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Monetary Policy & Commodity Prices

Study Center Gerzensee23-25 June, 2014

Jeffrey FrankelHarpel Professor, Harvard University

Lecture I: Monetary Influences on Commodity

Prices

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Commodity prices have been volatile in recent years.

What causes swings such as the 2008 & 2011 price spikes?

The role of real interest rates.

Appendices: I. Do speculators destabilize prices? II. Long-term commodity price trends.

Oil prices, for example, spiked in 2008,and reached a 2nd peak in 2011.

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The impact on commodity-exporting developing countries

Developing countries tend to be smaller than major industrialized countries, and more likely to specialize in the exports of basic commodities like oil, minerals, & agricultural commodities.

So they are more likely to fit the small open economy model:

price-takers, not just for their import goods, but for their export goods as well.

That is, the prices of their tradable goods are taken as given on world markets.

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The determination of the export price on world markets

The price-taking assumption requires 3 conditions:

low monopoly power, low trade barriers, Homogeneity: intrinsic perfect substitutability

as between domestic & foreign producers – a condition usually met by primary products and usually not met by manufactured goods & services. Besides homogeneity, we will also be assuming storability.

To be precise, not all barrels of oil are the same,nor are traded in competitive markets.

But the assumption that most commodity producers are price-takers holds relatively well.

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A qualification: Monopoly power

Saudi Arabia does not satisfy the 1st condition, due to its large size in world oil markets.

If OPEC functioned effectively as a true cartel, then it would possess even more monopoly power in the aggregate.

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To a 1st approximation, then, the local commodity price = (the exchange rate)

X ($ price on world markets).

(sj/c) = (s j/$ ) + (s$/c ) where s j/$ ≡ spot exchange rate in units of currency j per $,s $/c ≡ spot price of commodity c in terms of $;

=> a devaluation should push up the commodity price quickly and in proportion leaving aside pre-existing contracts or export restrictions.

The determination of the export price continued

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Why are commodity prices so volatile?

Demand elasticities are low in the short run, because the capital stock is designed to operate with a particular ratio of material inputs to output.

Supply elasticities are also often low in the short run, because it takes time to adjust output.

Because price elasticities of supply & demand are low, relatively small fluctuations in demand or supply (due, e.g., to weather) require a large change in price to re-equilibrate supply & demand.

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A given rise in demand causesa small price rise or a big price

risewith with high elasticities low

elasticities

{ {Poil Poil

Supply & demand for commoditySupply & demand for commodity

D

D

D'

D'

S

SThe increase

in demand drives up the price

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Volatility, continued

Inventories can cushion the short run impact of fluctuations,

but they are limited by storage costs due to capacity constraints and carrying cost (interest rate, insurance,

spoilage…)

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Volatility, continued

In the longer run, elasticities are far higher, both on the demand side and the supply side.

This dynamic was clearly at work in the oil price shocks of the 1970s –

quadrupling after the 1973 Arab oil embargo

doubling after the Iranian revolution of 1979,

which elicited relatively little consumer conservation or new supply sources in the short run, but a lot of both after a few years had passed.

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Volatility, continued

In the medium run, people started insulating their houses

and driving more fuel-efficient cars, and oil deposits were discovered & developed in new countries.

This is a major reason why the real price of oil came back down in the 1980s-1990s.

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Price of oil, 1970-2007

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Volatility, continued

In the medium term, commodities can showa cob-web cycle, due to the lags in response: The initial market equilibrium is a high price; the high price brings forth investment

and raises supply after some years, which in turn leads to a new low price, which discourages investment,

and thus reduces supply with a lag and so on.

In theory, if people have rational expectations, they should look ahead to the next price cycle before making long-term investments in housing or drilling.

But the complete sequence of boom-bust-boom over the last 35 years looks suspiciously like a cobweb cycle nonetheless.

1 2

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Four explanations for big recent increases in the prices of oil, minerals &

agricultural commodities (1) global growth

especially China (2) speculation

defined as purchases of commodities, in anticipation of gain at the time of resale.

However, this includes: not only possible destabilizing speculation (bandwagons), but also stabilizing speculation.

(3) easy monetary policy reflected in low real interest rates.

