Coyote Blog

Back in the 1970's, there were serious proposals in Congress to nationalize US oil companies.  My dad, who was an executive at a major oil company, was being constantly dragged to DC to testify in front of Congress to try to explain what a bad idea that would be.  This was a time of incredible economic ignorance in Washington, perhaps even more than average, when a Republican President had recently instituted wage and price controls and Congress was looking for ways to "fix" problems with oil supply that they themselves had caused with price control rules and other restrictions on exploration.

Think about what we know about state-run oil companies in Venezuela, Mexico and even Saudi Arabia:

• They always under-invest capital in well maintenance, preferring to route cash flow to social spending that helps maintain shaky governments in power.  Many folks don't understand this, but production from a well starts falling off almost from the moment you drill it.  Well's must be expensively reworked and maintained and upgrade to keep flowing over their life.  This has gotten so bad in Venezuela that the country with the world's largest oil reserves is running out of gas.  I worked with Pemex for years and, at least in the 1990's, were about 1 step away from Pemex looking just like Venezuela's state oil company
• They have missed most of the recent revolutions in technology, and do no technology development of their own.  If not for technology developed by private western oil companies, they would barely be ahead of Edwin Drake.
• They deal with price downturns by forming cartels and attempting to fix prices and reduce output.

Private oil companies at the same time:

• Reinvest massively in both new and existing fields, often with 20-30 year time horizons
• Continue to revolutionize technology - the shale boom is just one example
• Respond to market price downturns with innovation and efficiency improvements.

The link above is gated so here is an excerpt:

Now, with oil currently trading near $50 a barrel, these producers are trying to unleash fracking 2.0, the next step in the technological transformation of the sector that is aimed at extracting oil even faster and less expensively to eke out profits at that level.

The promise of this new phase is potentially as significant as the original revolution. If more producers can follow EOG’s lead and profitably ramp up output from shale drilling even at lower prices, the sector could become a lasting force that challenges OPEC’s ability to control market prices.

For a sector in which the previous era’s success was tied to the rapid expansion of output, the shift toward finding more cost-effective ways to get to that oil and gas is full of challenges. When oil prices dropped, critics wondered if the shale industry—rife with heavily indebted companies that had never turned a profit—would collapse.

EOG, with its longtime focus on low-cost production, is the producer many hope to emulate, thanks to the iSteer app and dozens of other homegrown innovations. Dubbed the “Apple of oil” by one analyst, EOG made its name as a pioneer in horizontal drilling and in finding ways to get oil out of shale—often dense layers of rock that hold oil and gas in tiny pores—a feat many once believed impossible.

Can you imagine people like Gina McCarthy running our state oil company?  Good god, we would have $10 gas and import 80% of our oil.

(Note:  This is an update of this post based on a new set of economically illiterate people in the White House).

Repeat after me:  Y=C+I+G+X-M is an accounting rule.  It does not explain anything about the economy.  It is as useful to telling us anything interesting about the economy as the equation biomass=plants+animals+bacteria tells us anything about the ecosystem.

Apparently our new commerce secretary is totally ignorant of this fact:

[New Commerce Secretary Wilbur Ross] has a simple but misguided view of global trade. He believes that good trade policy yields a national trade surplus, while bad deals produce trade deficits—as if every country in the world could run a trade surplus. In an August letter to this newspaper, Mr. Ross wrote, “It’s Econ 101 that GDP equals the sum of domestic economic activity plus ‘net exports,’ i.e., exports minus imports. Therefore, when we run massive and chronic trade deficits, it weakens our economy.”

Who taught him that? Imports are subtracted in GDP calculations to avoid overstating domestic production, not because they make us poorer. Many domestic products wouldn’t exist without foreign components.

Here is his faulty logic.  The GDP (Y) is calculated by adding Consumer spending + Investment by Business + Government spending + eXports and then subtracting iMports.  Because imports are subtracted in the GDP equation, they look to the layman like they shrink the economy.  How do we grow the economy?  Why, let's reduce that number that is subtracted!  But this is wrong.  Totally wrong.   Anything that reduces imports (e.g. a tariff) will likely reduce C+I+G by the same amount.   The M term is there simply to avoid double counting.  It has no economic meaning in this context whatsoever.  I have tried many times to explain this, but let me see if I can work by analogy.

Let's say we wanted an equation to count the amount of clothing we owned.  To make things simple, let's say we are only concerned with the total of Shirts, Pants, and Underwear.   Most of our clothes are in the closet, so we say our clothes are equal to the S+P+U we count in our closet.  But wait, we may have Loaned clothes to other people.  Those are not in our closet but should count in our total of our owned clothing.  So now clothes = S+P+U+L.  But we may also have Borrowed clothes.  Some of those clothes we counted in the closet may be Borrowed and thus not actually ours, so we need to back these out.  Our final equation is clothes owned = S+P+U+L-B.  Look familiar?

Let's go further.  Let's say that we want to increase our number of clothes owned.  We want wardrobe growth!  Well, it looks like those borrowed clothes are a "drag" on our wardrobe size.  If we get rid of the borrowed clothes, that negative B term will get smaller and our wardrobe has to get larger, right?

Wrong.  Remember, like the GDP equation, our wardrobe size equation is just an accounting identity.  The negative B term was put in to account for the fact that some of the clothes we counted in S+P+U in the closet were not actually ours.  If we decrease B, say by returning our friend's shirt, the S term will go down by the exact same amount.  Sure, B goes down, but so do the number of shirts we count in the closet.  So focusing on the B term gets us nowhere.

But it is actually worse than that, because focusing on reducing B makes us worse off.  If negative term B rises, our wardrobe is no larger, but we get the use of all of those other pieces of clothing.  Our owned wardrobe may not be any larger but we get access to more choices and clothing possibilities.  When we drive the negative term B down to zero, our wardrobe is no larger and we are worse off with fewer choices.  Similarly, in the the economy, focusing on reducing imports does not grow the economy, it just serves to make us poorer by reducing our buying choices and increasing the cost of consumer goods as well as manufacturing inputs.

I don't want to say that it's impossible for increases in imports to drag the economy.  For example, if oil prices rise, the imports number measured in dollars will likely rise, and the economy could be worse off as we have to give up buying other things to continue to buy the oil we need.  But, absent major price changes, drops in exports more likely just mirror drops in C+I+G.  If consumers are hurting, they spend less on everything, including imported goods.   At the end of the day, none of these numbers (Mr. Keynes, are you listening?) are independent variables.

Postscript:  Here is another example.  Imagine a company with three divisions, D1, D2, and D3.  How do we compute the company's total revenue?  Well, typically we would add the revenue from the three divisions, so Total Corporate Revenue R = RD1 + RD2 + RD3.  Oh, but there is a problem.  Some of the sales from each of our divisions are to each other.  We only want to measure our true revenue from external sales, so we need to subtract intra-company sales from the total (this is a very typical step in conglomerate accounting).  So total company revenue R = RD1+RD2+RD3-IC, where IC are the total of intra-company sales within the company between divisions.  If you had a new CEO who looked at this accounting, and the CEO's first thought was "if we got rid of all these intra-company sales, surely we would have more revenue, because they are subtracting from total revenue in the revenue equation."  What would you do with this CEO?  If you knew the first thing about corporate accounting, you would fire him or her immediately for being a moron.  Just because the IC term is negative in the accounting equation does not mean that intra-company sales are a drag on revenues.  Eliminating intra-comapny sales would likely reduce revenues and profits as company insiders are forced to find new, less trusted, and more expensive sources for their purchases than buying internally.

.... your paper prints headlines that say "Economists: Zero chance of Arizona recession."  I am sure Houston would have said the exact same thing, right up until oil prices dropped to $30 and suddenly there was like a 100% chance.  When the Arizona Republic makes a definitive economic prediction, bet the other side.

Anyway, I am considering this headline to be a flashing indicator of the top.  In 2005 I wrote about another such indicator that told me the housing market had peaked:

So, to date [May 31, 2005], I have been unconvinced about the housing bubble, at least as it applied to our community.  After all, demographics over the next 20-30 years are only going to support Scottsdale area real estate.

However, over the weekend I had a disturbing experience:   At a social function, I heard a dentist enthusiastically telling a doctor that he needs to be buying condos and raw land.  The dentist claimed to be flipping raw land parcels for 100% in less than 6 months.

For those who don't know, this is a big flashing red light.  When doctors and dentists start trying to sell you on a particular type of investment, run away like they have the plague.  At Harvard Business School, I had a great investment management class with a professor who has schooled many of the best in the business.  If an investment we were analyzing turned out to be a real dog, he would ask us "who do you sell this to?" and the class would shout "doctors!"  And, if the investment was really, really bad, to the point of being insane, the class would instead shout "dentists!"

Which reminds me that in the last 6 months I have started hearing radio commercials again urging folks to get into the house-flipping business and make their fortune.  Whenever institutions start selling investments to you, the average Joe, rather than just investing themselves, that should be taken as a signal that we are approaching a top**.  About 12-18 months before oil prices tanked, I started getting flooded with spam calls at work trying to sell me various sorts of oil exploration investments.

