1. 1 Monetary Policy & Commodity Prices Study Center Gerzensee 23-25 June, 2014 Jeffrey Frankel Harpel Professor, Harvard University Lecture I: Monetary Influences on Commodity Prices

2. 2 Commodity prices have been volatile in recent years. What causes swings such as the 2008 & 2011 price spikes? The role of real interest rates. Appendices: I. Do speculators destabilize prices? II. Long-term commodity price trends.

3. Oil prices, for example, spiked in 2008, and reached a 2 nd peak in 2011.

4. 4 The impact on commodity-exporting developing countries Developing countries tend to be smaller than major industrialized countries, and more likely to specialize in the exports of basic commodities like oil, minerals, & agricultural commodities. Developing countries tend to be smaller than major industrialized countries, and more likely to specialize in the exports of basic commodities like oil, minerals, & agricultural commodities. So they are more likely to fit the small open economy model: So they are more likely to fit the small open economy model: price-takers, 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 taken as given on world markets. That is, the prices of their tradable goods are taken as given on world markets.

5. 5 The determination of the export price on world markets 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, Homogeneity: intrinsic perfect substitutability as between domestic & foreign producers – Homogeneity: intrinsic perfect substitutability as between domestic & 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. Besides homogeneity, we will also be assuming storability. Besides homogeneity, we will also be assuming storability. To be precise, not all barrels of oil are the same, nor are traded in competitive markets. To be precise, not all barrels of oil are the same, nor are traded in competitive markets. But the assumption that most commodity producers are price-takers holds relatively well. But the assumption that most commodity producers are price-takers holds relatively well.

6. 6 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.

7. 7 To a 1 st approximation, then, To a 1 st approximation, then, the local commodity price = (the exchange rate) X ($ price on world markets). (s j/c ) = (s j/$ ) + (s $/c ) (s j/c ) = (s j/$ ) + (s $/c ) where s j/$ ≡ spot exchange rate in units of currency j per $, s $/c ≡ spot price of commodity c in terms of $; => a devaluation should push up the commodity price quickly and in proportion => a devaluation should push up the commodity price quickly and in proportion leaving aside pre-existing contracts leaving aside pre-existing contracts or export restrictions. or export restrictions. The determination of the export price continued

8. 8 Why are commodity prices so volatile? Demand elasticities are low in the short run, because the capital stock is designed to operate with a particular ratio of material inputs to output. Demand elasticities are low in the short run, because the capital stock is designed to operate with a particular ratio of material inputs 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. Because price elasticities of supply & demand are low, relatively small fluctuations in demand or supply (due, e.g., to weather) require a large change in price to re-equilibrate supply & demand. Because price elasticities of supply & demand are low, relatively small fluctuations in demand or supply (due, e.g., to weather) require a large change in price to re-equilibrate supply & demand.

9. 9 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 commodity D D D'D' D'D' S S The increase in demand drives up the price

10. 10 Volatility, continued Inventories Inventories can cushion the short run impact of fluctuations, can cushion the short run impact of fluctuations, but they are limited by storage costs but they are limited by storage costs due to capacity constraints and due to capacity constraints and carrying cost (interest rate, insurance, spoilage…) carrying cost (interest rate, insurance, spoilage…)

11. 11 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.

12. 12 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.

13. 13 Price of oil, 1970-2007

14. 14 Volatility, continued In the medium term, commodities can show a cob-web cycle, due to the lags in response: In the medium term, commodities can show 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

15. Four explanations for big recent increases in the prices of oil, minerals & agricultural commodities (1) global growth (1) global growth especially China especially China (2) speculation (2) speculation defined as purchases of commodities, in anticipation of gain at the time of resale. defined as purchases of commodities, in anticipation of gain at the time of resale. However, this includes: However, this includes: not only possible destabilizing speculation (bandwagons), not only possible destabilizing speculation (bandwagons), but also stabilizing speculation. but also stabilizing speculation. (3) easy monetary policy (3) easy monetary policy reflected in low real interest rates. reflected in low real interest rates. (4) financialization: (4) financialization: open position in commodities futures, open position in commodities futures, by commodity index funds & other traders by commodity index funds & other traders esp. since 2005 esp. since 2005

16. 16 Monetary influences on commodity prices We will show an arbitrage condition between the physical stock of a storable commodity like oil and the interest rate. We will show an arbitrage condition between the physical stock of a storable commodity like oil and the interest rate. The real price of oil should be high during periods when real interest rates are low (e.g., due to easy monetary policy), The real price of oil should be high during periods when real interest rates are low (e.g., due to easy monetary policy), so that a poor expected future return to holding oil offsets the low interest rate. so that a poor expected future return to holding oil offsets the low interest rate. By contrast, when real interest rates are high (e.g., due to tight money), current oil prices should lie below their long-run equilibrium, By contrast, when real interest rates are high (e.g., due to tight money), 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.

