabia also has big plans in that direction. And what it comes down to is that the export of crude oil is going to be less important. I hope that our political masters understand this, and if they don't I would like to see the good Jeff explain it to them using his mode of expression.
Ferdinand E. Banks 7.11.08
Lamda makes the relation between the change in price and the difference between desired and actual inventories linear. This choice is of course arbitrary, because in reality it might be something else. But linear is good enough for me, considering what I want my students to learn. Above all, in teaching economics and finance, I do not want my students to get the wrong idea about what math can do. It is enought for me that they understand the importance of inventories, because their Econ 101 books did not provide them with this information
Also, the link between futures prices and 'spot' prices is not as clear to me as it should be, if by spot prices you mean the price of physical oil. When I hear for example that the price of oil is $139/b, I dont have the slightest idea where and how that price was formed, other than it had something to do with supply and demand, and there is a market somewhere on which a contract was generated for oil that moved from seller to buyer for $130/b. For futures prices, however, I know that the price was formed in an auction market - an exchange - but I dont see an obvious connection between that market and the physical market, although there might be an obvious connection. In any event, I will have to do more on this subject, unfortunately.
Maybe one day I can produce the right paper to explain all this.
Peter Platell 7.11.08
Malcolm why would solar panel be concentrated at a filling station. Each single family house where the sun hits the building envelope is enough to produce your own hydrogen to your car plus realising energy self suffient house. The number is there. Most buildings has a building envelope which can produce more than enough with power as well as energy . It is only industries that need 100 MW under the roof that needs energy resources with higher power and energy density .
Everybody , Can anyone comment the S2P that Sandia is working on. I have heard other project going on where CO2 is captured from the air and putting together with water by solar energy to form methanol. The hydrogen economy seams litte far fetched ? Why not add carbon to the hydrogen and get a energy carrier that is possible to handle ? I am not a chemist but when I am asking chemist it seams that no one looking at that because everybody is busy with hydrogen. It seams that all strive for hydrogen is caused by the fuel cell. Why not use a steam engine that can use all kind of energy carrier and burn the fuel with very low harmful exhaust gas emissions
Fred , No comment on peak uranium or peak coal ?
Malcolm Rawlingson 7.11.08
The number is not there at night! Not everyone lives in a single family house. Almost everyone drives a car. What runs the compressor to store the hydrogen when the Sun is not out?
Malcolm Rawlingson 7.11.08
Don't need to write a research paper Todd to know that solar PV output drops to zero at night but society runs 24 hours a day.
I live in the real world where I ensure that people get their electrcity 24 hours a day 7 days a week at prices they can afford and at the flick of a switch. I know that what I propose works and works very reliably all day long all night long. I do my research walking around 885Mw turbines each day. One of our reactors has been operating at 100% full power for over 500 days non-stop and the rest not far behind....no storage required. It would do you good to visit a large generating station to see the scale of what you propose to replace. Then you will understand.
Here is your research assignment. Go to a big city at midnight and ask yourself how could all of this be run using windmills and PV cells. No Coal, No oil, No nuclear, No gas...... just renewables.
You'll also observe that most people do not live on farms in the middle of Nebraska. They live in cities and cities consume large amounts of electricity.
Ferdinand E. Banks 7.12.08
Peter, I haven't done anything with coal for a couple of years, and so I can't comment on that resource. There is a chapter on coal in my new textbook of course.
I don't worry about uranium. The French have solved that problem. When 'fresh' uranium gets scarce they will recycle the used stuff. Depending on how they recycle it, that should last them a few thousand years.
This morning there was something in Svenska Dagbladet by a genius (with an advanced degree) who claimed that the Swedish pulp and paper industry do not need electricity supplied by nuclear plants. He thinks that wind is capable of supplying the electricity needed by that industry.
People in this country will say and do anything to get a little popularity, wont they. I had the same attitude when I was in infantry leadership school in the US Army, but it didn't do me any good. Although I was first in my class, I still got expelled on the last day of the course, and was put to work on a garbage truck. That was a sweet experience that caused me to do a lot of reflecting about saying and thinking the wrong things.