** Postscript:  In 2010, when house prices were low and some were going for a song in foreclosure, there were no house flipping commercials on radio.   That is because Blackstone and other major institutions were too busy buying them up.  Now that these companies see less value, you are hearing house flipping commercials.   You know that guy who has a book with his fool-proof method for making a fortune?  So why is he wasting his time selling books for $2 a copy in royalties rather than following his method?

This article on Exxon stock seemed to be an allegory for the current problem central bankers face:

Earlier this month, Exxon Mobil (NYSE:XOM) reported Q4 2015 earningswhich, as expected, looked ugly considering the large decline in the price of oil over the last one and a half years. Exxon Mobil has long been one of the largest repurchasers of shares, spending a net of $89.74B on share buybacks during the 2010 through 2015 period. However, during the Q4 earnings release, management stated that share buybacks were being halted, presumably to preserve cash...

Contrast that with the strategy from 2008 when share buybacks were accelerated during the market fallout of the Lehman Brothers bankruptcy and the beginnings of what's now known as the Great Recession. Management reduced shares outstanding by 7.5% in 2008 alone...

Oil prices have sunk to lows not seen in more than a decade. The share price hit a low in the $60s in 2015 which hadn't been seen since late 2010. If you're of the belief that oil prices will rebound, eventually, then now should be the time that Exxon Mobil is ramping up the share buybacks not eliminating them.

This is the problem the author is highlighting:  Exxon ran up tens of billions in debt to stimulate the stock price in good times.  Now that times are bad, at least in the oil patch, the tank is empty (so to speak) and they have had to cease buybacks at the very time they would make the most sense (the same amount of money spent at lower stock prices would have higher impact on EPS).  The tank is empty enough that they might have to cut the dividend, an action with such negative consequences for stock value that it would likely undo all the effects of years of stock purchases.

I am not trying to beat up on Exxon -- I actually admire them as a well-managed company and pretty much every large corporation has gotten caught up in this unproductive Fed-inspired game of borrowing at close to zero and buying back stock (to my mind the financial equivalent of the Keynesian digging of holes and filling them back in).  But I hope you can see the analogy with the position of governments and central bankers.   For the last 5 years, when economic times have been good (alright, maybe just OK) governments have been deficit spending like crazy and central banks have been expanding their balance sheets with programs like QE to keep the economy stimulated.  But just as with the situation at Exxon, when the bad times come, bankers are going to find themselves with far fewer options than they had in 2008.

PS:  This is what Exxon really should have been doing the last 5 years -- hoarding their cash and borrowing reserves to be able to buy assets like crazy on the cheap in the next downturn.  They have always been able to do this in past downturns.  I suspect it may not be possible this time.

I continue to see reports about how bad falling oil prices are for the economy -- most recently some layoffs in the steel industry were blamed on the looming drop (or crash) in oil drilling and exploration driven by substantially lower prices.

I find this exasperating, a classic seen-and-unseen type failure whose description goes back at least to the mid-19th century and Bastiat and essentially constituted most of Hazlitt's one lesson on economics.  Yes, very visibly, relatively high-paid steel and oil workers are going to lose their jobs.  They will have less money to spend.  The oil industry will have less capital spending.

But the world will pay over a trillion dollars less this year for oil than it did last year (if current prices hold).  That is a huge amount of money that can be spent on or invested in something else.  Instead of just getting oil with those trillion dollars, we will still have our oil and a trillion dollars left over to spend.   We may never know exactly who benefits, but those benefits are definitely there, somewhere.  Just because they cannot be seen or portrayed in short visual anecdotes on the network news does not mean they don't exist.

Ugh, this is just beyond frustrating.  I would have bet that at least with oil people would have understood the unseen benefit, since we get so much media reportage and general angst when gas prices go up that people would be thrilled at their going down.  But I guess not.

I explained in simple terms why the world, mathematically, HAS to be better off with lower oil prices here.

The recent drop in oil prices has been met with a surprising amount of negativity, as if something bad is happening.  This strikes me as insane.  The world uses 90 or so million barrels of oil a day.  The recent $30+ price drop in oil thus equals a world savings of $1 trillion a year.

Sure, oil companies and their suppliers are worse off (and believe me, I care -- a lot of my portfolio was invested in such things when oil started dropping).  But the economy as a whole is clearly better off and wealthier.

To understand why, the analysis we need to undertake is an exact parallel of the broken window fallacy analysis.  Its sort of a healing window analysis.

After the oil price drop, consumers have a trillion dollars more and oil producers have a trillion dollars less.  Even right?  Actually, not.  Because consumers then spend that trillion on other things.  Those other manufacturers and producers get the trillion dollars lost to the oil industry.  Still even, right?  No.  Think of it this way:

Before the price drop

• Oil companies have $1 trillion extra revenue
• Other producers have no extra revenue
• Consumers have 90 million barrels a day of oil

After the price drop

• Oil companies have no extra revenue
• Other producers have $1 trillion extra revenue
• Consumers have 90 million barrels a day of oil AND $1 trillion of extra stuff (goods, service, savings, etc)

The world in the second case is wealthier.  And this is assuming all the people involved are private parties.   In fact, much of the oil revenue drop comes out of the hands of  value-destroying governments so that in fact the wealth increase in the price drop scenario is actually likely even greater than in this simplistic analysis.

Postscript:  OK, yes I am ignoring any cost of carbon pollution.  But the market is not set up to price that, and readers will know that I am skeptical that the cost is that high.  Never-the-less, this is a separate issue that if it needs to be dealt with should be dealt with as a carbon tax on fuels.  The price drop should not affect the value of that tax.  Or another way to put it, if one thinks the tax should be $30 per ton based on a $30 cost of carbon, it should be $30 per ton at $100 oil and $30 per ton at $60 oil.

I believe it was back in 1973, when my dad was an executive with an oil company, he got hauled in front of Congress to testify on the proposed Alaska pipeline.  Senators on the Left accused the industry of threatening the environment in the name of greed, by trying to bring oil to market that was entirely unnecessary.  A few months later, once the Arab oil embargo had begun, he was back in front of Congress answering questions from the same Senators who opposed the Alaska pipeline about whether the rumors were true that oil companies were holding tankers off-shore, purposely making the shortage worse and driving up prices.  It was an early life-lesson in government for me, watching my dad be publicly accused within months of seeking new oil supplies too aggressively and purposely withholding oil supplies from the market.

I am reminded of all this by the Keystone pipeline brouhaha.  One wonders how many of the people opposing the Keystone pipeline will be the first out on the picket line protesting oil prices the next time there is an oil price spike.

There is nothing surprising or unpredictable about the current oil boom, except perhaps how far it has gotten in the face of an Administration that has done virtually everything it can to stop it  (thank god there is oil and gas under private land).  Your humble scribe, neither an economist nor an expert in oil markets, wrote way back in 2005:

Everything old is new again.  Back in the late 70′s, all the talk was about the world running out of oil.  Everywhere you looked, "experts" were predicting that we would run out of oil.  Many had us running out of oil in 1985, while the most optimistic didn’t have us running out of oil until the turn of the century.  Prices at the time had spiked to about $65 a barrel (in 2004 dollars), about where they are today.  Of course, it turned out that the laws of supply and demand had not been repealed, and after Reagan removed oil price controls and goofy laws like the windfall profits tax, demand and supply came back in balance, and prices actually returned to their historical norms....

 Supply and demand work to close resource gaps.  In fact, it has never not worked.  The Cassandras of the world have predicted over the centuries that we would run out of thousands of different things.  Everything from farmland to wood to tungsten have at one time or another been close to exhaustion.  And you know what, these soothsayers of doom are 0-for-4153 in their predictions. ...

The vagaries of reserve accounting are very difficult for outsiders to understand.  I am not an expert, but one thing I have come to understand is that reserve numbers are not like measuring the water level in a tank.  There is a lot more oil in the ground than can ever be recovered, and just what percentage can be recovered depends on how much you are willing to do (and spend) to get it out.  Some oil will come out under its own pressure.  The next bit has to be pumped out.  The next bit has to be forced out with water injection.  The next bit may come out with steam or CO2 flooding.  In other words, how much oil you think will be recoverable from a field, ie the reserves, depends on how much you are willing to invest, which in turn depends on prices.  Over time, you will find that certain fields will have very different reserves numbers at $70 barrel oil than at $25....

All the oil doomsayers tend to define the problem as follows:  Oil production from current fields using current methods and technologies will peak soon.  Well, OK, but that sure defines the problem kind of narrowly.  The last time oil prices were at this level ($65 in 2004 dollars), most of the oil companies and any number of startups were gearing up to start production in a variety of new technologies.  I know that when I was working for Exxon in the early 80′s, they had a huge project in the works for recovering oil from oil shales and sands.  Once prices when back in the tank, these projects were mothballed, but there is no reason why they won’t get restarted if oil prices stay high.

Postscript:  I really need to find new topics to blog about.  The adjacent article in 2005 included this, a frequent topic on this site.  I had not idea I was writing about this so long ago:

When health care is paid for by public funds, politicians only need to argue that some behavior affects health, and therefore increases the state’s health care costs, to justify regulating the crap out of that behavior.  Already, states have essentially nationalized the cigarette industry based on this argument.

Hey, Obama Administration!  The evil speculators are moving oil prices again.  Time to get after them.  Hello?  Anyone there?  Where did everyone go?