17. High real interest rates reduce the price of storable commodities through 4 channels: ¤ by increasing the incentive for extraction today ¤ by increasing the incentive for extraction today rather than tomorrow rather than tomorrow think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled. think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled. ¤ b y decreasing firms' desire to carry inventories ¤ b y decreasing firms' desire to carry inventories think of oil inventories held in tanks. think of oil inventories held in tanks. ¤ by encouraging speculators to shift out of commodity contracts, and into treasury bills ¤ by encouraging speculators to shift out of commodity contracts, and into treasury bills the “financialization" of commodities. the “financialization" of commodities. ¤ by appreciating the domestic currency ¤ by appreciating the domestic currency and so reducing the price of internationally traded commodities in domestic terms and so reducing the price of internationally traded commodities in domestic terms even if the price hasn't fallen in terms of foreign currency. even if the price hasn't fallen in terms of foreign currency.

18. 18 The mechanisms at work in recent history 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 recent years, e.g., 2008, low interest rates again contributed to high commodity prices. In recent years, e.g., 2008, low interest rates again contributed to high commodity prices. References by the author include Frankel, 1986, 2005, 2008a,b, 2014; Frankel & Hardouvelis, 1985; Frankel & Rose, 2009. References by the author include Frankel, 1986, 2005, 2008a,b, 2014; Frankel & Hardouvelis, 1985; Frankel & Rose, 2009. Also Barsky & Summers, 1988; and Caballero, Farhi & Gourinchas, 2008. Also Barsky & Summers, 1988; and Caballero, Farhi & Gourinchas, 2008. Barsky & Killian, 2002, and Killian, 2009: many big oil price “shocks” have in reality been endogenous with respect to monetary policy. Barsky & Killian, 2002, and Killian, 2009: many big oil price “shocks” have in reality been endogenous with respect to monetary policy.

19. Figure 1a: Real commodity price index (Moody’s) and real interest rates

20. Figure 1b: Real commodity price index (Moody’s) and real interest rates

21. 21 The overshooting theory mechanics 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 (<= high “cost of carry”). Inventory demand falls (<= high “cost of carry”). => Oil prices fall. => 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: esp. storage costs. and other costs of carrying inventories: esp. storage costs. 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 real interest rate & real commodity price return to equilibrium values. In the long run, the real interest rate & real commodity price return to equilibrium values.

22. Literature on inventories We need to include inventories, We need to include inventories, E.g., Working (1949); Deaton & Laroque (1996); Ye, Zyren & Shore (2002,05,06) E.g., Working (1949); Deaton & Laroque (1996); Ye, Zyren & Shore (2002,05,06) and the role of speculation & interest rates. and the role of speculation & interest rates. Some have found evidence in inventory data for an important role for speculation, Some have found evidence in inventory data for an important role for speculation, driven by geopolitical fears: driven by geopolitical fears: disruption to the supply of Mideastern oil. disruption to the supply of Mideastern oil. Kilian & Murphy ( 2013); Kilian & Lee (2013). Kilian & Murphy ( 2013); Kilian & Lee (2013). But the speculative factor is inferred implicitly But the speculative factor is inferred implicitly rather than measured explicitly. rather than measured explicitly.

23. Empirical innovations of the 2014 paper Relative to past attempts to capture the roles of speculation or interest rates via inventories: Relative to past attempts to capture the roles of speculation or interest rates via inventories: How to measure speculation, i.e., market expectations of future commodity price changes ? How to measure speculation, i.e., market expectations of future commodity price changes ? Survey data collected by Consensus Forecasts Survey data collected by Consensus Forecasts from “over 30 of the world's most prominent commodity forecasters.” from “over 30 of the world's most prominent commodity forecasters.” How to measure perceived risk to commodity availability? How to measure perceived risk to commodity availability? Volatility implicit in options prices. Volatility implicit in options prices.