(4) financialization: open position in commodities futures,

by commodity index funds & other traders esp. since 2005

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Monetary influences on commodity prices

We will show an arbitrage condition between the physical stock of a storable commodity like oil and the interest rate.

The real price of oil should be high during periods when real interest rates are low (e.g., due to easy monetary policy), so that a poor expected future return

to holding oil offsets the low interest rate.

By contrast, when real interest rates are high (e.g., due to tight money), current oil prices should lie below their long-run equilibrium, because an expected future rate of price increase

is needed in order to offset the high interest rate.

High real interest rates reduce the price of storable commodities

through 4 channels: ¤ by increasing the incentive for extraction today

rather than tomorrow think of the rates at which oil is pumped, gold mined,

forests logged, or livestock herds culled. ¤ by decreasing firms' desire to carry inventories

think of oil inventories held in tanks. ¤ by encouraging speculators to shift out of

commodity contracts, and into treasury bills the “financialization" of commodities.

¤ by appreciating the domestic currency and so reducing the price of internationally

traded commodities in domestic terms even if the price hasn't fallen in terms of foreign currency.

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The mechanisms at work in recent history

Very low US real interest rates boosted commodity prices toward the end of the 1970s, especially in $ terms;

high US interest rates drove them down in the 1980s, especially in $.

In recent years, e.g., 2008, low interest rates again contributed to high commodity prices.

References by the author include Frankel, 1986, 2005, 2008a,b, 2014; Frankel & Hardouvelis, 1985; Frankel & Rose, 2009.

Also Barsky & Summers, 1988; and Caballero, Farhi & Gourinchas, 2008. Barsky & Killian, 2002, and Killian, 2009: many big oil price “shocks”

have in reality been endogenous with respect to monetary policy.

Figure 1a: Real commodity price index (Moody’s) and real interest rates

Figure 1b: Real commodity price index (Moody’s) and real interest rates

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The overshooting theory mechanics Monetary contraction temporarily raises the real

interest rate whether via rise in nominal interest rate, fall in expected inflation, or

both.

Inventory demand falls (<= high “cost of carry”).

=> Oil prices fall. How far? Until oil is widely considered "undervalued"

-- so undervalued that there is an expectation of future appreciation,

together with other advantage of holding inventories: the "convenience yield,”

that it is sufficient to offset the higher interest rate and other costs of carrying inventories: esp. storage costs.

Only then are firms willing to hold the inventories despite the high carrying cost.

In the long run, the real interest rate & real commodity price return to equilibrium values.

Literature on inventories We need to include inventories,

E.g., Working (1949); Deaton & Laroque (1996); Ye, Zyren & Shore (2002,05,06)

and the role of speculation & interest rates.

Some have found evidence in inventory data for an important role for speculation, driven by geopolitical fears:

disruption to the supply of Mideastern oil. Kilian & Murphy (2013); Kilian & Lee (2013).

But the speculative factor is inferred implicitly rather than measured explicitly.

Empirical innovations of the 2014 paper

Relative to past attempts to capture the roles of speculation or interest rates via inventories: How to measure speculation, i.e., market expectations

of future commodity price changes? Survey data collected by Consensus Forecasts from “over 30 of the world's most

prominent commodity forecasters.”

How to measure perceived risk to commodity availability?

Volatility implicit in options prices.

Derivation & estimation of the model

1) The overshooting model shows the effect of the real interest rate

on the real commodity price, holding storage costs constant. We can also show how the local-currency

commodity price depends on the local interest rate too.

2) We can infer storage costs from inventories.

3) The full commodity price equation Adds to the overshooting model:

inventories / storage costs; & economic activity / convenience yield.

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1st assumption: regressive expectations

E [Δq] = - θ (q-) (1)

E [ Δ (s – p ) ] = - θ (q-) (2)

where q ≡ s-p, the (log) real price of the commodity, ≡ long run (log) equilibrium real commodity

price, s ≡ natural logarithm of the spot price, and p ≡ (log of) economy-wide price index.

E (Δs) = - θ (q- ) + E(Δp). (2)

+ 2nd assumption: speculative arbitrage

E(Δs) + C = i, (3) where: C ≡ cy – sc – rp.

=> - θ (q- ) + E(Δp) + C = i

=> q - = - (1/θ) [i - E(Δp) – C ] (4) .

q is inversely proportionate to the real interest rate, if and C are constant.