My Forbes article is up for this week, and discusses 10 reasons why legislation frequently fails.  A buffet of Austrian economics, Bastiat, and public choice theory that I wrote for the high school economics class I teach each year.

Here is an example:

3.  Overriding Price Signals

The importance of prices is frequently underestimated.  Prices are the primary means by which literally billions of people (most of whom will never meet or even know of each others' existence) coordinate their actions, without any top-down planning.  With rising oil prices, for example, consumers around the world are telling oil companies:  "Go find more!"

For a business person, prices (of raw materials, labor, their products, and competitive products) are his or her primary navigation system, like the compass of an explorer or the GPS of a ship.  And just as disaster could well result from corrupting the readings of the explorer's compass while he is trekking across the Amazon, so too economic damage can result from government overriding price signals in the market.   Messing with the pricing mechanisms of markets turns the economy into a hall of mirrors that is almost impossible to navigate.  For example:

• In the best case, corrupting market prices tends to result in gluts or shortages of individual products.  For example, price floors on labor (minimum wages) have created a huge glut of young and unskilled workers unable to find work.  On the other side, in the 1970s, caps on oil prices resulted in huge shortages in the US and those famous lines at gas stations.  These shortages and gas lines were repeated several times in the 1970's, but never have returned since the price caps were phased out.
• In the worst case, overriding market price mechanisms can create enormous problems for the entire economy.   For example, it is quite likely that the artificially low interest rates promoted by the Federal Reserve over the last decade and higher housing prices driven by a myriad of US laws, organizations, and tax subsidies helped to drive the recent housing and financial bubble and subsequent crash.  Many will counter that it was the exuberance of private bankers that drove the bubble, but many bankers were like ship captains who drove their ships onto the rocks because their GPS signal had been altered

My new column is up at Forbes, and discusses the absurdity of blaming sustained higher oil and gas prices on speculators.

Is there a crime in the current oil prices?  Yes, but it’s not one of speculation.  Prices are a form of communication.  Higher prices tell consumers to use less oil, and producers to go find more.  The real crime today is that while the signal is flashing today to oil companies to go find more crude, the Obama administration has bent over backwards to make such efforts all but impossible.  In fact, the Obama Administration desperately tried and failed to increase oil and gas prices via cap and trade last year.  President Obama is not really against higher oil prices, he just wants them driven higher by the state, not by the markets.

Apparently, the leftish-progressive talking point du jour is that oil speculators  (and wouldn't you know it, those apparently include new libertarian uber-villains the Koch brothers) are artificially raising prices above what a "natural" market clearing price would be.

I have always presumed this to be possible for short periods of time - probably hours, perhaps days.  But if, for any longer period of time, market prices (I am talking here about prices for current oil and immediate delivery, not futures prices) stay above the market clearing price one would normally expect from current supply and demand, then oil has to be building up somewhere.  People would be bending over backwards to sell oil into the market, and customers would be using less.

If futures speculation has somehow unanaturally driven up current prices, where is the oil building up?  I understand the price can go up for future oil, because in futures the inventory is just paper.  But the argument is that futures trading is driving up current oil prices.  When the Hunt brothers tried to corner the silver market, they had to buy and buy and keep buying to sop up the inventory.

Sure, some folks may be storing oil on speculation (and by the way most oil companies are inventorying oil and gasoline this time of year in the annual build up between heating oil season and summer driving season) -- but storing physical oil is really expensive.  And the total capacity to do so incrementally is trivial compared to world daily demand.  A few tanker loads sitting offshore is not going to mean squat (total world crude inventory is something like 350 million barrels at any one time, so adding a million barrels into storage only increases inventory by 0.3% or about.   Another way to look at it is that storing a million barrels of oil represents about 17 minutes of daily demand.   If the price is really being held above the market clearing price, then we are talking about the necessity of buying millions of barrels of oil each and every day and storing them, and to keep doing so day after day after day to keep the price up.  And then once you stop, the price is just going to crash before you can sell it because of the very fact that word got out you are selling it.

I dealt with this in a lot more depth here.  I want to repost it in full.  It's a bit dated (different prices) but still relevant.  Note in particular the irony of my friends point #5 -- this was a real view held by many on the progressive Left.  Ironic, huh?

I had an odd and slightly depressing conversation with a friend the other night.  He is quite intelligent and well-educated, and in business is probably substantially more successful, at least financially, than I.

Somehow we got in a discussion of oil markets, and he seemed to find my position suggesting that oil prices are generally set by supply and demand laughable, so much so he eventually gave up with me as one might give up and change the subject on someone who insists the Apollo moon landings were faked. I found the conversation odd, like having a discussion with a fellow
chemistry PHD and suddenly having them start defending the phlogiston
theory of combustion. His core position, as best I could follow, was this:

1. Limitations on supply in the US, specifically limitations on new oil field development and refinery construction, are engineered by oil companies attempting to keep prices high.
2. Oil prices are set at the whim of oil traders in London and New York, who are controlled by US oil companies.  The natural price of oil today should be $30 or $40, but oil traders keep it up at $60.  While players upstream and downstream may have limited market shares, these traders act as a choke point that controls the whole market.  All commodity markets are manipulated, or at least manipulatable, in this manner
3. Oil supply and demand is nearly perfectly inelastic.
4. If there really was a supply and demand reason for oil prices to shoot up to $60, then why aren’t we seeing any shortages?
5. Oil prices only rise when Texas Republicans are in office.  They will fall back to $30 as soon as there is a Democratic president.  On the day oil executives were called to testify in front of the Democratic Congress recently, oil prices fell from $60 to $45 on that day, and then went right back up.

Ignoring the Laws of Economics (Price caps and floors)

While everyone (mostly) knows that we are suspending disbelief when the James Bond villain seems to be violating the laws of physics, there is a large cadre of folks that do believe that our economic overlords can suspend the laws of supply and demand.   As it turns out, these laws cannot be suspended, but they can certainly be ignored.  Individuals who ignore supply and demand in their investment and economic decision making are generally called "bankrupt," at least eventually, so we don’t always hear their stories (the Hunt brothers attempt to corner the silver market is probably the best example I can think of).  However, the US government has provided us with countless examples of actions that ignore economic reality.

The most typical example is in placing price caps.  The most visible example was probably the 1970′s era caps on oil, gasoline, and natural gas prices and later "windfall profit" taxes.  The result was gasoline lines and outright shortages.  With prices suppressed below the market clearing price, demand was higher and supply was lower than they would be in balance.

The my friend raised is different, one where price floors are imposed by industry participants or the government or more likely both working in concert.   The crux of my argument was not that government would shy away from protecting an industry by limiting supply, because they do this all the time. The real problem with the example at hand is that, by the laws of supply and demand, a price floor above the market clearing price should yield a supply glut.  As it turns out, supply guts associated with cartel actions to keep prices high tend to require significant, very visible, and often expensive actions to mitigate.  Consider two examples:

Realtors and their trade group have worked for years to maintain a tight cartel, demanding a 6% or higher agency fee that appears to be increasingly above the market clearing price.  The result of maintaining this price floor has been a huge glut of real estate agents.  The US is swimming in agents.  In an attempt to manage this supply down, realtors have convinced most state governments to institute onerous licensing requirements, with arcane tests written and administered by… the realtor’s trade group.  The tests are hard not because realtors really need to know this stuff, but because they are trying to keep the supply down.   And still the supply is in glut.  Outsiders who try to discount or sell their own home without a realtor (ie, bring even more cheap capacity into the system) are punished ruthlessly with blackballs.  I have moved many times and have had realtors show me over 300 houses — and you know how many For Sale By Owner homes I have been shown?  Zero.  A HUGE amount of effort is expended by the real estate industry to try to keep supply in check, a supply glut caused by holding rates artificially high.

A second example of price floors is in agriculture.  The US Government, for whatever political reasons, maintains price floors in a number of crops.  The result, of course, has been a supply glut in these commodities.  Sopping up this supply glut costs the US taxpayer billions.  In some cases the government pays to keep fields fallow, in others the government buys up extra commodities and either stores them (cheese) or gives them away overseas.  In cases like sugar, the government puts up huge tarriff barriers to imports, otherwise the market would be glutted with overseas suppliers attracted by the artificially high prices.  In fact, most of the current subsidy programs for ethanol, which makes almost zero environmental or energy policy sense, can be thought of as another government program to sop up excess farm commodity supply so the price floor can be maintained.

I guess my point from these examples is not that producers haven’t tried to impose price floors above the market clearing price, because they have.  And it is not even that these floors are not sustainable, because they can be if the government steps in to help with their coercive power and our tax money to back them.  My point is, though, that the laws of supply and demand are not suspended in these cases.  Price floors above the market clearing price lead to supply gluts, which require very extensive, highly visible, and often expensive efforts to manage.  As we turn now to oil markets, we’ll try to see if there is evidence of such actions taking place.

