Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

21 January 2011

Update on Oil and Gasoline Price Projections

[For a brief post on the effect of the civil war in Libya, click here. For comment on assertions of a speculative effect, click here.]

On 15 December 2010, I posted my own projection of future crude-oil and gasoline prices, under the provocative title, “Four Dollars a Gallon by Next Summer.” My most pessimistic projection, per the title, assumed that OPEC would not use its reserve production capacity to keep oil prices down. My most optimistic projection (in my fourth-from-last paragraph) was for $4-per-gallon gasoline in 25 months, or by January 2013. That forecast assumed that OPEC would use all its reserve capacity to hold prices down but projected that its reserve capacity would run out in 1.47 years, with the price rise to $4 to follow, per my math, seven months later. These projections flowed from simple arithmetic: estimates of percentage increases in global supply and demand, assuming that oil demand growth would follow growth in GDP.

On January 11, our own federal Energy Information Administration (EIA) released its more optimistic projections. From the consumer’s perspective, we can summarize them as follows:

Time FrameWest Coast Gas PricePrice Elsewhere
Summer 2011$3.47$3.22
Summer 2012$3.59$3.34

The EIA was honest about the uncertainty of its projections. As it explained, “the current market prices of futures and options contracts for gasoline suggest[] more than a 25 percent probability that the national average retail price for regular gasoline could exceed $3.50 per gallon in the June through September period in 2011 and an 8 to 10 percent probability that it could exceed $4.00 per gallon in August and September 2011.” Presumably West Coast prices would be 25 cents higher—apparently a permanent regional price differential. (See EIA Projections, “Highlight,” third bulleted paragraph.)

This means that oil-industry insiders and high-volume users expect a better-than-one-in-four chance of gas above $3.50 nationally next summer, and $3.75 on the West Coast. That is certainly not inconsistent with my simple outsider’s arithmetic, especially as my pessimistic projection depended entirely on what OPEC will do.

No one can foresee the future precisely, and no honest analyst will say he can. So what’s more interesting than the EIA’s numbers are the assumptions on which they rely. By far the most important variable is demand/consumption, since there can be no assurance of significant additional supply (enough to budge oil prices) once OPEC’s reserve capacity runs out. That capacity is generally known, but its precise size is in dispute. So the EIA’s projections, as much as my own, turn primarily on estimates of global economic growth and the extent (highly uncertain) to which conservation and alternative-energy conversion might decrease the ratio of growth in oil use to economic growth.

The EIA is explicit about its growth assumptions. As it illustrates in a complex but fascinating chart, it expects “[t]he non-OECD countries . . . to account for all of the world’s [oil-consumption] growth over the next 2 years, with the largest contributions coming from China, the Middle East, and Brazil.” In other words, the fastest-growing parts of the global economy will set the pace for global oil prices and for gasoline prices here at home. Numerically, EIA forecasts global oil-consumption growth as averaging “1.4 million bbl/d in 2011 and 1.6 million bbl/d in 2012[,]” against a base of 86.6 million barrels per day (mbbd) in 2010. That’s an increase of 1.6% in 2011 and 1.8% in 2012.

And there’s the rub. Does anyone in his right mind expect the fastest growing parts of the global economy to grow more slowly than the developed nations? In its very own second “Highlights” paragraph, the EIA projects “U.S. real gross domestic product (GDP) grow[th at] 2.2 percent in 2011 and 2.9 percent in 2012, [and] world real GDP (weighted by oil consumption) grow[th at] 3.3 percent and 3.7 percent in 2011 and 2012, respectively.”

So the EIA’s own oil-consumption-growth figures appear to be inconsistent with its economic-growth figures, and the inconsistency appears to be on the optimistic side. In simple terms, the EIA appears to be assuming that oil demand will not track GDP growth, not even by half, and even in the most rapidly developing nations. And of course GDP growth in the developing countries that the EIA expects to account for oil-demand growth will be far higher.

