1. 1 Energy Economics – I Jeffrey Frankel Harpel Professor, Harvard University ADA Summer School, Baku, Azerbaijan 7-9 July, 2010

2. 2 (1) Long-term trends: Are oil prices fated to rise as the world runs out? (2) Shorter-term movements: What causes swings such as the 2008 price spike?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

35. 35 Price of oil, 1869-2009

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

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

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

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

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

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

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

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

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

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

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

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

48. 48 Price of oil, 1970-2007

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

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

51. 51 The mechanism? High interest rates reduce the demand for oil, or increase the supply, through 3 channels: ¤ by increasing the incentive for extraction today rather than tomorrow; ¤ by decreasing firms' desire to carry inventories (oil stocks held in tanks or tankers) ¤ by encouraging speculators to shift out of spot oil contracts, and into treasury bills. All 3 mechanisms work to reduce the market price of oil, as when real interest rates where high in the early 1980s. All 3 mechanisms work to reduce the market price of oil, as when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising oil prices, as happened from Aug. 2007 to Sept. 2008. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising oil prices, as happened from Aug. 2007 to Sept. 2008. Call it an example of the “carry trade.” Call it an example of the “carry trade.”

52. 52 The monetary overshooting theory summarized Monetary contraction temporarily raises the real interest rate Monetary contraction temporarily raises the real interest rate whether via rise in nominal interest rate, fall in expected inflation, or both. whether via rise in nominal interest rate, fall in expected inflation, or both. Inventory demand falls. Oil prices fall. Inventory demand falls. Oil prices fall. How far? How far? Until oil is widely considered "undervalued" Until oil is widely considered "undervalued" -- so undervalued that there is an expectation of future appreciation -- so undervalued that there is an expectation of future appreciation together with other advantage of holding inventories: the "convenience yield“ together with other advantage of holding inventories: the "convenience yield“ that it is sufficient to offset the higher interest rate that it is sufficient to offset the higher interest rate and other costs of carrying inventories: storage costs plus any risk premium. and other costs of carrying inventories: storage costs plus any risk premium. Only then are firms willing to hold the inventories despite the high carrying cost. Only then are firms willing to hold the inventories despite the high carrying cost. In the long run, the general price level adjusts to the change in the money supply. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were Frankel "Expectations and Commodity Price Dynamics: The Overshooting Model," American J. of Ag. Economics (1986). Frankel "Expectations and Commodity Price Dynamics: The Overshooting Model," American J. of Ag. Economics (1986). __ & Hardouvelis, "Commodity Prices, Money Surprises, and Fed Credibility" J. of Money, Credit & Banking (1985). __ & Hardouvelis, "Commodity Prices, Money Surprises, and Fed Credibility" J. of Money, Credit & Banking (1985).

53. 53 Monetary influences on oil prices, continued Very low US real interest rates boosted commodity prices toward the end of the 1970s, Very low US real interest rates boosted commodity prices toward the end of the 1970s, especially in $ terms; especially in $ terms; high US interest rates drove them down in the 1980s, high US interest rates drove them down in the 1980s, especially in $. especially in $. In the years 2003-2010, low interest rates may again have been a source of high commodity prices. In the years 2003-2010, low interest rates may again have been a source of high commodity prices. References by the author include Frankel, 1986, 2008a,b; Frankel & Hardouvelis, 1985; Frankel & Rose, 2009; and "Real Interest Rates Cast a Shadow Over Oil," FTimes, April 15, 2005. References by the author include Frankel, 1986, 2008a,b; Frankel & Hardouvelis, 1985; Frankel & Rose, 2009; and "Real Interest Rates Cast a Shadow Over Oil," FTimes, April 15, 2005. Also Barsky & Summers, 1988; and Caballero, Farhi & Gourinchas, 2008. Also Barsky & Summers, 1988; and Caballero, Farhi & Gourinchas, 2008. Barsky & Killian (2002) and Killian (2009) believe that many big oil price “shocks” have in reality been endogenous with respect to monetary policy. Barsky & Killian (2002) and Killian (2009) believe that many big oil price “shocks” have in reality been endogenous with respect to monetary policy.

54. 54 Influences on oil inventories Regressors Real interest rate Standard Significant coefficient error at 10% 1. Real rate -5.96 0.29 * 2. Real rate -0.69 0.35 * & linear trend The spot-futures spread, risk & Industrial Production also appear significant in variants of the inventories equation. Source: Table 4, Frankel, “The Effect of Monetary Policy on Real Commodity Prices,” in Asset Prices and Monetary Policy, edited by John Campbell (University of Chicago Press), 2008, pp.291-327

55. 55 Real interest Spot- IP Δ IP Risk Δ risk Lagged rate futures inventories -0.394* -0.821* 0.397* -0.002* 0.089 0.041 0.062 0.001 -0.056 -0.079* 0.052* 0.000 0.931* 0.032 0.013 0.020 0.000 0.009 -0.211* -0.727* 0.131 -0.005* 0.085 0.040 0.126 0.001 -0.017 -0.071* 0.009 0.000 0.937* 0.032 0.012 0.045 0.000 0.009 * Asterisks indicate significance at the 5% level of significance. Non-stationary variables detrended by including quadratic terms in each regression Source: Frankel (2008) Influences on oil inventories, continued

56. 56 Reasons for the oil price rise, culminating in the 2008 spike As Jim Hamilton points out, it differed from the previous big oil price increases which arose in geopolitical disruptions to supply. As Jim Hamilton points out, it differed from the previous big oil price increases which arose in geopolitical disruptions to supply. Rather, there was a combination of rapidly growing demand, with stagnant supply. Rather, there was a combination of rapidly growing demand, with stagnant supply.