24. Derivation & estimation of the model 1) The overshooting model 1) The overshooting model shows the effect of the real interest rate on the real commodity price, shows the effect of the real interest rate on the real commodity price, holding storage costs constant. holding storage costs constant. We can also show how the local-currency commodity price depends on the local interest rate too. We can also show how the local-currency commodity price depends on the local interest rate too. 2) We can infer storage costs from inventories. 2) We can infer storage costs from inventories. 3) The full commodity price equation 3) The full commodity price equation Adds to the overshooting model: Adds to the overshooting model: inventories / storage costs; inventories / storage costs; & economic activity / convenience yield. & economic activity / convenience yield. 24

25. 1 st assumption: regressive expectations

27. Regression of real commodity price indices against real interest rate (1950-2012) Table 1 Dependent variable: log of commodity price index, deflated by US CPI VARIABLES CRB index Dow Jones Index Moody’s index Goldman Sachs Index Real interest rate-.041***-.034*** -.071** -.075*** (0.007)(0.006)(0.005)(0.007) Constant0.900***0.066***2.533***0.732*** (0.017)(0.016)(0.011)(0.018) Observations739 513 R 2 0.04 0.250.18 *** p<0.01 (Standard errors in parentheses.) q is inversely proportionate to the real interest rate The overshooting model :

28. For a model of commodity prices in local currencies, combine commodity price overshooting with Dornbusch exchange rate overshooting.

29. The overshooting equation for commodity prices in local currencies Equation (9) says the real commodity price observed in country j is high to the extent that Equation (9) says the real commodity price observed in country j is high to the extent that either the US real interest rate is low, either the US real interest rate is low, or the local real interest rate is low or the local real interest rate is low relative to the US real rate. relative to the US real rate. Equation tests for 8 floating-currency countries: Equation tests for 8 floating-currency countries: Local & US real interest rates do have significant effects on local real commodity price indices (CRB, Dow Jones, The Economist, Goldman Sachs, Moody’s & Reuters). Local & US real interest rates do have significant effects on local real commodity price indices (CRB, Dow Jones, The Economist, Goldman Sachs, Moody’s & Reuters). Frankel (2008). Frankel (2008). 29

30. 3a. Log Real CRB Commodity Price Index in Local Currency & Real Interest Rates Short-term interest ratesLong-term interest rates Sample Real US i rate Real interest differentialSample Real US rate Real interest differential Australia 1/1950-8/2005 -0.023*-0.076* 1/1950-8/2005 -0.057*-0.067* s.e. 0.006 0.003 0.005 0.004 Brazil 7/65-12/89 & 1/95-8/05 -0.024*-0.006* 5/1994-9/2005 -0.161*-0.001 s.e. 0.007 0.002 0.019 0.001 Canada 1/1950-9/2005 -0.047*-0.065* 1/1950-9/2005 -0.073*-0.076* s.e. 0.005 0.004 0.006 Chile 7/1997-9/2005 -0.063*-0.021* 2/1993-2/2004 -0.092*-0.018* s.e. 0.006 0.004 0.014 0.003 Mexico 1/1978-9/2005 0.055*-0.017* 1/1995-9/2005 0.047*0.000 s.e. 0.013 0.002 0.011 0.003 NZ 3/1978-8/2005 0.001 -0.067* 1/1950-8/2005 -0.081*-0.075* s.e. 0.009 0.004 0.006 0.004 Switzerlnd 1/1980-9/2005 0.034*-0.054* 5/1953-9/2005 -0.171*-0.095* s.e. 0.016 0.009 0.013 0.012 UK 1/1950-9/2005 -0.053*-0.086* 1/1950-9/2005 -0.106*-0.023* s.e. 0.010 0.007 0.006 Regressions of commodity price in local currency on interest rates Monthly observations (over largest possible sample of data since 1950) * significance at 5% significance level. Robust standard errors are reported.

31. Derivation of inventory demand equation E (Δs) + cy – sc – rp = i (3) or sc = [E (Δs)-i] +cy – rp. (7) 3 rd assumption: Storage costs rise with the extent to which inventory holdings strain existing storage capacity: sc = Φ ( INVENTORIES ). Invert: INVENTORIES = Φ -1 { sc }. And combine with the arbitrage condition (7): INVENTORIES = Φ -1 {[E(Δs)-i] +cy – rp} (8) The carry trade model

32. Petroleum stocks Millions of barrels (3) (4)(1)(2) Carry trade: E Δs - i0.12*** 0.02* (0.03) (0.01) Actual US IP growth 0.56*** 0.020.01 (0.15) (0.08) US Industrial Prod. log -0.01 0.01 (0.07)(0.04) Forecast 2-yr IP growth-0.674**-0.671**0.0030.000 (0.318) (0.146) Oil Stocks lagged log 0.91*** (0.05) Trend0.004*** 0.000 (0.000) Constant7.31***7.36***0.650.60 (0.01)(0.32)(0.39)(0.48) R2R2 0.84 0.97 Table 4 -- Oil Inventory Equation (1995-2011) 58 observations, quarterly