Ferdinand E. Banks 7.12.08
Mark, I think that you and I are pretty much on the same page here. The only remaining question is why didn't OPEC cut production when the price fell to $10/b.
One reason is that OPEC was not as strong as they are now: NOTHING SUCCEEDS LIKE SUCCESS. Despite appearances, OPEC was a weak cartel then, while they are a strong cartel now. What I can't understand is why Norway and Russia didn't cut production. Maybe they prefer less money to more.
Something else to understand here is that these countries REALLY AND TRULY believed that if they allowed the price to exceed 30 or 40 dollars, huge new deposits would be discovered. You probably remember Yamani's statement that there were still stones left when the stone age ended, which meant that if the oil producers went forward like gangbusters, they would end up having to use the stuff to fill swimming pools. (The question of saving oil for chemicals - which was raised by the Shah of Iran - was completely overlooked.) What has happened is that even if huge deposits are discovered it will not be enough, GIVEN THE INCREASE AND EXPECTED INCREASE IN DEMAND, GIVEN THE AMOUNT AND LOCATION OF RESERVES, AND GIVEN THE GOALS AND INTELLIGENCE OF THE EXPORTERS, OIL IS IN SHORT SUPPLY REGARDLESS OF THE AMOUNT IN THE CRUST OF THE EARTH!
Something that everyone ignores is that OPEC warned the oil exporters about all this, and suggested that importers and exporters should cooperate for the benefit of both. But NO: Milton Friedman and some of the other geniuses had said that OPEC would fall apart, and eventually technology and the price system would get the importers out of the corner. Technology will eventually get us out of the corner, but I am afraid that that operation will be far from optimal.
Yes, now that I have finished this song and dance, I appreciate your pointing out - as many contributors to this forum have - that it wouldn't make any sense at all for the oil exporters to search for and/or produce the amount of oil that President Bush asked them to produce, regardless of the assurances they gave or didn't give him.
Ferdinand E. Banks 7.12.08
Ryan, this "abstract model" of mine is the one I taught for 15 years to first year economics and finance students in Sweden, and many others in many countries. It is no more abstract than the models in the opening chapters of your Econ 101 textbook. It has to do with SHORT RUN pricing, and all it says is that price is a function of the difference between desired inventories and actual inventories.
At the present time though the important thing is the movement in trend (flow) demand and trend (flow) supply, i.e. pure Econ l01. It is gratifying to me as a teacher of energy economics that you have taken an interest in this issue, and obviously know something about it, but the bottom line is that - for the time being at least - the oil exporters are in the drivers seat. The politics that mean something now is whether the OPEC producers agree with each other about the way ahead, which apparently they do, and which means THAT THEY ARE GOING TO DO WHAT YOU WOULD DO IF YOU WERE IN THEIR PLACE, which is look out for number one.
Ferdinand E. Banks 7.12.08
James Curry, I'm a little vague on the things you mention, but let me say that despite my respect for the presidential candidates, I would have preferred seeing Mitt Romney or John Edwards as commander in chief. Of course, regardless of who becomes president, it could have been worse: we could have had Bill Clinton doing his act in some corner office of the White House.
And CaptainJohann, I have not thought as much about the strategic reserve as I should have, but everything considered, I'm afraid that Jeff Presley is right on that point. As for the holding of American dollars by other countries, I leave that topic strictly alone, because I cant understand it despite having taught finance for about 15 years.
Peter Platell 7.13.08
Malcolm Why should we compress hydrogen during nights ? During the day we generate and compress the hydrogen Yes not everyone lives in single famliy houses but multifamily houses, office m schools together makes the number right. Hydrogen economy seams indeed litte far fetched . Storing electriciy in electric battery will be a better choice albeit the electric battery has to improved. And what about generating methanol from solar thermal ( 500 C ) with CO2 and water on your own roof with an efficieny of 20 % . I think such a reversed combustion deserves much more attention than hydrogen.