The reasons behind US oil production and refining capacity constraints

As to his first point, that oil companies are conspiring with the government to artificially limit oil production and refining capacity, this certainly would not be unprecedented in industry, as discussed above.  However, any historical study of these issues in the oil industry would make it really hard to reach this conclusion here.  There is a pretty clear documented record of oil companies pushing to explore more areas (ANWR, offshore) that are kept off-limits due to environmental pressures.  While we have trouble imagining the last 30 years without Alaskan oil, the US oil companies had to beg Congress to let them build the pipeline, and the issue was touch and go for a number of years.  The same story holds in refining, where environmental pressure and NIMBY concerns have prevented any new refinery construction since the 1970′s (though after years and years, we may be close in Arizona).  I know people are willing to credit oil companies with just about unlimited levels of Machiavellianism, but it would truly be a PR coup of unprecedented proportions to have maintained such a strong public stance to allow more capacity in the US while at the same time working in the back room for just the opposite.

The real reason this assertion is not credible is that capacity limitations in the US have very clearly worked against the interests of US oil companies.  In production, US companies produce on much better terms from domestic fields than they do when negotiating with totalitarian regimes overseas, and they don’t have to deal with instability issues (e.g. kidnapping in Nigeria) and expropriation concerns.  In refining, US companies have seen their market shares in refined products fall since the 1970s.  This is because when we stopped allowing refinery construction in this country, producing countries like Saudi Arabia went on a building boom.  Today, instead of importing our gasoline as crude to be refined in US refineries, we import gas directly from foreign refineries.  If the government is secretly helping oil companies maintain a refining capacity shortage in this country, someone forgot to tell them they need to raise import duties to keep foreign suppliers from taking their place.

What Oil Traders can and cannot do

As to the power of traders, I certainly believe that if the traders could move oil prices for sustained periods as much as 50% above or below the market clearing price, they would do so if it profited them.  I also think that speculative actions, and even speculative bubbles, can push commodity prices to short-term extremes that are difficult to explain by market fundamentals.  Futures contracts and options, with their built in leverage, allow even smaller players to take market-moving positions.  The question on the table, though, is whether oil traders can maintain oil prices 50% over the market clearing prices for years at a time.  I think not.

What is often forgotten is that companies like Exxon and Shell control something like 4-5% each of world production (and that number is over-stated, since much of their production is as operator for state-owned oil companies who have the real control over production rates).  As a point of comparison, this is roughly the same market Toshiba has in the US computer market and well below Acer’s.  As a result, there is not one player, or even several working in tandem, who hold any real power in crude markets.  Unless one posits, as my friend does, that NY and London traders somehow sit astride a choke point in the world markets.

But here is the real problem with saying that these traders have kept oil prices 50% above the market clearing price for the last 2-3 years:  What do they do with the supply glut?  We know from economics, as well as the historic examples reviewed above, that price floors above the clearing price should result in a supply glut.  Where is all the oil?

Return to the example of when the Hunt’s tried to corner the silver market.  Over six months, they managed to drive the price from the single digits to almost $50 an ounce.  Leverage in futures markets allowed them to control a huge chunk of the available world supply.  But to profit from it (beyond a paper profit) the Hunts either had to take delivery (which they were financially unable to do, as they were already operating form leveraged positions) or find a buyer who accepted $50 as the new "right" price for silver, which they could not.  No one wanted to buy at $50, particularly from the Hunts, since they knew the moment the Hunt’s started selling, the price would crash.  As new supplies poured onto the market at the higher prices, the only way the Hunt’s could keep the price up was to pour hundreds of millions of dollars in to buy up this excess supply.  Eventually, of course, they went bankrupt.  But remember the takeaway:  They only could maintain the artificially higher commodity price as long as they kept buying excess capacity, a leveraged Ponzi game that eventually collapsed.

So how do oil traders’ supposedly pull off this feat of keeping oil prices elevated about the market clearing price?  Well, there is only one way:  It has to be stored, either in tanks or in the ground.  The option of storing the extra supplies in tanks is absurd, especially over a period of years – after all, at its peak, $60 of silver would sit on the tip of my finger, but $60 of oil won’t fit in the trunk of my car.  The world oil storage capacity is orders of magnitude too low.  So the only real option is to store it in the ground, ie don’t allow it to get produced.

How do traders pull this off?  I have no idea.  Despite people’s image, the oil producer’s market is incredibly fragmented.  The biggest companies in the world have less than 5%, and it rapidly steps down from there. It is actually even more fragmented than that, because most oil production is co-owned by royalty holders who get a percentage of the production.  These royalty holders are a very fragmented and independent group, and will complain at the first sign of their operator not producing fast and hard enough when prices are high.  To keep the extra oil off the market, you would have to send signals to a LOT of people.  And it has to be a strong and clear signal, because price is already sending the opposite signal.  The main purpose of price is in its communication value — a $60 price tells producers a lot about what and how much oil should be produced (and by the way tells consumers how careful to be with its use).  To override this signal, with thousands of producers, to achieve exactly the opposite effect being signaled with price, without a single person breaking the pack, is impossible.  Remember our examples and the economics – a sustained effort to keep prices substantially above market clearing prices has to result in visible and extensive efforts to manage excess supply.

Also, the other point that is often forgotten is that private exchanges can only survive when both Sellers AND buyers perceive them to be fair.  Buyers are quickly going to find alternatives to exchanges that are perceived to allow sellers to manipulate oil prices 50% above the market price for years at a time.  Remember, we think of oil sellers as Machiavellian, but oil buyers are big boys too, and are not unsophisticated dupes.  In fact, it was the private silver exchanges, in response to just such pressure, that changed their exchange rules to stop the Hunt family from continuing to try to corner the market.  They knew they needed to maintain the perception of fairness for both sellers and buyers.

Supply and Demand Elasticity

From here, the discussion started becoming, if possible, less grounded in economic reality.  In response to the supply/demand matching issues I raised, he asserted that oil demand and supply are nearly perfectly inelastic.  Well, if both supply and demand are unaffected by price, then I would certainly accept that oil is a very, very different kind of commodity.  But in fact, neither assertion is true, as shown by example here and here. In particular, supply is quite elastic.  As I have written before, there is a very wide range of investments one can make even in an old existing field to stimulate production as prices rise.  And many, many operators are doing so, as evidenced by rig counts, sales at oil field services companies, and even by spam investment pitches arriving in my in box.

I found the statement "if oil prices really belong this high, why have we not seen any shortages" to be particularly depressing.  Can anyone who sat in at least one lecture in economics 101 answer this query?  Of course, the answer is, that we have not seen shortages precisely because prices have risen, fulfilling their supply-demand matching utility, and in the process demonstrating that both supply and demand curves for oil do indeed have a slope.  In fact, shortages (e.g. gas lines or gas stations without gas at all) are typically a result of government-induced breakdowns of the pricing mechanism.  In the 1970′s, oil price controls combined with silly government interventions (such as gas distribution rules**) resulted in awful shortages and long gas lines.  More recently, fear of "price-gouging" legislation in the Katrina aftermath prevented prices from rising as much as they needed to, leading to shortages and inefficient distribution.

Manipulating Oil Prices for Political Benefit

As to manipulating oil or gas prices timed with political events (say an election or Congressional hearings), well, that is a challenge that comes up all the time.  It is possible nearly always to make this claim because there is nearly always a political event going on, so natural volatility in oil markets can always be tied to some concurrent "event."  In this specific case, the drop from $60 to $35 just for a Congressional hearing is not even coincidence, it is urban legend.  No such drop has occurred since prices hit 60, though prices did drop briefly to 50.  (I am no expert, but in this case the pricing pattern seen is fairly common for a commodity that has seen a runup, and then experiences some see-sawing as prices find their level.)

This does not mean that Congressional hearings did not have a hand in helping to drive oil price futures.  Futures traders are constantly checking a variety of tarot cards, and indications of government regulatory activity or legislation is certainly part of it.  While I guess traders purposely driving down oil prices ahead of the hearing to make oil companies look better is one possible explanation;  a more plausible one (short of coincidence, since Congress has hearings on oil and energy about every other month) is that traders might have been anticipating some regulatory outcome in advance of the hearing, that became more less likely once the hearings actually occurred.  *Shrug*  Readers are welcome to make large short bets in advance of future Congressional energy hearings if they really think the former is what is occurring.

As to a relationship between oil prices and the occupant of the White House, that is just political hubris.  As we can see, real oil prices rose during Nixon, fell during Ford, rose during Carter, fell precipitously during Reagan, were flat end to end for Bush 1 (though with a rise in the middle) and flat end to end for Clinton.  I can’t see a pattern.

If Oil Companies Arbitrarily Set Prices, Why Aren’t They Making More Money?

A couple of final thoughts.  First, in these heady days of "windfall" profits, Exxon-Mobil is making a profit margin of about 9% – 10% of sales, which is a pretty average to low industrial profit margin.  So if they really have the power to manipulate oil prices at whim, why aren’t they making more money?  In fact, for the two decades from 1983 to 2002, real oil prices languished at levels that put many smaller oil operators out of business and led to years of layoffs and down sizings at oil companies.  Profit margins even for the larges players was 6-8% of sales, below the average for industrial companies.  In fact, here is the profitability, as a percent of sales, for Exxon-Mobil over the last 5 years:

2006:  10.5%

2005:  9.7%

2004:  8.5%

2003:  8.5%

2002:  5.4%

2001:  7.1%

Before 2001, going back to the early 80′s, Exxon’s profits were a dog.  Over the last five years, the best five years they have had in decades, their return on average assets has been 14.58%, which is probably less than most public utility commissions allow their regulated utilities.  So who had their hand on the pricing throttle through those years, because they sure weren’t doing a very good job!  But if you really want to take these profits away (and in the process nuke all the investment incentives in the industry) you could get yourself a 15 to 20 cent decrease in gas prices.  Don’t spend it all in one place.