I’ll leave it to readers to evaluate the plausibility of the EIA’s assumptions. For example, China reported [last paragraph] that its GDP grew by 10.3% in all of 2010. The fact that our own real (non-financial) economy is stagnant in every way (excluding a few excellent companies like Apple, Boeing, and Caterpillar), may give us a jaundiced view of the explosive growth in the developing world, which will account for nearly all of oil-demand growth over the next two years.

One more point is in order. The EIA’s global oil-consumption chart carefully avoids breaking out total consumption by region, as it did in 2003. Presumably, the gross per-capita overconsumption of the US and Canada, as compared to the rest of the world, hasn’t changed much since then. What that overconsumption means is that rising oil and gasoline prices will hurt us (and our friends to the north) much worse than they hurt any other nation or region.

Until we reduce our oil dependence, it will act like a brake on our economy. It will reduce our economic growth both when our own economy expands (as it’s still the world’s largest) and when the rest of the world’s expands. In other words, as long as we remain so oil-dependent, economic growth here and elsewhere will strangle our own, just as a condemned man’s struggling tightens the noose. So I repeat my question from my first post on near-term oil prices: isn’t it time we got serious about energy?

P.S. Personal Disclosure. In the interests of full disclosure, I must report that I put my money where my mouth is. I own two commodities indices, one of which relies one-third on oil, shares in several oil companies, long-term call options on Exxon Mobil, and shares in several mining companies whose products are used for alternative energy.

Assertions of a Speculative Bubble

Yesterday I finished reading Matt Taibbi’s Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America. It’s a superb bit of economic reporting and writing, by a man who is not an economist and makes no claim to be. I recommend it highly to anyone who wants to understand what really happened to our economy since the turn of the century and who caused it.

Taibbi has credibility with me because he’s a quick study, extremely bright, a marvelously lucid writer and apparently afraid of no one and no subject, no matter how complex. All these qualities are desirable in journalists, and our mainstream media today nearly all lack them utterly. So Taibbi is, in my view, a national treasure.

What makes his book relevant to this post is his assertion, expressed in his Chapter 4, that speculation, in the form of newly minted commodities indices, caused much or most of the 2008 commodities bubbles. His reporting is credible enough to make me diffident about my positive statement to the contrary in my 2008 post, and to push me to attempt a quantitative explanation.

Taibbi’s case for a speculation-induced bubble rest on four facts he asserts, none of which I have any reason to challenge. First, the law once limited trading in commodities futures to those who produced and used the commodities, until Goldman Sachs and several other Wall Street firms got regulatory exemptions from those restrictions (in other words, a license to gamble on other people’s business) in the early nineties. Second, the regulatory authorities tried hard to keep those exemptions-by-letter secret, from the industry and the public, for nearly two decades. Those exemptions were what allowed Goldman and others to create and sell the commodities indices that now trade as ETFs.

Taibbi’s third point is his only quantitative one. From 2003 to July 2008, he reports, investment “in commodity indices rose from $13 billion to $317 billion—a factor of twenty-five in a space of a little less than five years.” Finally, Taibbi recounts the well-known 2008 bubbles in oil and food prices and reports that, for oil at least, expert insiders saw no reason for the bubble other than speculation and no serious imbalance between supply and demand. He concludes from these facts that speculation in commodities indices, whipped to fever pitch by sellers hawking their wares to pension funds and institutional investors, helped cause the bubbles.

Despite his irreverent and profane language (which in most cases is well deserved), Taibbi is accurate and careful about his facts. He never claims that this phenomenon was the sole cause of the bubbles, and he never estimates exactly how much the speculation contributed to them.

It’s one thing to say that money invested by speculators in commodities indices leaped 25 times in a few years. But without knowing the precise size of the various commodities markets, precisely how much of that speculation was long and short, and precisely how much of the investment came in the separate market for each separate commodity, that number tells us little. It tells us that a speculative effect is likely, but it doesn’t even nail down its existence unambiguously, let along its magnitude.