Regression of real commodity price indices against real interest rate (1950-2012)

Table 1 Dependent variable: log of commodity price index, deflated by US CPI

VARIABLESCRB

index

Dow Jones Index

Moody’s index

Goldman Sachs Index

Real interest rate -.041*** -.034*** -.071** -.075***

  (0.007) (0.006) (0.005) (0.007)Constant 0.900*** 0.066*** 2.533*** 0.732***

  (0.017) (0.016) (0.011) (0.018)

Observations 739 739 739 513 R2 0.04 0.04 0.25 0.18

*** p<0.01 (Standard errors in parentheses.)

q is inversely proportionate to the real interest rateThe overshooting model :

For a model of commodity prices in local currencies, combine commodity price overshooting

with Dornbusch exchange rate overshooting.

(sj/c j/c)) = (s j/$ - j/$ ) + (s$/c - $/c ) = (pj-j)- (1/ν)(ij - i$ - [Ej –E $]) - (1/θ)(i$–E $ – C)  

(q j/c - j/c ) = - (1/ν) (rj -r$ ) - (1/θ) (r$ – C). (9)

where s j/$ ≡ spot exchange rate in units of currency j per $,s $/c ≡ spot price of commodity c in terms of $;pj & p$ ≡ the price levels; j & $ the inflation rates;q j/c ≡ real price of commodity c in terms of currency j ;r$ & rj ≡ the real interest rates in the US & country j .

The overshooting equation for commodity prices in local

currencies Equation (9) says the real commodity

price observed in country j is high to the extent that either the US real interest rate is low, or the local real interest rate is low

relative to the US real rate. Equation tests for 8 floating-currency

countries: Local & US real interest rates do have

significant effects on local real commodity price indices (CRB, Dow Jones, The Economist, Goldman Sachs, Moody’s & Reuters).

Frankel (2008).

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3a. Log Real CRB Commodity Price Index in Local Currency & Real Interest Rates

 Short-term interest rates Long-term interest rates

  Sample

Real US i rate

Real interest

differential SampleReal US

rate

Real interest

differentialAustralia 1/1950-8/2005

-0.023 * -0.076 * 1/1950-8/2005

-0.057 *

-0.067 *

s.e.   0.006   0.003     0.005   0.004  

Brazil7/65-12/89 & 1/95-8/05

-0.024 * -0.006 * 5/1994-9/2005

-0.161 *

-0.001  

s.e.   0.007   0.002     0.019   0.001  

Canada 1/1950-9/2005-0.047 * -0.065 * 1/1950-9/2005

-0.073 *

-0.076 *

s.e.   0.005   0.005     0.004   0.006  

Chile 7/1997-9/2005-0.063 * -0.021 * 2/1993-2/2004

-0.092 *

-0.018 *

s.e.   0.006   0.004     0.014   0.003  Mexico 1/1978-9/2005 0.055 * -0.017 * 1/1995-9/2005 0.047 * 0.000  

s.e.   0.013   0.002     0.011   0.003  

NZ 3/1978-8/2005 0.001   -0.067 * 1/1950-8/2005-

0.081 *-

0.075 *s.e.   0.009   0.004     0.006   0.004  

Switzerlnd 1/1980-9/2005 0.034 * -0.054 * 5/1953-9/2005

-0.171 *

-0.095 *

s.e.   0.016   0.009     0.013   0.012  

UK 1/1950-9/2005-0.053 * -0.086 * 1/1950-9/2005

-0.106 *

-0.023 *

s.e.   0.010   0.007     0.007   0.006  

Regressions of commodity price in local currency on interest rates

Monthly observations (over largest possible sample of data since 1950)

* significance at 5% significance level. Robust standard errors are reported.

Derivation of inventory demand equation

E (Δs) + cy – sc – rp = i (3) or sc = [E (Δs)-i] +cy – rp. (7)

3rd assumption: Storage costs rise with the extent to which inventory holdings strain existing storage capacity: sc = Φ (INVENTORIES).

Invert: INVENTORIES = Φ-1 { sc } .