** One of the odder and forgotten pieces of legislation during and after the 1972 oil embargo was the law that divided the country into zones (I don’t remember how, by counties perhaps).  It then said that an oil company had to deliver the same proportion of gas to each zone as it did in the prior year  (yes, someone clearly took this right out of directive 10-289).  It seemed that every Representative somehow suspected that oil companies in some other district would mysteriously be hoarding gas to their district’s detriment.  Whatever the reason, the law ignored the fact that use patterns were always changing, but were particularly different during this shortage.  Everyone canceled plans for that long-distance drive to Yellowstone.  The rural interstate gas stations saw demand fall way off.  However, the law forced oil companies to send just as much gas to these stations (proportionally) as they had the prior year.  The result was that rural interstates were awash in gas, while cities had run dry.  Thanks again Congress.

As I have written a number of times, reserves numbers for oil are not based on the total oil though to be under the ground, but the total oil thought to be under the ground that is economically recoverable at expected prices.  Changes in technology and/or oil price expectations change the amount of reserves, even without the discovery of a single new field.

Oil companies have known about the formation, and the oil trapped in it, since at least the 1950s. But they couldn't get more than a trickle of oil from the dense, nonporous rock.

That began to change in the early 2000s, when companies in Texas began using new drilling techniques in a similar formation near Fort Worth known as the Barnett Shale. They would drill down thousands of feet and then turn and go horizontally through the gas-bearing rock"”allowing a single well to reach more gas. Then they would blast huge volumes of water down the well to crack open the rocks and free the gas trapped inside.

The real shift has come in the past two years as companies honed drilling techniques, leading to bigger wells, faster drilling and lower costs. Marathon, for example, last year took an average of 24 days to drill a well, down from 56 days in 2006."

So apparently, oil production in North Dakota may soon pass that of Alaska, though this is more due to the fact that production can be ramped up in North Dakota without an act of Congress, which is not the case in Alaska.

The largest threat to oil prices and production remains not peak oil, but the fact that most of the world's best reserves rest in the hands of state-run oil companies whose competence and willingness to invest for the long-term is sometimes in question.

I realize I did not comment on the Joe Romm oil price bet per se.  Here are two reasons I don't like the bet:

1.  Romm is making a catastrophic forecast (ie oil >$200) but wins his bet at $41, what one might consider a fairly normal current oil price.  This is very equivalent to Romm forecasting a 15F increase in world temperatures in the next century (which he has) but making a bet that he would win if temperatures go up by only 0.1F.  Clearly, a 0.1F increase over the next century would be considered by all a thorough repudiation of catastrophic anthropogenic global warming forecasts.  So why should he win the bet at this level?

2.  The bet, particularly in the next few years, has more to do with the current government's actions than Exxon's or Saudi Arabia's.  To bet that oil prices will stay low in nominal dollars, one must bet that Obama's deficits won't destroy the value of the dollar, that the Fed's expansionist monetary policy won't lead to inflation, that Congress won't pass some kind of legislative restrictions making oil production more expensive, and that the world won't sign a treaty to restrict carbon.  In short, Congress will have more effect in the near term on oil prices than flow rates in Saudi fields, and I am certainly not going to make a bet in favor of Congressional or Presidential restraint.

Postscript: Here is what you have to believe to accept Romm's 15F global warming forecast.   Here is how I opened that post.  It is interesting how similar the forecasting issues are:

For several years, there was an absolute spate of lawsuits charging sudden acceleration of a motor vehicle "” you probably saw such a story:  Some person claims they hardly touched the accelerator and the car leaped ahead at enormous speed and crashed into the house or the dog or telephone pole or whatever.  Many folks have been skeptical that cars were really subject to such positive feedback effects where small taps on the accelerator led to enormous speeds, particularly when almost all the plaintiffs in these cases turned out to be over 70 years old.  It seemed that a rational society might consider other causes than unexplained positive feedback, but there was too much money on the line to do so.

Many of you know that I consider questions around positive feedback in the climate system to be the key issue in global warming, the one that separates a nuisance from a catastrophe.  Is the Earth's climate similar to most other complex, long-term stable natural systems in that it is dominated by negative feedback effects that tend to damp perturbations?  Or is the Earth's climate an exception to most other physical processes, is it in fact dominated by positive feedback effects that, like the sudden acceleration in grandma's car, apparently rockets the car forward into the house with only the lightest tap of the accelerator?

Joe Romm of Climate Progress is a leading climate alarmist, telling the world that burning fossil fuels will increase CO2 concentrations by 0.04% of the atmosphere over the next century and thus destroy mankind.  As such, he is a supporter of the current cap-and-trade bill in Congress, whose purpose is to raise the price of fossil fuels (either directly as a tax or by restricting their supply) so that less will be used.

On a different but related topic, Joe Romm is also apparently a peak oil alarmist.  As I have written, I suspect real oil prices will rise steadily over the coming decades, but we aren't going to fall off some cliff and see a sudden hyperinflation of oil prices (temporary spikes are a different story).  He writes

The IEA's work makes clear that for oil to stay significantly below $200 a barrel (and U.S. gasoline to be significantly below $5 a gallon) by 2020 would take a miracle

I tend to doubt it, in part because I have seen so many very similar predictions ever since the mid-1970s, but I suppose some day someone will be right with one of these.   I wonder if there is some kind of psychological profile that causes people to see positive feedback-driven accelerating curves everywhere.

But here is my confusion -- he is absolutely convinced that oil is going up by $140 a barrel or more.  Let's look at this in the context of Co2.  The CBO estimates the clearing price for a ton of Co2 emissions under the current bill will be between $20-$30 a ton.  Since a barrel of oil creates about a third of a ton of CO2 emissions, this implies the cap and trade bill might increase the price of oil by $7-$10 per barrel.  But if Romm think oil is going up by natural market forces by $140+, why even bother?  Why not just put a tax on coal and be done with it?

I congratulate Mr. Romm, however.  If he is so sure of 2020 oil prices, there are all kinds of fabulous ways to become ridiculously wealthy with this knowledge.

Postscript:  There are two reasons why people have been making this same forecast for 30 years and have been wrong most of the time.

First, there is a very human tendency to assume current conditions and trends will go on forever.  Everyone is subject to this bias, even the smartest analysts.  Romm might argue that these are savvy, detail-oriented commodities analyst, but I only have to point to the recent behavior of savvy detail-oriented debt security analysts.

Second, analysts tend to apply current understandings of what technologies and substitutes are economic at $60 oil to a world where oil is priced at $160.  It just doesn't work that way.   The market for petroleum and its substitutes is enormously multi-variate and complex.  A $100 bump in prices will do things that are sometimes hard to predict in detail to the markets for exploration, new technologies, substitutes, conservation, etc.  But in all this complexity, the one thing we do know is that time and again, such changes have occurred quickly and decisively in response to rising oil prices, and have acted to mitigate and reverse price increases.

One ironic way of looking at it, since this is Joe Romm, is to say that there are negative feedbacks that cut in to slow and even reverse sharp rises in oil prices.  Romm seems to reject these negative feedbacks, in favor of a price model that rapidly accelerates.  This is all ironic, since this issue of negative vs. positive feedback is what separates climate alarmists like Romm from many climate skeptics like myself.

When I have discussions with folks about oil prices, supplies, and "peak oil," the conversation almost always requires some digression into the nature of oil reserves themselves.  The most important thing to understand is that men have never, ever even come close to pumpng out all the oil that is in a particular field.  Many, many fields have closed, but that is because the incremental cost to get the oil up and out are higher than expected oil prices.

So, changes in technology and changes in price can and do change expectations of how much oil can or will be recovered from a particular field.  For example, my family has a ranch near Glenrock, Wyoming.  When we first started going up there, the fields were booming.  Then they seemed to be completely shut down for a decade or more.  Recently, they were booming again, due to changes in technology and price.

My point, then, is that world recoverable reserve estimates are different -- for the same fields -- at expectations of $25 oil and $125 oil, but you seldom if ever see the MSM being very intelligent consumers of reserve data.   Michael Giberson addresses this issue in the context of an interesting year-end accounting issue:

Geoff Styles offers a timely discussion of how SEC requirements for reporting oil and gas reserves and current low prices will combine to force a potentially dramatic drop in reported oil and gas reserves as of the end of the year. In brief, current SEC rules require that oil and gas reserves reported on financial statements be limited to quantities very likely to be recoverable at the end-of-year market price for such resources. Given the quite low price expected at year end 2008 - current prices are under $40/bbl while 2007 prices ended over $95/bbl, companies owning oil and gas reserves will report sharply lower amounts of oil and gas in reserve.

Un-savvy investors may be alarmed - where did all that oil go? - and un-savvy political commentators will find the reports as more evidence for peak oil. But as Styles points out, the reserves are not going anywhere, and the resources are still there to be had for a price.

Styles explains that while current SEC rules require reserves reports to be based upon a single day's price, industry practice has long shifted to using less-volatile metrics for reserves evaluation. The SEC has proposed adapting its rules so as to reduce the effects of price volatility on reserves reporting, and Styles says the upcoming dramatic "loss" of reserves demonstrates the urgent need for such a change.