Fred yes but this recycle ? aren't that stuff something bad from proliferation point of view. I have read several article the last year that new nucler power will cost a lot, about 8000 USD /kW to built ? If that is true it seams that much cheaper to implement large solar thernal power in the dessert and distribute the electricty to populated places ?
Ferdinand E. Banks 7.13.08
Spoken like a true European Peter. Instead of building the most economical nuclear facilities in the world in Sweden, you wamt solar power harvested from somewhere in the Sahara, and piped to Stockholm. Or something.
As for this cost of nuclear power that you cite, that sounds very wrong to me. Of course, reardless of what the actual cost is, the nuclear plants that will be constructed in the future should have commenced construction six or seven years ago when the interest rate was lower than it has been for decades. I tell you what, let's trade: Sweden leaves the EU and I become the biggest propagandist in this country for renewable energy.
Todd McKissick 7.14.08
Peter, Regarding your comments to Malcolm. Don't feed the trolls. He's been told dozens of times that PV and wind are not being promoted but solar thermal is much better. I even got him interested enough in residential solar thermal CHP that he wanted to know how much and when he could get one for his house, but that was in a private email which I still have. He also refuses to acknowledge that any form of storage is possible beyond the problematic ones. Basically, I'm tired of his uninformed input that lacks any intelligence on anything other than nuclear. If you again go through the effort to inform him or pin him down to specific questions, he will simply disappear without a reply. It's not worth your time.
Professor Banks, to his credit, leaves the options open for renewables to prove their economics and technical viability before passing judgement. When we finally get these systems up and running, I believe he will reconsider them on their own merit because he realizes that the magnitude of the coming crisis warrants the benefits and competition that all technologies can offer.
Bob Amorosi 7.14.08
Malcolm may not respond to specific questions and rule out all other forms of generation because he like many others many only like to hear want they want to hear. Put another way it's easier to tune out or not discuss what you don't want to hear or discuss.
I am probably being a little too harsh on Malcolm though, he is probably more in tune and informed on renewables than he would like to have us think. But being in the nuclear world where he earns his living, he may in fact be very much like our political leaders where the latter prefer to either say nothing or simply ridicule suggested change to the status quo when questions on sensitive issues are directed at them. It is better to be all ears that to say something that is potentially against vested interests.
I believe Fred Banks and you are right on in recognizing that all options for renewables should be left open, AS LONG AS substantial R&D is being poured into them with the goals of proving economic and technical viability through their commercial implementation. I have learned myself witnessing over 25 years of massive technological that is actually safer to be an optimist EXPECTING dreams to come true instead of being a pessimist thinking the status quo only will survive.
Bob Amorosi 7.14.08
... "over 25 years of massive technological progress"
Ferdinand E. Banks 7.15.08
Whoa, I think that a clarification is necessary here, Bob. Yes, the options for renewables should be left open in that they should be given the opportunity to show what they are capable of. But no more. Those green people want to do more - mostly out of greed, but also out of ignorance. For instance, a comprehensive survey of environmental excellence was just published in Newsweek, and Sweden was second (globally). Assuming that the hydro in this country is a given, then the reason for that ranking was, of course, the nuclear. But try explaining that to the stupid politicians and bureaucrats in this country who work overtime to convince the parasites in Brussels of their environmental/renewable commitment.
It's clear to me, and to just about everybody in this forum, that a lot of new items are going to be necessary in the optimal energy package of the future. But the important thing now is for goverenments to assist in financing pilot versions of these new items, and to educate the 'broad masses' - to use a Marxian term - in the optimality of nuclear as the reliable and (comparatively) inexpensive base on which those other things will rest. For instance, the unteachables in this country - by whom I mean the politicians and a large slice of the university educated bureaucrats - still can't understand the role that electricity and a superior educational system played in providing their worldly goods.