And combine with the arbitrage condition (7):

INVENTORIES = Φ-1 {[E(Δs)-i] +cy – rp} (8)

The carry trade model

Petroleum stocks Millions of barrels (3) (4) (1) (2)Carry trade: EΔs - i 0.12*** 0.12*** 0.02* 0.02*

(0.03) (0.03) (0.01) (0.01)

Actual US IP growth 0.56*** 0.56*** 0.02 0.01(0.15) (0.15) (0.08) (0.08)

US Industrial Prod. log -0.01 0.01

(0.07) (0.04)Forecast 2-yr IP growth -0.674** -0.671** 0.003 0.000

(0.318) (0.318) (0.146) (0.146)

Oil Stocks lagged log 0.91*** 0.91***(0.05) (0.05)

Trend 0.004*** 0.004*** 0.000 0.000(0.000) (0.000) (0.000) (0.000)

Constant 7.31*** 7.36*** 0.65 0.60(0.01) (0.32) (0.39) (0.48)

R2 0.84 0.84 0.97 0.97

Table 4 -- Oil Inventory Equation (1995-2011) 58 observations, quarterly

Now put inventories into the commodity price equation

When inventories rise, the commodity price falls.

WEO, IMF, April 2012

Complete equation for determination of price There is no reason for the net convenience yield, C, to be constant.

C ≡ cy – sc – rp (3) q- = - (1/θ) (i - E(Δp) – C) (4)

Substituting from (3) into (4), q = - (1/θ) [i-E(Δp)] + (1/θ) cy - (1/θ) sc - (1/θ) rp (5)Hypothesized effects:

Real interest rate: negative Convenience yield: positive

Economic activity Risk of disruption

Storage costs: negative sc = Φ (INVENTORIES).

Risk premium Measured directly: [E(Δs)-(f-s)] Or as determined by volatility σ : ambiguous

Measured by actual volatility or option-implied subjective volatility

Estimation of determination for real prices,commodity-by-commodity, 1950-2012

 Table 2a -- 1st half (1) (2) (3) (4) (5)

Commodity: Copper Corn Cotton Live cattle Live hogs

Real interest rate -0.07*** -0.05* 0.01 -0.05*** -0.04***(0.02) (0.03) (0.01) (0.02) (0.01)

Log World GDP -0.46 0.62 0.56 2.26 -2.62**constant 2000US$ ; WDI (0.57) (0.57) (0.58) (1.48) (1.12)

Log Inventories -0.19*** -0.07 -0.13 1.12 0.42*(0.06) (0.17) (0.12) (0.78) (0.24)

Spread, % 0.000 -0.006 -0.001 -0.007*** -0.004*** Future-Spot (0.002) (0.003) (0.001) (0.002) (0.001)

Volatility: Std.dev. 3.04*** 0.94 0.20 -0.27 -1.02of log price over past year (0.72) (0.91) (0.53) (0.78) (0.61)Linear trend -0.00 -0.04** -0.04* -0.08* 0.05

(0.02) (0.02) (0.02) (0.04) (0.03)

Constant 16.94 -20.26 -14.94 -81.65 74.87**(17.29) (16.54) (17.29) (51.77) (33.00)

Observations (annual) † 50 51 51 32 39R2 0.55 0.66 0.76 0.51 0.80

*** p<0.01, ** p<0.05, * p<0.1 (Robust standard errors in parentheses.) † Some commodities have shorter sample periods.

Estimation of determination for real prices,commodity-by-commodity, 1950-2012, continued

*** p<0.01, ** p<0.05, * p<0.1 (Robust standard errors in parentheses.) † Some commodities have shorter sample periods.

 Table 2a -- 2nd half (6) (7) (8) (9) (10) (11)

Commodity: Oats Petroleum Platinum Silver Soybeans Wheat

Real interest rate -0.04** -0.02 0.08*** -0.02 -0.04** -0.003(0.016) (0.071) (0.015) (0.025) (0.016) (0.021)

Log World GDP 1.56** -4.42 3.38*** 3.63* 0.38 0.33(constant 2000 US$);WDI (0.593) (4.984) (0.753) (2.012) (0.837) (0.702)

Log Inventories -0.31** -2.82 -0.24*** 0.01 0.04 -0.45*(0.13) (4.43) (0.03) (0.11) (0.09) (0.24)

Spread, % -0.015* -0.002 -0.000 -0.010** -0.007** -0.001 Future-Spot (0.003) (0.003) (0.001) (0.004) (0.003) (0.003)