And it couldn't happen to a nicer guy (hat tip to a reader):

Venezuela's daily oil production has fallen by a quarter since President Hugo
  Chavez won power, depriving his "Bolivarian Revolution" of much of
  the benefit of the global boom in oil prices...

The state oil company, PDVSA, produced 3.2 million barrels per day
in 1998, the year before Mr Chavez won the presidency. After a decade
of rising corruption and inefficiency, daily output has now fallen to
2.4 million barrels, according to OPEC figures. About half of this oil
is now delivered at a discount to Mr Chavez's friends around Latin
America. The 18 nations in his "Petrocaribe" club, founded in 2005, pay
Venezuela only 30 per cent of the market price within 90 days, with
rest in instalments spread over 25 years.

The other half - 1.2 million barrels per day - goes to America, Venezuela's only genuinely paying customer.

Meanwhile,
Mr Chavez has given PDVSA countless new tasks. "The new PDVSA is
central to the social battle for the advance of our country," said
Rafael Ramirez, the company's president and the minister for petroleum.
"We have worked to convert PDVSA into a key element for the social
battle."

The company now grows food after Mr Chavez's price
controls emptied supermarket shelves of products like milk and eggs.
Another branch produces furniture and domestic appliances in an effort
to stem the flow of imports. What PDVSA seems unable to do is produce
more oil.

Venezuela has proven reserves of 80 billion barrels,
but estimates suggest that it may possess 142 billion barrels - more
than anywhere else except Saudi Arabia....

All
this means that Venezuela has missed much of the benefit from the oil
boom and, now that prices are falling, Mr Chavez faces huge financial
problems. Nobody is sure at what point his government would be unable
to pay its bills, but most sources consulted believe this would
probably happen if oil falls to $80 a barrel. Yesterday, oil was
trading at $79.80.

More on "peak oil" being at least partially a function of state mis-management of promising oil reserves here.  Jim Kingsdale estimated last year, when prices were over $100 for oil, that oil prices would probably trade under $50 if the reserves were controlled by private companies rather than government buffoons.

From the Interagency Task Force on Commodity Markets, via Mark Perry:

The Task
Force's preliminary assessment is that current oil prices and the
increase in oil prices between January 2003 and June 2008 are largely
due to fundamental supply and demand factors. During this same period,
activity on the crude oil futures market "“ as measured by the number of
contracts outstanding, trading activity, and the number of traders "“
has increased significantly. While these increases broadly coincided
with the run-up in crude oil prices, the Task Force's preliminary
analysis to date does not support the proposition that speculative
activity has systematically driven changes in oil prices.

The
world economy has expanded at its fastest pace in decades, and that
strong growth has translated into substantial increases in the demand
for oil, particularly from emerging market countries. On the supply
side, the production of oil has responded sluggishly, compounded by
production shortfalls associated with geopolitical unrest in countries
with large oil reserves. As it is very difficult to rely on substitutes
for oil in the short term, very large price increases have occurred as
the market balances supply and demand (see top two charts above).

If
a group of market participants has systematically driven prices,
detailed daily position data should show that that group's position
changes preceded price changes. The Task Force's preliminary analysis,
based on the evidence available to date, suggests that changes in
futures market participation by speculators have not systematically
preceded price changes. On the contrary, most speculative traders
typically alter their positions following price changes, suggesting
that they are responding to new information "“ just as one would expect
in an efficiently operating market.

Congress and other agencies have commissioned studies of this type on oil markets and prices approximately every 90 days or so for the last 35 years, and every one of them have come to the same conclusion:  Oil markets move based on the participant's best guesses about trends in supply and demand.  Duh.  As I wrote previously, the last hydrocarbon price manipulation case I have seen in court was aimed at a group that allegedly manipulated prices for 30 seconds at the end of a trading day whose closing price affected certain contracts.  And it is not clear that they were successful. 

A few weeks ago, Kevin Drum had a post on shale oil development, quoting from a speech by Congressman Ken Salazar.  It is hard to really excerpt the piece well, but my take on their argument against shale oil leasing is:

• Shale oil technology is unproven
• The government is leasing the shale oil rights too cheap
• There is already plenty of shale oil land for development, so new leases won't increase development
• This is just being done by the Bush Administration to enrich the oil companies
• The administration is rushing so fast that Congress has not had the chance to put a regulatory regime in place

In many ways, the arguments are surprisingly similar to those against new offshore and Alaskan oil leasing.  Through it all, there is this sort of cognitive dissonance where half the arguments are that the oil won't be developed, and the other half seem to be based on an assumption that a lot of oil will be developed.  For example, how can the leases be "a fire sale" if shale oil technology is unproven and development is not likely to occur?  I would say that if these assumptions were true, then any money the government gets for a worthless lease is found money. 

Similarly, how are oil companies going to enrich themselves by paying for leases if the technology is not going to work and no development is going to occur?  This same bizarre argument became Nancy Pelosi's talking point on offshore oil leasing, by saying that oil companies were somehow already cheating us by not drilling in leases they already have.  Only the most twisted of logic could somehow come to the conclusion that oil companies were enriching themselves by paying for leases were they found no developable oil.

From the standpoint of Democratic Party goals, there is absolutely nothing bad that happens if the government leases land for oil shale or oil drilling and oil companies are unable to develop these leases  (there is some small danger of royalty loss if leases are not developed when they could be economically, but most private royalty agreements are written with sunset periods giving the lease-holder a fixed amount of time to develop the lease or lose it -- I don't know how the government does it).  The net result of "no drilling" or "oil shale technology turns out not to work" is that the government gets money for nothing. 

Here is the problem that smart Democrats like Drum face, and the reason behind this confusing logic:  They have adopted environmental goals, particularly the drastic reduction of CO2 in relatively short time frames, that they KNOW, like they know the sun rises in the east, will require fuel and energy prices substantially higher than they are today.  They know these goals require substantially increased pain and lifestyle dislocation from consumers who are already fed up with fuel-cost-related pain.  This is not because the Democrats are necessarily cruel, but because they are making the [faulty] assumption that the pain and dislocation some day from CO2-driven global warming outweighs the pain from higher priced, scarcer energy.

So, knowing that their policy goal is to have less oil at higher prices, and knowing that the average consumer would castrate them for espousing such a goal, smart Democrats like Drum find themselves twisted into pretzels when they oppose oil development.  They end up opposing oil development projects because in their hearts they want less oil around at higher prices, but (at least until their guy gets elected in November) they justify it with this bizarre logic that they oppose the plan because it would not get us oil fast enough.  The same folks who have criticized capitalism for years for being too short-term focused are now opposing plans that don't have a payoff for a decade or so.

At the end of the day, most Democrats do not want more oil developed, and they know that much higher prices will be necessary to meet their climate goals.  It sure would be refreshing to hear someone just say this. As I wrote at Climate Skeptic, the honest Democrat would say:

Yeah, I know that $4 gas is painful.  But do you know what?  Gas
prices are going to have to go a LOT higher for us to achieve the CO2
abatement targets I am proposing, so suck it up.  Just to give you a
sense of scale, the Europeans pay nearly twice as much as we do for
gas, and even at those levels, they are orders of magnitude short of
the CO2 abatement I have committed us to achieve.  Since late 2006, gas
prices in this country have doubled, and demand has fallen by perhaps
5%.  That will probably improve over time as people buy new cars and
change behaviors, but it may well require gasoline prices north of $20
a gallon before we meet the CO2 goal I have adopted.  So get ready.

Postscript:  By the way, oil companies have been trying to develop shale oil since the 1970s.  Their plans went on hold for several decades, with sustained lower oil prices, but the call by the industry to the government for a clarified regulatory regime has been there for thirty years.  The brief allusion in Salazar's speech to water availability is a valid one.  I saw some studies at Exxon 20+ years ago for their Labarge development that saw water availability as the #1 issue in making shale oil work.

PPS:  I mention above that the pain of fuel prices not only hits the wallet, but hits in term of painful lifestyle changes.  One of the things the media crows about as "good news" is the switch to mass transit from driving by a number of people due to higher oil prices.  This is kind of funny, since I would venture to guess that about zero of those people who actually switched and gave up their car for the bus consider it good news from their own personal life-perspective.  Further, most of the reduction in driving has been the elimination of trips altogether, and not via a switch to mass transit.  Yes, transit trips are up, but on a small base.  95%+ of reduced driving trips are just an elimination of the trip.  Which is another form of lifestyle pain, as presumably there was some good reason to make the trip before.

Update: Updated on Canadian Oil Sands production here.  Funny quote:

Fourth, and potentially most important, the U.S. "green" lobby is
pushing legislation that could limit purchases of oil sands products by
U.S. government agencies based on its GHG footprint.  It would be well
beyond stupid for Congress to prohibit our buying oil from Canada while
we increase buying it from countries that threaten our security.  But
just because something is stupid certainly does not mean Congress may
not do it.

Kudos to Kimberly Strassel for going off on a world class rant against their airlines, and their desire to blame their woes on "oil speculators."

