Wednesday, June 6, 2012

Supply curves: Kinked? Or merely confused?

I'm still working through the comments from Saturday's post--actually, this is the second post working through one comment. The first reply-post dealt with the question of affording the necessary work of restructuring our built environment. This one is about Jason's other point, wondering how much of the kinked supply curve I showed in the original post was about geopolitics, especially events around the Iraq War, rather than being simply a story about inability to expand production. "We should of course be pointing to resource limitations, but the danger is that if Oil output soars as Iraq retools, then all those naysayers will point to that as evidence for their position."

The Iraq story is a reasonable guess but it doesn't end up fitting the data all that well. Here's a recasting of the kinked supply curve, with the different parts broken out:
You can see that the original price run-up goes from sometime in 2004 to July of 2008. Then there's the dramatic price collapse from August of 2008 through the next January, followed by a renewed rise back to around $100 per barrel, where it has hung out for more than a year (though it has slipped in the last month or so--the data only run through February of this year).

If you look at the data on Iraqi oil production, 2004 was actually their recent low.
Their output was falling from 2000 through 2003, with stable oil prices, and their output has risen almost continuously since then, as the price has gone to its 2008 record, then plummeted, then come back up.

And while every little bit helps, Iraq's output is about 3% of global output:

Iraq aside, it's interesting to compare the recent price pattern with earlier experience.

The data start in January 1974, so they miss the initial 1973 price jump from the Mideast war of that year. Then there's a remarkably stable plateau through April 1979, followed by the spike up to almost $100 (in 2011 $) in 1981. 1986 through 2003 are another period of stability, this time at a lower price than in the 1970s, and finally the nearly vertical data since 2004. The purple bump in the middle is the price spike (and reduced global output) associated with Iraq's invasion of Kuwait in 1990.

In 1978, Iran and Iraq together made up 12.4% of the world's oil production. Then Iran took a whack at its own production with its revolution, followed up by Iran and Iraq whacking at each other's production with Iran-Iraq War. In 1979 the two countries produced 6.7 million barrels per day, out of a world total of 59.3 million. By 1981, global production had fallen by 2 million barrels per day, to 57.3 million, but Iranian plus Iraqi production had fallen 4.5 million barrels, to a daily rate of 2.2 million. That's certain to leave a mark on your market.

The most recent run-up has no event of comparable scale; it looks a lot more like global demand was rising with the growth of China, India, and Brazil and the housing bubbles in the U.S. and parts of Europe, and producers just couldn't keep up.

(I remember repeatedly hearing about assurances from the Saudi oil minister that they desired a price of about $40 per barrel, when the actual price was around $60, then that they desired a price of $60 when it was $80, then that they considered $70 to be a sustainable price, when the world was paying $100, and so on. They claim to be the "swing producer," the one with so much spare capacity that they can sell more oil as needed to keep the price where they want it. Their failure to do so while saying they wanted to ... it did tend to strengthen the argument that they weren't able.)

What about the last little tail of the first chart in this post? From March 2011 to February 2012, the quantity has moved pretty consistently rightward at a stable price. Is this a new plateau, like 1974-1979, or 1986-2003? Maybe. I certainly don't have a crystal ball. But if it is a plateau, it's at a remarkably high price, around $100, as opposed to the mid-$40s of the 1970s or the roughly $30 price of the 1980s and 90s. To stay at this price for an extended time would be new territory for the global economy.

Four years ago I was asked to make after-dinner remarks at the dedication of Golisano Hall, the most recent addition to Hartwick's campus. Since the building has LEED certification (an indication of good environmental performance), I talked about how its construction fit into what we were experiencing with oil prices. (I'm not saying that asking me to speak after the dinner was a good idea, merely that that's what happened.) This was the fall of 2008, when the price of oil was around $80 per barrel, but people were still freaked out by the early-July price of $147, and we didn't yet know that by the end of the year it would fall all the way back to $40, nor that it would then more or less steadily make its way back above $100.
I certainly didn't see it coming, but I was comfortable making one prediction, which was that we might see something like prosperity, but it would be with a high oil price; and we might see low oil prices, but that would be during times of economic contraction. I thought that it would be a long time before we again saw cheap oil and a prosperous economy at the same time.

And I think that's been borne out. The global economy sort of recovered from the financial mess of 2008, and oil returned to historically high levels. Now the price is softening, back into the range of $80 per barrel, but U.S. GDP growth is slowing, the Eurozone is heading back into recession, and even China's economy is looking sluggish compared to what  they've gotten used to.