33. Now put inventories into the commodity price equation When inventories rise, the commodity price falls. WEO, IMF, April 2012

34. Complete equation for determination of price

35. Estimation of determination for real prices, commodity-by-commodity, 1950-2012 Table 2a -- 1 st half (1)(2)(3)(4)(5) Commodity:CopperCornCottonLive cattleLive hogs Real interest rate -0.07***-0.05*0.01-0.05***-0.04*** (0.02)(0.03)(0.01)(0.02)(0.01) Log World GDP-0.460.620.562.26-2.62** constant 2000US$ ; WDI (0.57) (0.58)(1.48)(1.12) Log Inventories-0.19***-0.07-0.131.120.42* (0.06)(0.17)(0.12)(0.78)(0.24) Spread, %0.000-0.006-0.001-0.007***-0.004*** Future-Spot(0.002)(0.003)(0.001)(0.002)(0.001) Volatility: Std.dev.3.04***0.940.20-0.27-1.02 of log price over past year(0.72)(0.91)(0.53)(0.78)(0.61) Linear trend-0.00-0.04**-0.04*-0.08*0.05 (0.02) (0.04)(0.03) Constant16.94-20.26-14.94-81.6574.87** (17.29)(16.54)(17.29)(51.77)(33.00) Observations (annual) † 5051 3239 R2R2 0.550.660.760.510.80 *** p<0.01, ** p<0.05, * p<0.1 (Robust standard errors in parentheses.) † Some commodities have shorter sample periods.

36. Estimation of determination for real prices, commodity-by-commodity, 1950-2012, continued *** p<0.01, ** p<0.05, * p<0.1 (Robust standard errors in parentheses.) † Some commodities have shorter sample periods. Table 2a -- 2 nd half (6)(7)(8)(9)(10)(11) Commodity: OatsPetroleumPlatinumSilverSoybeansWheat Real interest rate -0.04**-0.020.08***-0.02-0.04**-0.003 (0.016)(0.071)(0.015)(0.025)(0.016)(0.021) Log World GDP1.56**-4.423.38***3.63*0.380.33 (constant 2000 US$);WDI(0.593)(4.984)(0.753)(2.012)(0.837)(0.702) Log Inventories-0.31**-2.82-0.24***0.010.04-0.45* (0.13)(4.43)(0.03)(0.11)(0.09)(0.24) Spread, %-0.015*-0.002-0.000-0.010**-0.007**-0.001 Future-Spot(0.003) (0.001)(0.004)(0.003) Volatility: Std.dev. 0.91-0.081.10***5.15***1.86**1.81*** of log price over past year(0.66)(0.69)(0.36)(0.67)(0.87)(0.65) Linear trend-0.09***0.17-0.12***-0.12*-0.04-0.03 (0.03)(0.14)(0.03)(0.06)(0.03)(0.02) Constant-45.54***156.65-98.36***-111.77*-13.65-7.09 (16.33)(142.65)(22.41)(60.57)(24.71)(20.18) Observations (annual)502947444851 R2R2 0.630.340.730.620.710.74

37. A panel across all 11 commodities offers hope for greater statistical power Table 3a Dependent variable: real commodity prices (log) (492 annual observations) (1)(6)(7) Real interest rate-0.02*-0.03**0.01 (0.01) Log World GDP0.013.45*** (constant 2000 US$) WDI(0.24)(0.77) Global Business Cycle7.22*** (HP-Filtered World GDP) (1.08) Quadratic Trend0.001*** (0.000) Log Inventories-0.14*** -0.13*** (0.03)(0.02) Future-Spot Spread, %-0.003*** (0.001) (0.000) Volatility: Standard deviation 1.81***1.92***1.77*** of log spot price of past year(0.52)(0.51)(0.47) Linear Trend-0.02*-0.02***-0.19*** (0.01)(0.00)(0.04) Constant0.010.32-101.90*** (7.01)(0.23)(22.93) R2R2 0.460.490.51

