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Oil Fundamentals and The Oil Future

By Ferdinand E. Banks | Mon, 16 August 2010 16:55 | 0

In the next edition of my energy economics textbook, I rehash and augment my interpretation of various controversies having to do with fundamentals’ versus speculation (i.e. gambling) when considering the spectacular oil price rises of e.g. 2008. I have ranted about this issue in at least a dozen papers and lectures, and it was also examined at some length in my recent course on oil and gas economics at the Asian Institute of Technology (Bangkok).

Then what is the object of the present brief exercise? The answer is that the  ‘fundamentals’ aspect of the dispute is more important than I originally believed, and it has been inadequately presented.  Assuming that I have some responsibility for the latter deficiency, it might be best way to commence this  exposition  with a casual perusal of some materials  found in the early chapters of your favourite Economics 101 textbook. I’m speaking of course of  the movements of (flow) supply and (flow) demand in a competitive or quasi-competitive market, and the influence of these movements on price. (‘Flow’ refers to dealing with units that have a time dimension, such as barrels/day.)

Bringing oil into the picture, since about 2003-04 the demand for oil has shown a tendency to (on the average) outrun supply, which is largely due to economic growth in Asia. This situation was reflected in a trend increase in the price of oil that lasted until late in 2008. Furthermore, about three barrels of conventional (or ‘near conventional’) oil are being consumed for every barrel discovered and added to reserves, which invigorated the oil price increase, because it indicated what the future supply-demand scenario might entail.

The trend increase referred to above reached a climax in the summer of 2008 when the price of oil touched 147 dollars per barrel (= $147/b). That price, in conjunction with the estimates presented by eminent energy professionals of what the future price could be, provided an unfortunate impetus to the macroeconomic and financial market meltdowns that began in the late-summer/early-autumn of 2008. Toward the end of 2008 the price of oil  began to fall, and the decline continued until it reached $32/b. Today it is $80/b, and to explain how that price is possible in the context of a still weak global macroeconomy, requires at least some acquaintance with a correct definition of oil market fundamentals.

But first let’s move to a famous forecast of the oil price by the Nobel Prize laureate Professor Milton Friedman in Newsweek (March 4, 1974). He claimed that OPEC was on the verge of collapse, and suggested in that item and/or elsewhere that the price of oil could not be held at more than $5/b.

The fundamentals that Friedman was attempting to exploit consisted of fusing the supply-demand scheme alluded to above with some variant of the ‘Market Share’ and/or Stackelberg oligopoly models, and then extending this arrangement. The extension amounted to no more than recognizing that there have probably been cartels – or ‘producers organizations’, as OPEC labelled itself – since the Middle Ages, and just about all of them failed because human beings have the annoying habit of preferring more money to less money. Thus, when the opportunity presents itself, one or several members do not continue to follow the output program initially agreed upon by the cartel organizers.

I began shaking my head at this over-simplified version of oil market fundamentals the first time I gave a talk on oil – at the Australian National University in 1978. As it happens I was mistaken, because I was thinking in terms of the long rather then the short term, and the long term at that point in history was very far in the future. Now the long term that I attempted to describe in my papers and books  has arrived, and it features a sophisticated OPEC creating a framework for its members’ activity in which the explanatory power of conventional supply-demand and oligopoly models is unambiguously and totally inadequate.

I have no desire to demean Economics 101 or 201, however I’m afraid that to estimate what might happen on the global oil scene of the future, we should go to a combination of game theory – a la John von Neumann – in addition to what might be called Bayes’ law. I seem to remember publishing a paper recently on what John von Neumann had in mind when he was developing game theory, but for those who missed that contribution, von Neumann ignored  simple mathematical constructions  of the kind taught at the storefront university I attended in Chicago, as well as the unsound neoclassical paradigms that are presented undergraduates at Harvard and Yale. Instead he was concerned with the kind of behaviour  that he described to Jacob Bronowski in the course of a taxi ride in London during the second world war: bluffing, deception, misrepresentation, conflict between opponents who are occasionally overwhelmed by spasms of irrationality, etc.. When they are rational however, von Neumann suggested that  these players should concentrate on not  losing rather than obtaining an unambiguous win.

If you require an example of misrepresentation, I can cite some of the estimates of conventional oil availability launched in a recent Oxford Energy Forum. Without going into detail I can note that they were generally questionable, and it was clear to me at least that their   purpose was to convince oil importing countries that they can ignore claims and rumours that the output of several prominent oil producing regions will peak  before the end of the present decade.

As for Bayes’ law, this has to do with correcting prior probabilities (and assumptions)  as  posterior evidence (of a subjective or statistical nature) becomes available. As far as I can tell, as compared to the oil importing countries, OPEC has evolved to a point where they are doing this all the time, and doing it brilliantly, which explains why the price of oil has reached $80/b, despite continued macroeconomic and financial market fragilities  in the global economy. It should also be noticed that a few OPEC countries have grandly informed the media that they can and will greatly expand the production of oil, and some governments  and  research establishments in the oil  importing countries have  accepted this fantasy.

Personally I think that governments should pay more attention to Cristophe de Margerie, CEO of the French ‘major’ TOTAL, who claims that the oil production ceiling is considerably below that commonly believed. They might also give some thought to what I regard as the core of the strategy that OPEC has adopted, which is to produce as little oil as possible. I see no harm in confessing that this is exactly what I would do if I were in their place, as I try to make clear in my forthcoming long survey (2010) of the world oil market. The basic issue, which is usually not understood, is growth and not oil revenues.

By way of concluding this presentation, several  things seem worth emphasizing. Unless a discussion of oil market  fundamentals goes beyond the supply and demand curves in the first few chapters of the Economics 101 textbooks, it should be blatantly disregarded. Similarly, trying to come to grips with oil market fundamentals might – or might not – warrant a reference  to  one or more of the standard oligopoly models.  But regardless, nothing is more important than studying and thinking about the present and expected behaviour (i.e. strategy) of OPEC.

I’m willing to accept that the interests of oil exporters and oil importers partially overlap, and so it might be a good idea if all parties in the oil market attempt to comprehend this phenomenon, and systematic efforts are made to obtain an inter-temporal outcome that is optimal for both producers and consumers of oil. This observation immediately leads me to note that one of the seldom discussed laws of game theory suggests that in a conflict-like situation, if cooperation is possible it should always be attempted.

By. Professor Ferdinand E. Banks

REFERENCES

Banks, Ferdinand E. (2010)  A Modern Survey of World Oil: Realities and Delusions.
             To be published by UNESCO.
_____ . (2010). Economics, economists, and the oil and gas future.  Energy Politics.
            (Forthcoming)
_____ . (2007). The Political Economy of World Energy: An Introductory Textbook
           .  London and Singapore: World Scientific
_____ . The Political Economy of Oil. (1982) Lexington Massachusetts:
              D.C. Heath &
Bezat, Jean-Michel (2008). ‘Les marches spéculent désormais sur une pénurie de
             pétrole en 2016’. Le Monde. (Friday 23 May).
von Neumann, John, and Oscar Morgenstern (1944). The Theory of Games and
           Economic Behaviour. Princeton: Princeton University Press

About the author

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