There are good reasons for what looks like perpetual tightness in global oil markets, and they're summed up well in a recent paper by James Hamilton from UC San Diego. First, he makes a strong case, for the U.S. and then for the global oil market, that expanded production has come much more from finding new places to drill, rather than by getting more oil out of known deposits. This matters, because one of the reasons for most economists' complacency about energy prices is a pristine faith in the efficacy of prices: as oil prices go up, people will conserve, and technology will find a way to produce more. Well, people do conserve, but that often happens through recession. And if expanded production comes more from going to new places, then that's troubling, because it's not clear how many more new places there are now, compared to in the 1970s.

Second, Hamilton argues that we're entering an age when oil will have to be priced like an exhaustible resource, rather than like an inexhaustible resource. That may seem unremarkable--after all, oil is an exhaustible resource, so why should it be noteworthy if it's priced like one? And what does it mean to price something like an inexhaustible resource.

In most situations, economists argue that things will be priced at their marginal cost of production: if you're willing to pay the amount it will cost me to produce one more unit of something, then I'll be willing to produce it and sell it to you. But an exhaustible resource is different. In addition to looking at the cost of pulling it out of the ground, I need to consider that every additional barrel I pump and sell this year is one less barrel that I'll be able to pump and sell in some future year.

The economist Harold Hotelling formalized this in what has become known as the Hotelling Rule, which says that the price of a non-renewable resource should go up at the rate of interest. Let's say you can earn 5% per year investing in the stock market; that means that you should expect the in situ price of oil (the price for it sitting in the ground) to also rise at 5% per year.

Over the great majority of its history, oil pretty clearly hasn't done that.
From BP Energy Outlook 2030,
There are various candidates for explaining why oil prices haven't done what Hotelling's theory so elegantly says they should do. Hamilton argues that, for most of the Oil Age, it was reasonable to assume that the potential supply was really large compared to what was being used, and that we didn't know just how large it was. Applying the Hotelling Rule requires that you have a pretty good idea how much of the resource there is (along with a number of other difficult conditions), so it's reasonable that if we kept revising upward our estimate of how much oil there is, we wouldn't be inclined to put much weight on future scarcity in setting our prices. Which means you'd sell oil more or less at its marginal cost (the current cost of getting another barrel out of the ground).

Even if Iraqi production comes on like gangbusters (and I have my doubts), we're not going back to the experience before 1970, when annual discoveries tended to be much larger than annual consumption. Which means the owners of oil deposits may start pricing it more like Hotelling says they should, charging an increasing premium above production costs to make it worth their while to give up the future revenue.

So sure, Iraq may be able to considerably increase its production. And people with a more optimistic take on oil supplies may point to that to argue that I don't know what I'm talking about. But there are so many aging fields in decline, from the North Sea, to Mexico's Cantarell, to possibly even Saudi Arabia's Ghawar, that I wouldn't expect Iraq to be a game-changer. I still see things the way I did in 2008, that we'll either have cheap oil (though not that cheap), or prosperity (though probably not that prosperous), but not both.

Anyone looking for a light-hearted after-dinner speaker?


  1. Hi Karl,
    Thank you for this quite remarkable and in-depth analysis. I guess I would still say there's a lot of politics playing with oil, and obviously have been since 1973 and before. That probably is more routine for commodity production than most are led to believe, but oil seems unusually charged.

    I would also note that an inflation calculator tells me an item that went for $40 in 1975 should be about $170 today--in that context, a $100/barrel plateau (if that occurs) doesn't seem like a remarkably high price. It certainly is high in the context of the 1980s and 1990s, but maybe those prices were simply remarkably and ridiculously low. I remember thinking gas was too cheap back then--the low price of oil was also a huge factor in driving the Soviet Union out of business.

  2. Hi Jason,

    The "$40 in 1975" has already been adjusted for inflation. The "current-dollar" price during the second half of the 1970s was between $10 and $14--in other words, about $40 in terms of the value of a dollar in 2011. So a plateau at $100 would actually be something new under the sun.

    If you look at the last chart in the post, taken from BP's "Energy Outlook," the light green line is inflation-adjusted. The dark-green line gives the nominal price, or the number of dollars that people were paying at the time.

    In nominal terms, recent prices are much higher than those from the last spike around 1980, and those in turn are much higher than at the dawn of the Oil Age. But when you strip away the effects of inflation, now and 1980 and the 1860s all had comparable oil prices.

  3. Oops! Thank you for the clarification. So much for my econ career. No chart-reading abilities.