Where is the money going to come from for all this. Well, NUCLEAR PAYS FOR ITSELF, so you don't need to worry about that. As for the 'start-up money, seed capital, or whatever they call it, there is more than enough of that around, although I prefer not to open that can of worms just yet.
Bob Amorosi 7.15.08
I agree that a new renewable generation must show what it is capable of first before letting them fend for themselves without government financial incentives. My point was as long as R&D and incentives are being thrown at them, don’t count them totally out.
I do believe some governments recognize nuclear will be the base that others will rest on, Ontario does anyway and so do I. But until others can prove themselves commercially on a large scale, nuclear will gradually become another monopoly for new plants that need to be built, especially if you believe conventional fossil sources will eventually go extinct either due to taxes on carbon emissions or because we will run out of their fuel sources. Without SOME competition for future plants, there will be few if any restraints on nuclear’s capital costs which are their biggest nemesis. The higher they go, the harder it is to raise the money as the longer it stretches out the payback times.
Mark McClurkin 7.15.08
Fred and others,
Thank you for your responses regarding the reasons that OPEC may not have been able to keep the level of oil at $40/bbl back in the early 80's and how that set of exact circumstances may not replicate itself this time around for the world economy. I agree with you that regardless of the merits of global warming, its providing a wave of interest and passion around energy independence, which I believe will lead to more global political stability.
Todd, you are spot on with what is happening in the UAE. My company is building an aluminum smelter/gas fired power plant there. They are looking to create added value to their vast gas reserves by producing aluminum. That means ultimately the rest of the world gets less LNG and also does not get to produce as much aluminum. We see that with the huge cash inflows they are attempting to develop all aspects of their economy from heavy industry to entertainment/travel.
Besides the renewable energy initiative they are pursuing, they are looking to capture CO2 on natural gas combined cycle plants. Of course they can actually use the CO2 for oil reservoir enhancement.....but capturing CO2 off a natural gas power plant??? Here's a wacky idea for them burn coal and they would get even more CO2 for enhanced oil recovery projects. Actually I believe they have consisdered this.
What we may find is that with the large amount of money that the UAE is putting into renewables it may actually accelerate their development, reliability and cost competitiveness. They are building a 50,000 resident "green city", which will act as a large application laboratory for renewables and conservation, that the rest of the world may benefit from. So in effect we (oil consumers) are funding alternative energy research and application.
Todd McKissick 7.15.08
Fred, Bob has nailed it with nuclear. I haven't received any hard numbers from any nuclear advocate in any forum in the last few years telling of how the prices break down. (except for muddying through propaganda) This is the only way I can place value on its accuracy. All that is tossed out is sponsored info. The one report that I suspected was non-partisan was dismissed without cause. How is this helping the cause, unless they are, in fact, secretly expensive.
The inflation and monopolistic tendencies are very real. In my state, we are exclusively coal and nuclear but our prices are rising just like everywhere else. If nuclear was the cheaper of the two, then our next plant would go that way but we're getting more coal. Since we have fully regulated, state owned utilities, and they run the power authority, there are almost no roadblocks to either one. I guess, however, I should also concede to wait until one is built before I discount them.
Mark, In Parkent, Uzbekistan, they are using concentrated solar to power their aluminum smelter with lots of gas savings. Look for "Physics-Sun".
The UAE green city, Masdar, is quite impressive but what most people miss is that it will cost $15B to build BEFORE the 50,000 residents and 15,000 businesses take out mortgages to buy one of these sustainable homesteads. Then the inhabitants won't even have power bills.
Ferdinand E. Banks 7.16.08
Everything I know about nuclear I know from working in Sweden and France, and that was enough to convince me that nuclear is still the wave of the future - unless the voters go completely off their rockers. About capital costs being the nemesis of nuclear, Bob, they wouldn't have been if they had started constructing the next generation of plants when interest rates were at rock bottom.