Volatility: Std.dev. 0.91 -0.08 1.10*** 5.15*** 1.86** 1.81***of log price over past year (0.66) (0.69) (0.36) (0.67) (0.87) (0.65)

Linear trend -0.09*** 0.17 -0.12*** -0.12* -0.04 -0.03(0.03) (0.14) (0.03) (0.06) (0.03) (0.02)

Constant -45.54*** 156.65 -98.36*** -111.77* -13.65 -7.09(16.33) (142.65) (22.41) (60.57) (24.71) (20.18)

Observations (annual) 50 29 47 44 48 51R2 0.63 0.34 0.73 0.62 0.71 0.74

A panel across all 11 commoditiesoffers hope for greater statistical power

Table 3a Dependent variable: real commodity prices (log)(492 annual observations) (1) (6) (7)

Real interest rate -0.02* -0.03** 0.01(0.01) (0.01) (0.01)

Log World GDP 0.01 3.45*** (constant 2000 US$) WDI (0.24) (0.77)

Global Business Cycle 7.22*** (HP-Filtered World GDP) (1.08)

Quadratic Trend 0.001***(0.000)

Log Inventories -0.14*** -0.14*** -0.13***(0.03) (0.02) (0.02)

Future-Spot Spread, % -0.003*** -0.003*** -0.003***(0.001) (0.001) (0.000)

Volatility: Standard deviation 1.81*** 1.92*** 1.77*** of log spot price of past year (0.52) (0.51) (0.47)Linear Trend -0.02* -0.02*** -0.19***

(0.01) (0.00) (0.04)

Constant 0.01 0.32 -101.90***(7.01) (0.23) (22.93)

R2 0.46 0.49 0.51

Panel across all 11 commodities; First differences guard against non-stationarity

Table 3b Dependent variable: Δ real commodity prices (log)(1) (6) (7)

Δ Real interest rate -0.021 -0.001 -0.029**(0.013) (0.006) (0.012)

Global Business Cycle 6.765*** (HP-Filtered World GDP) (1.035)

Forecast 2-yr.US GDP growth 8.575*** 11.365*** (Consensus Forecasts monthly) (1.978) (2.178)

Quadratic trend 0.002***(0.000)

Δ Log Inventories -0.004 -0.08 -0.008(0.061) (0.0481) (0.056)

Δ Future-Spot Spread, % -0.001*** -0.002*** -0.002***(0.000) (0.0005) (0.000)

Δ Volatility: Std.dev. of -0.067 0.192 0.068 log spot price of past year (0.184) (0.213) (0.208)

Linear Trend 0.010*** 0.002*** -0.024***

(0.002) (0.000) (0.005)

Constant -0.314*** -0.043*** -0.271***

(0.068) (0.009) (0.071)

Observations 216 486 216

R2 0.22 0.17 0.27

In conclusion… The model can accommodate each of

the explanations for recent increases in commodity prices: economic activity, speculation, and easy monetary policy. Based on “carry trade”: arbitrage relationship

between expected price change & costs of carry: interest rate, storage costs & convenience yield.

And on “overshooting”: prices are expected to regress gradually back to long-run equilibrium

 

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Appendix I: Do speculatorsdestabilize prices?

Yes, speculators are important in commodities markets.   The spot price is determined in markets

where participants typically base their supply & demand in part on their expectations of future increases or decreases in the price.   

That is speculation.  But it need not imply bubbles or destabilizing behavior.

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Are speculators bad? continued

Speculators often fulfill useful functions: If they know the price is temporarily high, they

sell short, thereby moderating today’s high price.

If they have reason to think there will be a future increase in demand, they go long, thereby driving up today’s low price and sending

the market signal needed to spur investment. In these cases they are the messenger

delivering the news about economics fundamentals.

Admittedly, there are sometimes speculative bubbles, a self-confirming movement of the market price away from fundamentals.

An example of commodity speculation

In the 1955 movie version of East of Eden, the legendary James Dean plays Cal. 

Like Cain in Genesis, he competes with his brother for the love of his father.  

Cal “goes long” in the market for beans, in anticipation of a rise in demand if the US enters WWI. 

An example of commodity speculation, cont.

Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father, a moralizing patriarch. 