I want to say thanks for the July 10 email you sent to
all your customers seeking to explain why today's air travel experience
is so painful. The letter, signed by 12 of you, explained that "oil
speculators" -- presumably by betting on future oil prices -- are
killing your industry and thus requested that I, as a consumer,
pressure Congress to rein in this "unchecked" market "manipulation."

I admit that just lately I'd begun to feel that flying
was something akin to having my intestines fished out with a long hook.
Actually, I'd been wondering whom to blame for the fact that it would
probably be cheaper, easier and maybe even faster to drive to wherever
I want to go than to board one of your planes. Suddenly, all is clear.

I now understand that it is oil speculators who set
your hiring policies and who must have outlined the three types of
people you may employ: those who grunt at me, those who sigh deeply as
if my presence has ruined their day and those who are actively hostile
to my smallest request.

She goes off for quite a bit more.  Check it out.  I guess I am glad somebody's futures are going up in value.  My airline travel futures, also known as frequent flier miles, seem to get devalued constantly.

Over the last year or so, I have been relatively optimistic for a relatively significant drop in oil prices over the next 2-4 years followed by a number of years of price stability at this lower level.  This would be a direct analog to what happened in the 80's after the 1978 oil price spike.

One argument readers have made against this scenario is that a much larger percentage of the world's oil potential is controlled by lumbering state oil companies than was the case in 1978, particularly given the US Congress's continued cooperation with OPEC in keeping US oil reserves off-limits to drilling.  The theory runs that these state run oil companies have a number of problems:

• they move and react very slowly
• they don't have the technical competence to develop more difficult  reserves
• they don't have the political will to divert oil profits from social programs (including oil industry over-employment and patrimony) to capital spending

This latter issue is a big one - even keeping current fields running at a level rate requires constant capital and technological infusions.  I have written about this issue before, and I am sympathetic to this argument.  Here is Jim Kingsdale on this issue:

Events in Iran since the Revolution are an eery echo of what has
happened in Venezuela since the advent of Chavez.  Skilled workers and
foreign capital and technology have fled.  Corruption has become
rampant  along with incompetence.  Production of over 6 mb/d fell to
below 3 mb/d after the Revolution and is currently about 3.8 mb/d.  The
pre-revolutionary head count of 32,000 employees has grown to 112,000.

Since the Revolution Iran has exported $801.2 billion of oil but
nobody knows where that money has gone.  "Certainly none of it was
invested in Iranian oil infrastructure which badly needs renovation and
repair, upstream and downstream."  The author claims the Iranian
petro-industry is "on the brink of bankruptcy" although such a claim is
not documented.

It is clear that Iran, Venezuela, Mexico, Nigeria, and Iraq together
represent an enormous percentage of the world's oil deposits and
production that is being mismanaged.  The political and management
dysfunctions in all of these countries simultaneously is a major reason
for the world's current energy crisis.  If these countries all operated
in a standard capitalist mode, I suspect oil would be below $50 a
barrel and the ultimate supply crisis might be five or ten or even
fifteen years beyond when we will see it fairly soon.  There seems to
be little hope that any of these countries will make a dramatic change
in their oil productivity soon.

I am coming around to this argument.  I still think that oil prices are set for a fall, but lower prices may not last long if this analysis is correct.

Update: Of course Maxine Waters would like to add the United States to this list of countries with incompetent government management of oil reserves.

We have rising oil prices and falling housing prices.  Mortgages are defaulting and stocks have been falling of late.  The dollar is in the tank.  But at the end of the day, the world still sees the US as the safest and most productive place to invest its money:

Its odd to me that from time to time we go through periods of angst (e.g. the late 1980s panic that the Japanese were "buying up America") about this effect, but we should instead be assured by this vote of confidence from the rest of the world.  One might argue that folks are simply buying US assets today because they are cheap, and certainly the dollar's fall makes US assets relatively less expensive.  But assets are cheap in Russia and Nigeria and Venezuela too, and you don't see the world rushing to invest a few trillion dollars in those locales. 

Postscript:  This foreign ownership of US assets also makes the world a more stable place.  I am always stunned when people argue that Chinese ownership of a trillion dollars of US debt securities gives them power over us.  Huh?  Since when does holding someone's debt give you power?  I don't think Countrywide Mortgage is feeling too powerful today.  The fact is that holding our debt and owning US assets gives China (and other nations) a huge shared interest in our stbility and continued prosperity.

As a followup to my point on oil prices, here are a selection of posts on oil prices and speculation that have caught my eye of late:

McQ writes about the charge of "inactive" oil leases, which Democrats attempted to use as an excuse for not opening up new lease areas for drilling

Tyler Cowen has a big roundup on the topic, with many links, and Alex Tabarrok has a follow-up.  Cowen discusses rising oil prices in the context of Julian Simon here.

Michael Giberson also addresses speculation, while observing that non-industrial buyers have not increased their position in the futures market as oil prices have risen

Don Boudreaux has thoughts on drilling restrictions

Finally, via Scrappleface:

When the U.S. Supreme Court reconvenes on the first Monday in
October, the nine Justices may consider whether the Constitutional
preamble clause "secure the Blessings of Liberty to ourselves and our Posterity" guarantees an individual right to drill for oil.

Now that the court, in a 5-4 ruling on the Heller case, has upheld
the Second Amendment right of "the people," not just state-run
militias, to keep and bear arms, some scholars say the court may be
willing to go the next logical step and recognize the peoples' right to
acquire their own fuel.

A number of readers have written me, the gist of the emails being "you have written that X or Y is NOT causing higher oil prices -- what do you think IS causing high oil prices?"  Well, OK, I will take my shot at answering that question.  Note that I have a pretty good understanding of economics but I am not a trained economist, so what follows relates to hard-core economics in the same way pseudo-code relates to C++.

My first thought, even before getting into oil, is that commodity prices can be volatile and go through boom-bust periods.  Here, for example, is a price chart of London copper since 1998:

While oil prices have gone up by a factor of about four since 1998, copper has gone up by a factor of about 15!  But the media seldom writes about it, because while individual consumers are affected by copper prices, they don't buy the commodity directly, and don't have stores on every street corner with the prices posted on the street.

For a number of years, it is my sense that oil demand has risen faster than supply capacity.  This demand has come from all over -- China gets a lot of the press, but even Europe has seen increases in gasoline use.  Throughout the world, we are on the cusp of something amazing happening - a billion or more people in Asia and South America are emerging from millennia of poverty.  This is good news, but wealthier people use more energy, and thus oil demand has increased.

On the supply side, my sense is that the market has handled demand growth up to a point because for years there was some excess capacity in the system.  The most visible is that OPEC often has been producing below their capacity, with Saudi Arabia as the historic swing producer.  But even in smaller fields in the US, there are always day to day decisions that can affect production and capacity on a micro scale.

One thing that needs to be understood - for any individual field, it is not always accurate to talk about its capacity or even its "reserves" as some fixed number.  How much oil that can be pumped out on any given day, and how much total oil can be pumped out over time, depend a LOT on prices.  For example, well production falls over time as conditions down in the bottom of the hole deteriorate  (think of it like a dredged river getting silted up, though this is a simplification).  Wells need to be reworked over time, or their production will fall.  Just the decision on the timing of this rework can affect capacity in the short term.  Then, of course, there are numerous investments that can be made to extend the life of the field, from water flood to CO2 flood to other more exotic things.  So new capacity can be added in small increments in existing fields.  A great example is the area around Casper, Wyoming, where fields were practically all shut-in in the 1990's with $20 oil but now is booming again.

At some point, though, this capacity is soaked up.  It is at this point that prices can shoot up very rapidly, particularly in a commodity where both supply and demand are relatively inelastic in the short term.

Let's hypothesize that gas prices were to double this afternoon at 3:00PM from $4 to $8.  What happens in the near and long-term to supply and demand?

In the near term, say in a matter of days, little will change on the demand side.  Everyone who drove to work yesterday will probably drive today in the same car -- they have not had time to shop for a new car or investigate bus schedules.  Every merchandise shipper will still be trucking their product as before - after all, there are orders and commitments in place.  People will still be flying - after all, they don't care about fuel prices, they locked their ticket price in months ago. 

However, people who argue that oil and gas demand is inelastic in the medium to long term are just flat wrong.  Already, we are seeing substantial reductions in driving miles in this country due to gas price increases.  Demand for energy saving investments, from Prius's to solar panels, is way up as well, demonstrating that prices are now high enough to drive not only changed behaviors but new investments in energy efficiency.  And while I don't have the data, I am positive that manufacturers around the world have energy efficiency investments prioritized much higher today in their capital budgets.

There are some things that slow this demand response.  Certain investments can just take a long time to play out.  For example, if one were to decide to move closer to work to cut down on driving miles, the process of selling a house and buying a new one is lengthy, and is complicated by softness in the housing markets.  There are also second tier capacity issues that come into play.  Suddenly, for example, lots more people want to buy a Prius, but Toyota only has so much Prius manufacturing capacity.  It will take time for this capacity to increase.  In the mean time, sales growth for these cars may be slower and prices may be higher.  Ditto solar panels. 

Also, there is an interesting issue that many consumers are not yet seeing the full price effects of higher oil and gas prices,and so do not yet have the price incentive to switch behavior.  One example is in air travel.  Airlines are hedged, at least this year, against much of the fuel price increase they have seen.  They are desperately trying not to drive people out of air travel (though DHS is doing its best) and so air fares have not fully reflected fuel price increases.  And since many people buy their tickets in advance, even a fare increase today would not affect flying volumes for a little while.

