In a recent podcast episode, I analyzed three different scenarios where today’s expectations about future economic conditions can affect supplies and prices in the near term. Specifically, I analyzed this mechanism for three different goods: (i) US fiat dollars, (ii) barrels of crude oil, and (iii) ounces of gold. In the first installment of this blog post series, I covered the case of US dollars. In the present post we will cover the case of crude oil. Specifically, we will analyze what happens if people come to expect a massive increase in the supply of crude oil in the near future.
The Hotelling Framework for Oil
Before analyzing what happens when things change—namely, there’s “breaking news” that makes oil investors radically update their forecasts—we should first specify a framework for thinking about the oil market when things are stable. For this exercise, I think it’s most useful to take as a baseline the pioneering model spelled out in 1931 by economist Harold Hotelling. (I give more nuance on Hotelling’s approach in this article, but I will give the gist of it here.)
The special nature of oil and other exhaustible resources (such as coal and silver but not like wheat or timber) is that, absent change, the natural course of events is for its remaining supply to shrink over time. So as economists, even if we’re trying to model a “long run steady state,” we can’t use a model to determine the long-run equilibrium price. Rather, in Hotelling’s baseline model, the amount of oil is fixed, and so every barrel consumed today means one fewer barrel available in the future. So how can we approach this type of situation, to come up with some principles to pin down today’s spot price of oil?
To give a flavor of the answer, for simplicity let’s strip all of the uncertainty out of the supply side. Specifically, suppose that the entire stockpile of crude oil available within planet Earth is conveniently located in large pools at the surface, spread equally among (say) 10,000 deposits. Furthermore suppose that each pool of oil is owned by a separate company. We assume the owners of the oil look at today’s spot price, and make projections about future prices (aided by complex financial markets), and set their current rate of oil extraction (in terms of barrels/day) in order to maximize the present-value of their oil wealth.
Interest Rates Are Decisive
With this simple (yet instructive) framework, the answer pops out immediately: In equilibrium, if an individual company is maximizing the market value of its pool of oil, it must be the case that on the margin, it is indifferent between extracting one more barrel today, versus carrying that marginal barrel forward a year and selling at the spot price at that time.
For example, suppose the spot price of oil today is $100/barrel, and that the interest rate is 5%. If the company sells an extra barrel today, it gets $100 in revenue which can then be invested to grow to $105 in one year. Or, the company can keep that particular barrel in the pool, then sell it for the spot price of oil in one year. Hotelling showed that for the current extraction plan to make economic sense, the company’s executives must believe that the spot price of oil will rise to $105 by next year.
If the executives thought the spot price wouldn’t rise to $105, then they would make more profit by selling more barrels today, and using the proceeds to buy bonds. On the other hand, if they thought the spot price would rise more (perhaps to $110), then they would make more profit by holding barrels off the market (that they originally had planned on selling today) and carrying them to the future.
But of course, all of the companies’ executives are thinking this way. In equilibrium (in this simplistic model where nobody is exploring for new oil, etc.), it must be the case that the oil companies collectively extract so many barrels each year such that the spot price of oil rises exactly in accordance with the market rate of interest.
This makes sense, especially for those versed in the Austrian School of economics. Loosely speaking, the interest rate is an indicator of how “impatient” society is for consumption; a high interest rate signals a desire for immediate gratification, whereas a low interest rate signals a willingness to defer consumption today in exchange for more down the road.
In this context, then, it makes sense that a society with an interest rate of, say, 20% would consume its finite stock of oil more quickly (leading to 20% year/year price rises and consequently rapid reduction in the annual rate of oil consumption) while a society with an interest rate of 3% would carry the same stock of oil much longer into the future, as it consumed fewer barrels per year.
The Impact of an Expected Future Oil Glut
Now that we’ve sketched a basic framework, we can assess the impact of a sudden change in expectations. Similar to our USD example from Part 1, here we can imagine that a new pool of oil is discovered, which will double the total quantity of oil available to humanity. However, the hitch is that this particular pool is located in a remote location in South America, and it will take one full year to cut away the foliage and lay a pipeline to get it to a port for shipping. (Assume the monetary expense of preparing the infrastructure is negligible in the grand scheme, but it nonetheless takes time to start bringing the new barrels on the market.)
If we assume that the oil companies around the world think this is a one-off discovery, how will they update their operations? Assuming the newfound wealth doesn’t reduce the global market rate of interest (other things equal, richer people tend to save a higher fraction of their income), the effect will be to cause a drop in today’s price of oil, which will go along with a higher rate of extraction from the original pools. Motorists will see a sharp drop in the price of gasoline, and frequent fliers will enjoy lower airfare as the price of jet fuel plummets.
What is fascinating about this example is that humanity effectively will be benefiting from the discovery of future oil even before it has become physically available. In the real world, we saw a version of this when President George W. Bush made an announcement allowing for exploration in offshore lands, and oil prices dropped during the speech itself. Critics mocked the idea that a policy change allowing for new oil production years down the road could provide motorists relief in the present, but they were ignoring the fact that current deposits could be exploited more rapidly in the light of new expectations.
A Numerical Simulation
As with the previous installment, here we can present a numerical simulation (based on plausible parameters for the behavior involved) to help the reader visualize the scenario we presented above. As with all of these examples, this one should not be taken too seriously; the purpose of this series is simply to show how changing expectations about the future can influence production and consumption facts today.
With all of those caveats in mind, here is a numerical simulation. The story runs like this: Originally, the world price of oil is $119/barrel, the extraction rate is 64 million barrels per day, and the stockpile of proved reserves is 1,567 billion barrels. The interest rate is 5%, and the price elasticity of demand for oil is -0.3. (These parameter choices are close to the real world, but I had to make them all internally consistent in the Hotelling model.)
With these choices, the model unfolds over time like this:
As we explained above, the spot price of oil rises at 5% annually, which dovetails with the constantly falling annual production rate of oil (i.e. the extraction rate) and the correspondingly smaller stockpile of remaining oil.
Now suppose that at Year 5, there is a sudden announcement that the proved reserves in one year’s time will be double what was originally projected. Specifically, people learn at the start of Year 5 that in twelve months, some 1,434 billion new barrels of oil will be Delivered. Events unfold in the following way:
At Year 5 (when the Announcement is made), prices fall from $153 per barrel down to $15/barrel. Extraction normally would have been 59.7 million barrels/day, but now doubles to 119.4 mbd. Here is a longer horizon:
The big picture is that the doubling of the available stockpile leads to a doubling of the rate of extraction. This leads to a massive fall in oil prices, even before the new supplies are delivered to the market. (Incidentally, the prices fall so dramatically because we’ve used a real-world estimate for the elasticity of the demand for oil. Going the other way, if we wanted to cut global oil consumption in half, prices would have to skyrocket; simply doubling them wouldn’t do it.)
Conclusion
As with the USD example, so too with a physical commodity like oil, we see that there is a sense in which changing expectations about the future can “pull forward” the new supplies and affect prices today. In the next post we’ll show what happens with gold, which blends the features of fiat money and physical commodities.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together the dependability of Whole Life insurance policies with the benefits of blockchain-based finance.
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