What makes the math even more difficult is that each EFT index includes six or more different commodities. Typically they include basic crops, oil, precious metals and industrial metals like aluminum and copper. So without knowing which part of the huge surge in investment went into each, it’s hard to estimate the magnitude of any speculative effect.

If the speculation was indeed mostly on the long side, which a steady rise in the actual prices of commodities tended to suggest, what was the reason? It’s hard to believe that hard-nosed pension-fund managers were engaging in the same sort of irrational exuberance that had burst the dot-com bubble just a couple of years before. If they all ran, herd-like, to play in commodities, there probably was a reason. Maybe it was the Malthusian effect of the rest of the world (other than North America, Japan and Europe) jumping on a rapidly moving global development bandwagon.

Does this mean I reject Taibbi’s conclusion? No. His reporting has convinced me that there probably was a substantial speculative effect. But how big it was we just don’t know.

If the speculative effect was as much as half of the total, it means that my timelines (and the EIA’s) for various gas-price benchmarks probably should be doubled. If so, we might not get to $4-a-gallon gas for four years, instead of two. But get there we will, eventually, because the vast majority of the human race is building internal combustion engines and becoming addicted to gasoline at an incredibly rapid rate, as if there were no tomorrow.

There is an irony in all this. In focusing on food, Malthus may have picked the wrong commodity. Crops are somewhat elastic in supply, for mankind can grow more of them just by clearcutting forest and converting it into arable land. Even if the land is less arable than previously developed farms, it still will grow something and increase the supply of crops. There is certainly some limit to the process, including the fact that cutting down all the Earth’s remaining trees will destroy the oxygen-carbon dioxide cycle that supports all life on Earth. But it’s not clear we are anywhere near that drastic stage yet.

Oil and metals are a different story altogether. There are only so much in the Earth’s crust, shallow enough so we can get them, and atomic transmutation (for metals) is far too slow and expensive. So as more and more people demand more copper, aluminum and oil to build and run their machines, they are all working overtime to increase demand beyond supply and therefore to raise prices. We simply can’t increase the available amount of these commodities the way we can with crops; the amount available to us was fixed when the Earth formed four billion years ago or (in the case of oil) when oil formed from the primordial ooze.

That simple fact may have been a prime motivator behind the over-investment in indices that helped cause the 2008 bubble. But that doesn’t mean the imbalance of supply and demand is not real. It just means that our estimates of when the imbalance will tip decisively against us are less certain.

The Effect of the Civil War in Libya

This post has been getting lots of hits since the civil war in Libya started. I hope that doesn’t mean readers consider me a genius for having predicted the recent (as of March 11, 2011) spurt in oil prices. I didn’t. I didn’t foresee the peaceful revolutions in Tunisia and Egypt or the civil war in Libya, let alone their effect on oil prices. That effect is a short-term phenomenon; what I’m predicting above are medium-term and long-term effects.

As I confess above, predicting oil and gasoline prices is part art, part science. So the reasons for any prediction are as important as the conclusions. My predictions above don’t account for the civil war in Libya; they’re based on the fundamentals of supply and demand.

Libya’s troubles support my predictions in one respect and oppose them in another. They show how precariously balanced are global supply and demand for oil, and how slowly the major producers like Saudi Arabia and OPEC are to respond to bottlenecks in supply. Libya is just the world’s twelfth-largest oil producer. When its problems produce a ten-percent rise in oil prices in just a week, you can tell the system has little slack.

On the other hand, the abrupt price rise also reflects a significant impact of speculation in commodities futures. I have downplayed that impact above. But it will play an increasing role in raising oil prices as more and more people (like myself, I confess) try to make money out of a deplorable situation: our political and business leaders continuing to ignore the clear and present danger of oil addiction for four decades.

As speculative excesses arise and pull back, oil prices will rise and fall. But despite this volatility, the “secular” trend will go nowhere but up. That’s the inevitable Malthusian consequence of our globe having passed Peak Oil but continuing feverishly to build oil-burning cars, trucks and planes, the plants to make them, and the roads to take them.

For my take on how to influence Libya’s civil war, click here and here.

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