57. 57 Past oil price shocks arose in geopolitical supply disruptions Exogenous disruptions in world petroleum supply. ––––––––––––––––––––––––––––––––––––— Date Event Drop in world Drop in U.S. oil production real GDP Nov.1956 Suez Crisis 10.1% -2.5% Nov.1973 Arab-Israel War 7.8% -3.2% Nov.1978 Iran Revolution 8.9% -0.6% Oct.1980 Iran-Iraq War 7.2% -0.5% Aug.1990 Persian Gulf War 8.8% -0.1% ––––––––––––––––––––––––––––––––––––— Source: Hamilton (2003, p.11).

58. 58 Price of oil, 1940-2008 March 2008

59. 59 Reasons for the 2007-08 oil price spike, continued Instability among oil producers; fear of US-Iran conflict; misguided US ethanol subsidies; etc., Instability among oil producers; fear of US-Iran conflict; misguided US ethanol subsidies; etc., But the solution must be macroeconomic: But the solution must be macroeconomic: Prices of other minerals & agricultural products increased at the same time. Prices of other minerals & agricultural products increased at the same time. Many said speculators were driving up the price. Many said speculators were driving up the price. Two macroeconomic fundamentals could explain the decade’s boom in commodity markets: Two macroeconomic fundamentals could explain the decade’s boom in commodity markets: Low interest rates in the US; Low interest rates in the US; rapid growth worldwide, especially in China & India. rapid growth worldwide, especially in China & India.

60. 60 The rapid growth in world demand, especially from Asia, is obviously part of it The rapid growth in world demand, especially from Asia, is obviously part of it 2003-2007 2003-2007 and now back again since mid-2009. and now back again since mid-2009. But what explains the accelerated price rise in 2008? But what explains the accelerated price rise in 2008? All forecasts for growth in Asia & the world had been downgraded by then. All forecasts for growth in Asia & the world had been downgraded by then. Only the easing of US monetary policy fits. Only the easing of US monetary policy fits. Reasons for the 2007-08 oil price spike, continued

61. 61 Don Kohn and Paul Krugman: low interest rates or speculation could not be the causes, because oil inventories were low. It is true that low interest rates or speculation, other things equal, should in theory increase firms’ desire to hold inventories. US crude oil inventories did not appear especially low or high in the graph above, showing June 1998-June 2008 (from Bloomberg).

62. 62 World markets are relatively integrated, so it is world inventories that should matter most. Oil inventories in developed countries were above average during most of the year, as the graph shows. They rose in January 2008, when the Fed aggressively cut interest rates. These numbers are far from conclusive… Source : Oil Market Report: International Energy Agency

63. 63 Conclusion: Causes of 2008 Oil Spike Hamilton (2009) Primary causes: Booming demand and stagnant production Primary causes: Booming demand and stagnant production Possible secondary factors: Possible secondary factors: Low interest rates Low interest rates Speculation Speculation When the global recession is over, the fundamental imbalance will return. When the global recession is over, the fundamental imbalance will return. Thus the long-term and short-term may be linked: Thus the long-term and short-term may be linked: Malthus/Hotelling/Hubbert prediction of global scarcity Malthus/Hotelling/Hubbert prediction of global scarcity The 2008 price spike The 2008 price spike

64. 64 Addendum: Are speculators bad? Sure, speculators are important in commodities markets. Sure, speculators are important in commodities markets. The spot price of oil especially on a day-to-day basis, is determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price. The spot price of oil especially on a day-to-day basis, is determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price. That is speculation. That is speculation. But it need not imply But it need not imply bubbles or destabilizing behavior.

65. 65 Are speculators bad? continued Speculators often fulfill useful functions: Speculators often fulfill useful functions: If they know the price is temporarily high, they sell short, thereby moderating today’s high price. If they know the price is temporarily high, they sell short, thereby moderating today’s high price. If they have reason to think there will be a future increase in demand, they go long, thereby driving up today’s low price and sending the market signal needed to spur investment. If they have reason to think there will be a future increase in demand, they go long, thereby driving up today’s low price and sending the market signal needed to spur investment. In these cases they are the messenger delivering the news about economics fundamentals. In these cases they are the messenger delivering the news about economics fundamentals. Admittedly, there are sometimes speculative bubbles, a self-confirming movement of the market price away from fundamentals. Admittedly, there are sometimes speculative bubbles, a self-confirming movement of the market price away from fundamentals.

66. 66 A story from the 1955 movie East of Eden: The legendary James Dean plays Cal. The legendary James Dean plays Cal. Cal “goes long” in the market for beans, anticipating an increase in demand if the USA enters World War I. Cal “goes long” in the market for beans, anticipating an increase in demand if the USA enters World War I. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father. But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.” But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.” Cal has been the agent of Adam Smith’s famous invisible hand: By betting on his hunch about the future, he has helped raise the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the British Army). Cal has been the agent of Adam Smith’s famous invisible hand: By betting on his hunch about the future, he has helped raise the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the British Army). The movie even treats us to a scene in which Cal watches the beans grow, which real-life speculators seldom get to do. The movie even treats us to a scene in which Cal watches the beans grow, which real-life speculators seldom get to do.

67. 67 In Giant, it’s oil that James Dean invests in, before World War II again raises demand

68. 68