38. Panel across all 11 commodities; First differences guard against non-stationarity Table 3b Dependent variable: Δ real commodity prices (log) (1)(6)(7) Δ Real interest rate-0.021-0.001-0.029** (0.013)(0.006)(0.012) Global Business Cycle6.765*** (HP-Filtered World GDP)(1.035) Forecast 2-yr.US GDP growth8.575***11.365*** (Consensus Forecasts monthly)(1.978)(2.178) Quadratic trend0.002*** (0.000) Δ Log Inventories-0.004-0.08-0.008 (0.061)(0.0481)(0.056) Δ Future-Spot Spread, %-0.001***-0.002*** (0.000)(0.0005)(0.000) Δ Volatility: Std.dev. of-0.0670.1920.068 log spot price of past year (0.184)(0.213)(0.208) Linear Trend 0.010***0.002***-0.024*** (0.002)(0.000)(0.005) Constant -0.314***-0.043***-0.271*** (0.068)(0.009)(0.071) Observations 216486216 R2R2 0.220.170.27

39. In conclusion… The model can accommodate each of the explanations for recent increases in commodity prices: economic activity, speculation, and easy monetary policy. The model can accommodate each of the explanations for recent increases in commodity prices: economic activity, speculation, and easy monetary policy. Based on “carry trade”: arbitrage relationship between expected price change & costs of carry: interest rate, storage costs & convenience yield. Based on “carry trade”: arbitrage relationship between expected price change & costs of carry: interest rate, storage costs & convenience yield. And on “overshooting”: prices are expected to regress gradually back to long-run equilibrium And on “overshooting”: prices are expected to regress gradually back to long-run equilibrium

40. 40

41. 41 Appendix I: Do speculators destabilize prices? Yes, speculators are important in commodities markets. Yes, speculators are important in commodities markets. The spot price is determined in markets where participants typically base their supply & demand in part on their expectations of future increases or decreases in the price. The spot price is determined in markets where participants typically base their supply & 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.

42. 42 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.

43. An example of commodity speculation In the 1955 movie version of East of Eden, the legendary James Dean plays Cal. In the 1955 movie version of East of Eden, the legendary James Dean plays Cal. Like Cain in Genesis, he competes with his brother for the love of his father. Like Cain in Genesis, he competes with his brother for the love of his father. Cal “goes long” in the market for beans, in anticipation of a rise in demand if the US enters WWI. Cal “goes long” in the market for beans, in anticipation of a rise in demand if the US enters WWI.

44. An example of commodity speculation, cont. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father, a moralizing patriarch. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father, a moralizing patriarch. But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and tells him 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 tells him he will have to “give the money back.”

45. Cal has been the agent of Adam Smith ’ s famous invisible hand: Cal has been the agent of Adam Smith ’ s famous invisible hand: By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the Army). thereby increasing the supply so that more is available precisely when needed (by the Army). The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to see. The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to see. An example of commodity speculation, cont.

46. 46 Appendix II: Long-term world price trend (i) The old “structuralist school” (Prebisch-Singer): (i) The old “structuralist school” (Prebisch-Singer): The hypothesis of a declining commodity price trend The hypothesis of a declining commodity price trend (ii) Hypotheses of a rising price trend (ii) 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

47. 47 Permanent upward trend? It looked like it in 2007. Price of oil

48. 48 But not in 2009. One needs to look at the very long term

49. 49 (i) 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

50. 50 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.

51. 51 “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.

52. 52 (ii) Hypotheses of rising trends 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. (A) Hotelling: depletable resources; (A) Hotelling: depletable resources; (B) Malthus: geometric population growth. (B) Malthus: geometric population growth.

53. 53 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.

54. 54 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.

55. 55 Price of oil, 1900-2006 Oil shocks 1 1973 Arab oil embargo 2. 1979 fall of Shah of Iran 3. 2008 spike

56. 56 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.

57. 57 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.

58. 58 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)

59. 59 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.

60. 60 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.

61. 61 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.

62. 62 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

63. 63 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?

64. 64 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]

65. 65 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.

66. 66 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.

67. 67 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 claimed the 2000-2008 run-up in oil prices confirmed a predicted global “Hubbert’s Peak.” [1] Some claimed the 2000-2008 run-up in oil prices confirmed a predicted global “Hubbert’s Peak.” [1] [1] Are we witnessing a peak in world oil production? Are we witnessing a peak in world oil production? forecasts of such peaks have proven erroneous in the past. forecasts of such peaks have proven erroneous in the past. The “fracking revolution” supports the opposite view. The “fracking revolution” supports the opposite view. [1][1] E.g., Deffeyes (2005). [1] Hubbert’s Peak – Global

68. 68 HeatUSA.com blog Hubbert’s Peak – global

69. 69 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.

70. 70 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.

71. 71 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]

72. 72 What is the trend in the price of oil in particular? 1869-1969: Downward 1869-1969: Downward 1970-2011: Upward 1970-2011: Upward The long run: Unclear ? The long run: Unclear ?

73. 73 Price of oil, 1869-2009

74. 74