Another such example that is probably even more important are countries where consumers do not pay world market prices for gas and oil, with prices subsidized by the government (this is mostly true in oil producing countries, where the subsidy is not a cash subsidy but an opportunity cost in terms of lost revenue potential).  China is perhaps the most important example.  As we mentioned earlier, Chinese demand increases have been a large impact on world demand, as illustrated below:

All of these new consumers, though, are not paying the world market price for gasoline:

While consumers in much of the world have been reeling from spiraling
fuel costs, the Chinese government has kept the retail price of
gasoline at about $2.60 a gallon, up just 9% from January 2007.

During that same period, average gas prices in the U.S. have surged
nearly 80%, to about $4 a gallon. China's price control is great for
people like Tang, who drives long distances in his gas-guzzling Great
Wall sports utility vehicle.

But
Tang and millions of other Chinese are bracing for a big jump in pump
prices. The day of reckoning? Everybody believes it's coming right
after the Summer Olympics in Beijing conclude in late August.

Demand, of course, is going to appear inelastic to price increases if a large number of consumers are not having to pay the price increases.

Similarly, there are factors on the supply side that make response to large price increases relatively slow.  We've already discussed that there are numerous relatively quick investments that can be made to increase oil production from a field, but my sense is that most of these easy things have been done.  Further increases require development of whole new fields or major tertiary recovery investments in existing fields that take time.  Further, we run up against second order capacity issues much like we discussed above with the Prius's.  Currently, just about every offshore rig that could be used for development and exploration is being used, with a backlog of demand.  To some extent, the exploration and development business has to wait for the rig manufacturing business to catch up and increase the total rig capacity.

There are also, of course, structural issues limiting increases in oil supply.  In the west, increases in oil supply are at the mercy of governments that are schizophrenic.  They know their constituents are screaming about high oil prices, but they have committed themselves to CO2 reductions.  They know that their CO2 plans actually require higher, not lower, gas prices, but they don't want the public to understand that.  So they demagogue oil companies for high gas prices, while at the same time restricting increases in oil supply.  As a result, huge oil reserves in the US are off-limits to development, and both the US and Canada are putting up roadblocks to the development of our vast reserves of shale oil.

Outside of the west, most of the oil is controlled by government oil companies that are dominated by incompetence and corruption.  For years, companies like Pemex have been under-investing in their reserves, diverting cash out of the oil fields into social programs to prop up their governments.  The result is capacity that has not been well-developed and institutions that have only limited capability to ramp up the development of their reserves.

One of the questions I get asked a lot is, "Isn't there a good reason for suppliers to hold oil off the market to sustain higher prices?"  Well, let's think about that.

Let's begin with an analogy.  Why wouldn't Wal-mart start to hold certain items off the market to get higher prices?  Because they would be slaughtered, of course.  Many others would step in and fill the void, happy to sell folks whatever they need and taking market share from Wal-mart in the process.  I think we understand this better because we know the players and their motivations better in retail than we do in oil.  But the fact is that Wal-mart arguably has more market power, and in the US, more market share than any individual oil producer has worldwide.  Oil producers have seen boom and bust cycles in oil prices for over a hundred years.  They know from experience that $130 oil today may be $60 oil a year from now.  And thus holding one's oil off the market to try to sustain prices only serves to miss the opportunity to get $130 for one's oil for a while.  People tend to assume that the selfish play is to hold oil off the market to increase prices, but in fact it is just the opposite.  The player who takes this strategy reduces his/her own profit in order to help everyone else. 

This is a classic prisoner's dilemma game.  Let's consider for a moment that we are a large producer with some ability to move prices with our actions but still a minority of the market.  Consider a game with two players, us and everyone else.  Each player can produce 80% of their capacity or 100%.  A grid showing reasonable oil price outcomes from these strategies is shown below:

Reductions in our production from 100% to80% of capacity increases market prices, but not by as much as would reductions in production by other producers, who in total have more capacity than we.  Based on these prices, and assuming we have a million barrels a day of production capacity, the total revenue outcomes for us of these four combinations are shown below, in millions of dollars (in each case multiplying the price times 1 million barrels times the percent production of capacity, either 80 or 100%):

We don't know how other producers will behave, but we do know that whatever strategy they take, it is better for us to produce at 100%.  If we really could believe that everyone else will toe the line, then everyone at 80% is better for us than everyone at 100% -- but players do not toe the line, because their individual incentive is always to go to 100% production.  For smaller players who do not have enough volume to move the market individually (but who make up, in total, a lot of the total production) the incentive is even more dramatically skewed to producing the maximum amount.

The net result of all this is that forces are at work to bring down demand and bring supply up, they just take time.  I do think that at some point oil prices will fall back out of the hundreds.  Might this reckoning be pushed backwards a bit by bubble-type speculation?  Sure.  People have an incredible ability to assume that current conditions will last forever.  When oil prices were at $20 for a decade or so, people began acting like they would stay low forever.  With prices rising rapidly, people begin acting like they will continue rising forever.  Its an odd human trait, but a potentially lucrative one for contrarians who have the resources and cojones to bet against the masses and stick with their bet despite the fact that bubbles sometimes keep going up before they come back down.   

I don't have the economic tools to say if such bubble speculation is going on, or what a clearing price for oil might be once demand and supply adjustments really kick in.  I do have history as an imperfect guide.  In 1972 and later in 1978 we had some serious price shocks in oil:

Depending on if you date the last run-up in prices from '72 or '78, it took 5-10 years for supply and demand to sort themselves out (including the change in some structural factors, like US pricing regulations) before prices started falling.  We are currently about 6 years into the current oil price run-up, so I think it is reasonable to expect a correction in the next 2-3 years of fairly substantial magnitude. 

Postscript:  I have left out any discussion of the dollar, which has to play into this strongly, because what I understand about monetary policy and currencies wouldn't fill a thimble.  Suffice it to say that a fall in value of the dollar will certainly raise the price, to the US, of oil, but at the same time rising prices of imported oil tends to make the dollar weaker.  I don't know enough to sort out the chicken from the egg here,

I find the current political demagoguery that oil speculators are now the ones responsible for higher oil prices to be absolutely laughable.  I am willing to believe that oil supply and demand are perfectly inelastic over very short time periods, meaning that we might expect little change in supply or demand over a couple of days or weeks after a price change, allowing for a fairly free range of speculative excesses.  However, there is every evidence that oil is by no means perfectly price inelastic, and supply and consumption do change with price.  Already in the past few months we have seen, for example, substantial reductions in passenger car miles in this country. 

For any period of time longer than hours or days (or perhaps weeks), any cabal that is somehow manipulating oil prices well above the natural market clearing price is going to have to deal with a problem:  Extra oil.  Lots of it.  Even if the supply side is sticky due to shortages currently in drilling equipment, demand is not.  People are going to use less, and at the same time, every supplier is going to be trying to send every barrel to market as quick as they can  (oil producers know that prices that rise will eventually fall again -- that is the history of oil.  They are all programmed to move as much product as possible when prices are at all time highs).

A lot of dynamics, such as a short squeeze, can create a speculative bulge, but if speculators are somehow purposefully keeping oil prices high for long periods of time, they must be doing one of three things:

1. Storing a lot of oil somewhere
2. Creating an extensive system of production controls that keeps oil supply off the market.
3. Have someone with deep pockets subsidize consumer demand for oil by selling excess oil off at below market prices.

One is just not possible, not in the quantities that would be required.  Two sort of happens in a haphazard and not very consistent way with OPEC, though it is hard to convince me that futures traders in Chicago have an active partnership with large state-run oil companies.  Three is actually happening, with the Chinese government continuing to sell gasoline and other petroleum products at below market prices, but there is evidence that there are limits to how much further they will take this.  Again, I think this is being done for reasons other than cooperation with mercantile exchange traders in the US.

To a large extent, this theory, if it is anything more than just populist capitalism-bashing, is a result of extreme ignorance.  There are an incredible number of people involved in the oil markets every day in numerous countries with numerous different incentives, such a large number that it is impossible to imagine a conspiracy.  There have been a couple of cases of proven petroleum commodity price manipulation in these trading markets - most of these have involved manipulation of prices at the end of the day on certain futures expiration and/or Platt's pricing windows.  The time frame for these manipulations have been on the order of 1-2 minutes.

But here is the best argument against this manipulation for higher prices, and it is amazing to me that no one ever thinks of it.  Sure, there are a bunch of really savvy people in the commodity trading business who are long on oil and want the price to be higher.  But for every seller, there is a buyer on the other side, someone who is at least as savvy and is desireous of lower prices.  Yes, I know it is a complicated concept, but for every trader selling there is one buying.  If there is an extended conspiracy to push up oil prices by speculators, do you really think the buyers are just going to sit on their hands and take it?  And do you really think the exchanges are going to be happy with this behavior, threatening the integrity of their trading system (really their only asset)?  Just ask the Hunt family, which attempted to corner the market and drive prices up in silver, only to have major buyers and the exchanges stop them cold, driving the Hunts in the process into bankrupcy. 

I wrote about this same topic previously here.