Todd, I just can't see the relevance of what is happening in Uzbekistan and Masdar for yours truly. As I keep saying, the Swedes have the desire and - in theory - the technical ability to make this country a solar-wind paradise, but they haven't and can't and shouldn't waste any more time and money and gusto trying.
There are many facets of this issue that I haven't understood, but there is a big 'thing' in Sweden today about the government increasing its ability to monitor 'private' communications. I have no problem with this at all, but in thinking about it I remember a conference in Germany where someone used the expression "electricity facism" . What that meant - I guess - was that nuclear involved a larger government commitment in one way or another because of the security issue. Amory Lovins has also addressed this matter, suggesting that sun and windpower under local control was better than large centralized installations, which I thought was fruitcake when I heard/read it, and hold even stronger to that opinion now.
No, I'm very sorry, but as Bill Tilden said, "never change a winning game, and always change a losing game". France is safe for nuclear, and for this country (Sweden) initiating a nuclear retreat and renewable advance is the wrong way to go, and that applies to a lot of elsewheres - though perhaps not to Uzbekistan and Masdar.
Len Gould 7.16.08
Fred: I used to be where you are on nuclear, but that was before I figured out how this "free market" on energy (SMD) worked. I conclude that no matter what technological breakthroughs may ever occur in any forseeable future term, things are now finally organized so that we lowlife electricity customers are now set up to pay huge unearned rents to those market investors who own large central generating facilities, who in Canada's case for example are not likely even Canadian. It is so bad that even if for example a technical breakthrough occured in Optical Rectenna solar, or micro-solar CHP and they could produce and store / retrieve power at 1/.10th the cost of capital of nuclear, if they are installed centrally we lowlife customers will continue to pay the full price for nuclear generation right up until the last plant shuts down, at which time the price would drop to where it should have been. It is very rational to expect such a breakthrough in solar generation within the life of nuclear stations built today.
It is the characteristics of the "free" SMD market which has turned me, simply as a logical customer, from a bandwagon proponent of the technological excellence i can see in nuclear generation into the now dissapointed and increasingly frustrated "potential" opponent of nuclear development, both fission and fusion. The change is very recent and i am becomming increasing adamant.
Len Gould 7.16.08
sb: "will continue to pay the full price and profits set by nuclear generation for all centrally generated power, including from the 1/10th cost installations"
Peter Platell 7.16.08
Fred I feel more like an american, I believe in free market. I am convinced that US will take the lead and develope small scale distributed energy technololgy which harness renewable whereas Europe will be stucked with large centralised monoply energy players. If I have to choose Ibetween EU and renewable want you to be a big proponents of renewable, That is an very exciting world where many players will compete with each other.
Todd ; yes sometimes I got too tired to fight against the establishment but after some hours work with technology development I regain my energy
I read recently a book "Innovators dilemma". I was about sustain development and disruptive technology , Schumpeters would call it creative destruction. Sustain development ( Suboptimizing existing technology and structures) is something that really is characterising energy business so far but when renewable that is spread over all roofs is getting harnessed , then we will se something really disruptive happend in the energyworld
Len . I think I agree but what does SMD means ? Peter Platell
Mark McClurkin 7.16.08
Todd, thanks for the Usbek note I will look it up.
I will offer that $15B for Masdar City is equal to 120 days of UAE oil production. My assumption is that they are making an excess or unforcasted margin of $50/bbl at today's current market prices and they are producing 2.5Mbbl/day. So what if we had started taxing every bbl of crude oil that came into the US over the past 20 years to the tune of $5/bbl. And invested that in nuclear and alternative energy development. Wonder where we would be now. I am not a proponent of excessive taxation and if we had taxed oil that heavily we may not have had the economic growth that we have experience in the past 20 years, but what if we had had that kind of energy policy foresight?
