naked capitalism

Here I wanted a light weekend and what does Jim Hamilton do but go and put up a link to a very interesting new paper of his. This is from the introduction:

How would one go about explaining what oil prices have been doing and predicting where they might be headed next? This paper explores three broad ways one might approach this. The first is a statistical investigation of the basic correlations in the historical data. The second is to look at the predictions of economic theory as to how oil prices should behave over time. The third is to examine in detail the fundamental determinants and prospects for demand and supply. Reconciling the conclusions drawn from these different perspectives is an interesting intellectual challenge, and necessary if we are to claim to understand what is going on.

In terms of statistical regularities, the paper notes that changes in the real price of oil have historically tended to be (1) permanent, (2) difficult to predict, and (3) governed by very different regimes at different points in time.

From the perspective of economic theory, we review three separate restrictions on the time path of crude oil prices that should all hold in equilibrium. The first of these arises from storage arbitrage, the second from financial futures contracts, and the third from the fact that oil is a depletable resource. We also discuss whether commodity futures speculation by investors with no direct role in the supply or demand for oil itself could be regarded as a separate force influencing oil prices.

In terms of the determinants of demand, we note that the price elasticity of demand is challenging to measure but appears to be quite low and to have decreased in the most recent data. Income elasticity is easier to estimate, and is near unity for countries in an early stage of development but substantially less than one in recent U.S. data. On the supply side, we note problems with interpreting OPEC as a traditional cartel and with cataloging intermediate-term supply prospects despite the very long development lead times in the industry. We also relate the challenge of depletion to the past and possible future geographic distribution of production.

Our overall conclusion is that the low price-elasticity of short-run demand and supply, the vulnerability of supplies to disruptions, and the peak in U.S. oil production account for the broad behavior of oil prices over 1970-1997. Although the traditional economic theory of exhaustible resources does not fit in an obvious way into this historical account, the profound change in demand coming from the newly industrialized countries and recognition of the finiteness of this resource offers a plausible explanation for more recent developments. In other words, the scarcity rent may have been negligible for previous generations but is now becoming significant.

Some interesting extracts:

All of the above test results are consistent with the claim that the real price of oil seems to follow a random walk without drift. The price increased over the sample by 172% (logarithmically), but a process like this one could just as easily have decreased by a comparable amount. While one might have forecasting success with more detailed specifications over shorter samples, the broad inference with which we come away is that the real price of oil is not easy to forecast….It is sometimes argued that if economists really understand something, they should be able to predict what will happen next. But oil prices are an interesting example (stock prices are another) of an economic variable which, if we really understand it, we should be completely unable to predict.

Hamilton goes through the economics of depletion, point out that it may be rational for producers to pump less under circumstances, and provides some anecdotal support, including this item from the November 2006 Energy Information Administration Country Analysis Brief on Kuwait

“Project Kuwait,” to be developed over 25 years, was first formulated in 1997 by the SPC, to increase the country’s oil production by 500,000 (and to help compensate for declines at the mature Burgan field)…. However, the controversy over Kuwait’s reserve figure could have a significant impact on the country’s capacity expansion plans. Opposition MPs have called for production to be kept within 1 percent of reserves in order to ensure that oil is available for future generations, though the proposal has not yet been passed into law. Even taking the 100-billion-barrel figure, the 1 percent limit would restrict Kuwait’s production to under 3 million bbl/d, increasing difficulty of efforts to pass the Project Kuwait legislation.

For the cautious Hamilton, this bit was a surprise:

At any given point in history, some of the world’s producing fields are well into decline, some are at plateau production, and others are on the way up. It is not clear what “average” or “typical” decline rate would be appropriate to apply to aggregate global production, but a plausible ballpark number might be 4%. That means that in the absence of new projects, global production would decline by 3.4 mb/d each year. To put it another way, a new producing area equivalent to current annual production from Iran (OPEC’s second biggest producer) needs to be brought on line every year just to keep global production from falling.

Despite these discouraging observations, an update of the CERA methodology would leave one still quite optimistic about near-term oil supplies. An open-source web database6 tabulates a total of 6.9 mb/d in new gross production capacity from new projects that are scheduled to begin producing in 2008. Projects in Saudi Arabia, Russia, and Mexico account for about a third of this gross increase. Data currently available for the first two months of 2008 show actual production in Saudi Arabia down 350,000 b/d from its average 2005 value and Mexican production down 400,000 b/d from 2005. Russian production is down 100,000 b/d from its average level in the second half of 2007.

Although declining production from mature fields and delays in ramping the new fields up to full production will doubtless eat up a fair bit of the 6.9 mb/d new gross production capacity, it seems there is a lot left over. In the absence of significant new geopolitical disruptions to petroleum supply, some might anticipate an end to the recent plateau in global production, and significant net gains in supply for 2008.

Hamilton also stresses the limits of information. For instance:

In fact, the “quotas” and measured production levels are themselves fairly vague. The Energy Information Administration, International Energy Agency, and private organizations such as Platts all have different estimates of what the actual [OPEC] production numbers are.

And

The production declines [in Saudi Arabia} also coincided with a doubling in the number of their active oil rigs, leaving some to speculate that the magnificent Ghawar oil field had begun to decline. The necessary data to confirm or refute that conjecture are not publicly available.

The paper is very much worth reading, and also has quite a few good charts.