But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and tells him he will have to “give the money back.” 

Cal has been the agent of Adam Smith’s famous invisible hand: By betting on his hunch about

the future, he has contributed to upward pressure on the price of beans in the present,

thereby increasing the supply so that more is available precisely when needed (by the Army). 

The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to see.

An example of commodity speculation, cont.

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Appendix II:Long-term world price trend

(i) The old “structuralist school” (Prebisch-Singer):

The hypothesis of a declining commodity price trend

(ii) Hypotheses of a rising price trend Hotelling, non-renewable resources, & the

interest rate Malthusianism & the “peak oil” hypothesis

(iv) Empirical evidence Statistical time series studies

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Permanent upward trend?It looked like it in 2007.

Price of oil

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But not in 2009.One needs to look at the very long term

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(i) The old “structuralist school”

Raul Prebisch (1950) & Hans Singer (1950)

The hypothesis: a declining long run trend in prices of mineral & agricultural products

relative to the prices of manufactured goods. The theoretical reasoning:

world demand for primary products is inelastic with respect to world income.

That is, for every 1 % increase in income, raw materials demand rises by less than 1%.

Engel’s Law, an (older) proposition: households spend a lower fraction of their income on basic necessities as they get richer.

Demand => P oil

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Structuralists, continued

This hypothesis, if true, would imply that specializing in natural resources was a bad deal.

Mere “hewers of wood & drawers of water” would remain forever poor if they did not industrialize.

The policy implication of Prebisch: developing countries should discourage

international trade with tariffs, to allow their domestic manufacturing sector to

develop behind protective walls, rather than exploiting their traditional

comparative advantage in natural resources as the classic theories of free trade would have it.

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“Import Substitution Industrialization” policy (ISI)

was adopted in the 1950s, 60s and 70s in most of Latin America and much of

the rest of the developing world.

The fashion reverted in subsequent decades, however.

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(ii) Hypotheses of rising trends

Persuasive theoretical arguments that we should expect oil prices to showan upward trend in the long run.

(A) Hotelling: depletable resources; (B) Malthus: geometric population

growth.

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Assumptions for Hotelling model

(1) Non-perishable non-renewable resources: Deposits in the earth’s crust are fixed in total

supply and are gradually being depleted.

(2) Secure property rights:Whoever currently has claim to the resource can be confident that it will retain possession, unless it sells to someone else,

who then has equally safe property rights. This assumption excludes cases where warlords

compete over physical possession of the resource.

It also excludes cases where private oil companies fear that their contracts might be abrogated or their holdings nationalized.

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If property rights are not secure,

the current owner has a strong incentive to pump the oil quickly, because it might never benefit if the oil is left in the

ground.

That is one explanation for the sharp rise in oil prices from 1973 to 1979: Western oil companies in the 1960s had anticipated

that newly assertive developing countries would eventually nationalize the reserves within their borders,

and thus had kept prices low by pumping oil more quickly than if they been confident that their claims would remain valid indefinitely

until they indeed lost control in 1973.

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Price of oil, 1900-2006Oil shocks

1 1973 Arab oil embargo2. 1979 fall of Shah of Iran3. 2008 spike

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While we are on the subject of the 1970s oil shocks…

A more common explanation for the oil price increases of 1973-74 and 1979-80 is simply geopolitical disruptions: Yom Kippur War and Arab Oil Embargo Revolution in Iran and Fall of the Shah

Less common explanations: Excessively easy monetary policy

coming from US Fed accommodation of Vietnam deficits “The world is running out of oil.” We consider both later.

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One more assumption, to keep the Hotelling model

simple: (3) The fixed deposits are easily

accessible: the costs of exploration, development, &

pumping are small compared to the value of the oil.

Hotelling (1931) deduced from these assumptions the theoretical principle:

the price of oil in the long run should rise at a rate equal to the interest rate.

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King Abdullah of Saudi Arabia, with interest rates close to zero,apparently believes that the rate of return on oil reserves is higher if he doesn't pump than if he does:   

"Let them remain in the ground for our children and grandchildren..." (April 12, 2008)

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The Hotelling logic: The owner chooses how much oil to pump

and how much to leave in the ground. Whatever is pumped can be sold at today’s

price (price-taker assumption) and the proceeds invested in bank deposits or US Treasury bills, which earn the current interest

rate.