Ferdinand E. Banks 7.17.08
Len and Peter and anybody else who is interested, let me repeat the situation here in Sweden with electricity. This country and Norway produced the lowest cost electricity in the world, Norway mostly hydro, and Sweden approximately equal amounts of hydro and nuclear. What I did not know however until comparatively recently was that the price of electricity in Sweden was also among the lowest in the world, and where reliability is concerned I only remember one 'outage': that was a cold winter night and lasted 10 or 15 minutes. It was my opinion though that even with things working as smoothly as they did, a mistake was being made in not paying the top managers and technicians (e.g. engineers more), but naturally that was impossible because billions had to be sent to stone-age countries.
Then came the EU. The government control of the electric sector was loosened, and the top brass of the largest utility - and probably the others - decided to spend most of their time in Germany. I don't have to tell you I hope what happened to their salaries, and I remember someone telling me that they spent money down there as if it was going out of fashion. They pushed through deregulation here in order to get more cash to invest, only they forgot to say that a big slice of that investment would take place in Germany. Naturally they didn't give a damn when two reactors were shut off here, because although they dont know much economics, they understand that when supply does down, price goes up.
Reminds me of what a friend said when I lived in Geneva and suggested that his colleagues at the university were peculiar: "they're not peculiar," he said, "they're just criminals." That's what we are dealing with here, along with a toxic combination of know-nothings in the Swedish government and Brussels: not since the German people turned their future over to Hitler has anything so crazy taken place in a highly civilized country. By the way Peter, they probably will eventually get around to building more nuclear here in Sweden, but in the US it is a CERTAINTY. Even Mr Bush understands how stupid it is to dismantle a nuclear sector that is gradually increasing in efficiency, and whose problems can be easily solved in time. And I would forget about a carte blanche for competition if I were you. Ask the people of e.g. California and Illinois what competition meant for them when they deregulated electricity.
Len Gould 7.17.08
Peter. By SMD i mean "Standard Market Design" which is the auction-like system used to set (presently wholesale) electricity prices in "de-regulated" market areas such as Ontario and likely Sweden.
Jim Beyer 7.17.08
If your solar gadget could undercut nuclear, then by the rules of SMD, you could underbid them, and thus be first in line for the payoffs. If more solar stuff was built, they could continue to push under the nuclear price point and eventually push them out of profitability. I do think SMD is a little odd, but it is a market.
Len Gould 7.18.08
Jim: My concern with SMD is not regarding competition from renewables, but with the effects of a relatively small but costly addition to baseload in any area. eg. Ontario, now settling average market prices at $0.046 / kwh for 20 GW of generation, is about to build 2 to 4 GW of new nuclear baseload which, by all calculations i've seen here will be forced to bid into the market at $0.090 / kwh for 24/7 to break even. So assuming it will not operate for 20 yrs or so at a loss, result of SMD (every generator gets paid the price of highest bidder) is effectively doubling the total price paid to the other 18+ GW of generation in order to replace 1.6 GW of coal with new nuclear and provide for 0.4 GW load growth.
The SMD market (and "de-regulation" in general) is primarily a means to transfer another $5 billion / yr unnecessarily by economic fundamentals (eg. existing Bruce Nuclear is showing a profit on all sales above $0.036/kwh) from ratepayers to owners of existing generation.
BTW, SMD is also the main reason only N Gas generation can be built in any "de-regulated" market. Here, even simple cycle N Gas peakers, esp. those who've had longer-term fuel contracts in place, can presently underbid new nuclear (or clean coal, renewables, etc.), which is a stupid market incentive system to have in place for the long term.
Peter Platell 7.18.08
Fred I think we always end up to the same conclusion when we dicuss. For me energy business ( activity) a business that is to large extent is build up during plan economic conditions. Everybody was going to have the right to electricity and the society couldn't leave that vision to the free market. Further more , energy supply as fossil fuel and uranium with high energy density and terrific storage qualities makes it easy to implement large centralised energy system where energy commodity was distributed to the costumer in monoply lines. Now when climate change starts to make impression on people and also some peope starst to reflect over what finite recources might implicate the free market players will start to invest in new disruptive technology that harnessed the only energy source we can rely on, Solar energy.