If the value of the oil in the ground is not expected to rise in the future, then the owner has an incentive to extract more of it today, so that he earns interest on the proceeds.

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The Hotelling logic, continued:

As oil companies worldwide react in this way, they drive down the price of oil today, below its perceived long-run level.

When the current price is below its long-run level, companies will expect the price to rise in the future.

Only when the expectation of future appreciation is sufficient to offset the interest rate will the oil market be in equilibrium.

Only then will oil companies be close to indifferent between pumping at a faster rate and a slower rate.

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Hotelling, continued:

To say the oil price is expected to increase at the interest rate means that it should do so on average; it does not mean that there won’t be

price fluctuations above & below the trend.

The theory does imply that, averaging out short-term unexpected fluctuations, oil prices in the long term should rise at the interest rate.

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If there are costs of extraction & storage?

-- non-negligible costs (but assume constant) ? then the trend in prices will be lower

than the interest rate, by that amount.

If there is a constant convenience yield from holding inventories?

then the trend in prices will be higher than the interest rate, by that amount.

The arbitrage equilibrium equation:E Δp oil = interest rate + costs – convenience

yield

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The upward trend idea is older than Hotelling.

It goes back to Thomas Malthus (1798) and the first fears of environmental scarcity: Demand grows with population, Supply does not. What could be clearer in economics than the prediction that price will rise?

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Over the two centuries since Malthus, or the 70 years since Hotelling,

exploration & new technologies have increased the supply of oil at a pace that has roughly counteracted the increase in demand from growth in population & incomes.[1]

[1] Krautkraemer (1998) and Wright & Czelusta (2003, 2004, 2006).

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Hubbert’s Peak – U.S.

Just because supply has always increased in the past does not necessarily mean it always will in the future.

In 1956, M. King Hubbert, an oil engineer,

predicted that the flow supply of oil within

the US would peak in the late 1960s and then decline permanently.

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The prediction was based on a model in which the fraction of the country’s reserves

that has been discovered rises through time, and data on the rates of discovery versus

consumption are used to estimate the parameters in the model.

Unlike myriad other pessimistic forecasts, this one came true on schedule, earning subsequent fame for its author: U.S. oil output indeed peaked in the late

1960s.

Hubbert’s Peak – U.S.

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Planet Earth is a much larger place than the USA, but it too is finite.

Some analysts have extrapolated Hubbert’s words & modeling approach to claim that the same pattern will follow for extraction of the world’s oil reserves.

Some claimed the 2000-2008 run-up in oil prices confirmed a predicted global “Hubbert’s Peak.” [1]

Are we witnessing a peak in world oil production? forecasts of such peaks have proven erroneous in the

past. The “fracking revolution” supports the opposite view.

[1] E.g., Deffeyes (2005).

Hubbert’s Peak – Global

68HeatUSA.com blog

Hubbert’s Peak – global

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The complication: supply is not fixed.

True, at any point in time there is a certain stock of oil reserves that have been discovered.

But the historical pattern has long been that, as that stock is depleted, new reserves are found.

When the price goes up, it makes exploration & development profitable for deposits farther

under the surface or underwater or in other hard-to-reach locations.

…especially as new technologies are developed for exploration & extraction.

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The empirical evidence With strong theoretical arguments on both

sides, either for an upward trend or for a downward trend, it is an empirical question.

Terms of trade for commodity producers had a slight up trend from 1870 to World War I, a down trend in the inter-war period, up in the 1970s, down in the 1980s and 1990s, and up in the first decade of the 21st

century.

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What is the overall statistical trend

in commodity prices in the long run?

Some authors find a slight upward trend, some a slight downward trend. [1] The answer seems to depend, more than anything

else, on the date of the end of the sample: Studies written after the 1970s boom found an upward

trend, but those written after the 1980s found a downward

trend, even when both went back to the early 20th

century.

[1] Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington & Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Hadass & Williamson (2003), Reinhart & Wickham (1994), Kellard & Wohar (2005), Balagtas & Holt (2009) and Harvey, Kellard, Madsen & Wohar (2010).

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What is the trend in the price of oil in particular?

1869-1969: Downward 1970-2011: Upward The long run:

Unclear ?

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Price of oil, 1869-2009

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