The problem that California faced will every society sooner or later face and there will a lot of oligarks running the old utilities and raising big bonus before they change business model or going down. There will be a tough ride before the human being has learned to harness solar energy and some countries will take lead and be the next century wealth fare state. They will be independet on other countries energy supply , create a lot of new innovative jobs and have attractive exports products. This is my conviction Peter Platell
Richard Vesel 7.18.08
Two comments, as I pass through the recent history of postings...
Malcolm Rawlings: 70% of the oil pumped out of the ground is used to produce gasoline, jet fuel, and fuel oils. The next largest chunk, about 20%, is used for lubricants, and only 3% goes for plastics. These are figures directly from the oil refining industry. On the nuclear front, yes there are lots of plans, but still no construction - so we are ten years from nuclear adding to the solution, and as we have seen, a lot of havoc can be wrought in far less than a decade.
Dr. Banks: When oil fell to $10 a barrel, it was due to overproduction, but just a few percent. The spot market was flooded with oil no one wanted, and the OPEC nations could not agree on who should or would slow down production. They were all trying to keep their meager income streams from drying up, and no one was willing to, in a coordinated fashion, cut production by the necessary few percent, to dry up the spot market. That all ended when, naturally, the long term demand increases caught up with the rates of production, the spot market went back to normal inventory levels, and we entered the current bull market in oil, as the world economy reheated after the Y2K and 911 induced recessions were over. What *I* think will happen when this oil bubble will burst, is a somewhat more enlightened (from a self-interest standpoint) on the part of the OPECers, to manage production levels such that the spot market does not get flooded again, or at least not nearly as severely as in the past oil-depression.
I am not saying that 90% of the price of oil is due to speculation, I am saying about 1/3 of the current price is due to speculation. Speculation is in play whenever any commodity price chart takes on the telltale "hockey stick" appearance, and prices are rising in a seemingly exponential fashion - on a logarithmic chart, no less.
It seems that the entire airline industries association thinks speculation is a serious issue too, and I am sure they have their own reference group of economists from which they seek advice, before getting together en masse, to ask the public to pressure the political and regulatory institutions to curb oil price speculation. I received such a letter last week, and I am sure many of you "frequent fliers" have, too. If there is any industry that is going to be completely ruined by $200/bbl oil, it will be the airline industry. Business fliers will still fly, but the common tourist, will have to find other alternatives besides an airline flight to get them to their vacation spots, or off visiting relatives. From my recent flights (I am writing from an airport at this moment), I would say that at least half are not business travelers.
I was also at the first Intersolar US show, this week, and was pleased to see that the cost of producing electricity from PV and thermal solar is finally within true striking distance of fossil fueled production, and that we can expect much of the peak demand for electricity to be taken over, in suitable locations, by distributed solar energy systems. The first few gigawatts of solar generating stations are moving from planning to construction and operational phases in the next 24-36 months. Even better news ... and please, no one needs to rehash some tired arguments about the non-cost effectiveness of PV generation. Panels which will generate 1kw peak of power, will produce 30,000 - 60,000 kilowatt-hours over their expected useful lifetime, at a value of $0.12 to $0.30 per hour (the cost of afternoon power typically sold in an ISO. The 1kw of panels will very soon (within one year) cost $3k or less, and the fuel (but not the O&M) is free. The price of power is going up, and the price of the panels is now steadily declining, so the math is now in favor of solar distributed generation as a viable part of the generation mix.
Jeff Presley 7.18.08
Richard, If "speculation" were as powerful as you say generating a 33% increase in a commodity's price, we'd see MUCH more of it in every commodity. However, there has to be more to the equation, since there are players on both sides of the fence looking to make money. If I were an energy trader and knew you were unreasonably long on oil, I'd short you and collect the profits immediately. The reason speculation even has a chance in the oil market is because supply and demand are virtually identical, as Fred has so eloquently stated time and again.
You'll note the current price of oil seems to be dropping, and the reason for that is obvious. The traders are listening to President Bush dropping the ban on offshore drilling and asking for oil shale to open up. The traders aren't looking at the present, but the future. They recognize that the Democrats aren't going to stand up and be counted voting against more drilling while their constituents are "suffering" under $4/gal gas. Those traders are seeing a future SUPPLY coming on line of about 20 billion bbls, and they obviously recognize ceteris parabus demand might not keep up, so they hedge their bets and take some money off the table. Things aren't truly equal though, and they can also see demand destruction occurring around the world, meaning they can see higher supply (IN THE FUTURE) coupled with lower demand (IN THE FUTURE).
As to airlines, I find it interesting that Southwest was the beneficiary of that "speculation" the other airlines are so concerned about. Perhaps that's why they aren't complaining so much, what with their $49/bbl oil contracts they bought on the futures markets (speculatively) several years ago. Of course Southwest started locking in low oil prices back in '98 when it was $10.70 / bbl, while United was stupidly wasting money fighting with their (equally stupid) unions.
Jeff Presley 7.18.08
Richard, Question on the solar show. Did those 1Kw PV's at $3K each include the converters from DC to AC?
Ferdinand E. Banks 7.19.08
Oh me oh my. Do you mean that I've got to go back to the drawing board again?
Anyway, Richard Vesel, I'm with Jeff now that he's with me. Moreover, as for one-third of the oil price being due to speculation, I wouldn't believe that even if it was true, because as a certified teacher of economics I would say that that was a disequilibrium situation.
As usual, I start at the bottom line, which in this case imeans that a unified, textbook OPEC can get any oil price they want. As Richard Vesel pointed out, OPEC couldn't agree on something or other, and so the oil price dipped to $10/b. (Somebody else who didn't have their heads screwed on right were Russia and Norway, but there is no point in going into that now.) Anyway, OPEC today is very different from OPEC ten years ago where this agreeing business is concerned, and while they can't get ANY price that they want, they can do pretty well, thanks to certain aspects of their composition and general competence. As for this price-fixing thing, what they (theoretically) want is a price that will do more than maximize today's profits. What they (in theory)have to think about is a price that will maximize their profits over a long time horizon, which means that they should take into consideration the effect of their price strategy on future demand. Let me add something to that contention: they want a price that will maximize their diversification out of oil.
The question then comes up as to what is the optimal price of oil for OPEC in the NEAR future. That price of course is constrained by the bad news in the international macroeconomy, which means that downward movements probably make more sense than upward, although I'd have to think about that when the sun is not out. Of course, the ideal OPEC will have no difficulty figuring this out, because the price rises over the past few years have given them options AND confidence that they never dreamed of only a few years ago. That's one of the advantages of being in the driver's seat.
On this speculation versus fundamentals bit, a former student recently informed me of some work by several Oxford types in which they have assured the rest of us that we are completely and totally wrong. My reaction here was as follows: if you want to believe that speculation and the futures market determines the price of physical oil, then they can give you some nice reasons if I am not present, but if I were in the front row of the seminar room, I'm afraid that I would have to point out that their history of the oil price is for the birds. Today's oil price is due to depletion in many large deposits, bad news on the exploration front, Saudi Arabia's decision to keep the output of sustainable oil about 10mb/d or less, and China and India finally getting getting their act together. No amount of shouting, screaming, cursing, pressing computer keys and listening to the wisdom of economics reference groups in all this wide world's trading rooms and brokerages can offset that.
tony knight 7.18.12
fred is right. people in california and illinois know how hard it is to avail enough oil espeially for their automobiles since those countries are well civilized already and almost all of the citizens depend on car for their everyday lives.
the economy is still on a downward slope leading Ontario's auto parts companies like ford and chrylser are having a hard time coping up with the situation. and their shops in california ( see: http://www.automd.com/shops/CA/ ) are obviously experiencing difficulties nowadays.