Why Do Oil Prices Jump (and Fall)?

• Introduction • Stylized facts of the World Oil Market

• Economic explanations of price volatility • Political economics (Public Choice)

• Stochastic Processes • Final Remarks

Chart of crude oil prices since 1981

real ($2014/b)

World Oil Market Stylized Facts I

• Large time constants (demand & supply) - sluggish • Price volatility (in the top notch) • Importance of OPEC – reserves, trade • Political interventions on both, demand and supply • Politics versus Economics • Environment, Global Warming • Natural experiments:

money & development, monopolies – private vs state (below).

Stylized Facts II • Competitive fringe –

smooth at capacity • High variability in

OPEC =World demand– NonOPEC

• Benevolent OPEC (like Microsoft)? Yet private monopolies are constrained (compare PG&E) but state monopolies (OPEC) are not! (Adelman).

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

1965 1970 1975 1980 1985 1990 1995 2000 2005

Saudi Arabia σ = .15

OPECσ = .05

Non-OPECσ = .01

Standard Dev. – Growth in Oil Production

Surprise: High Oil Prices since 2004

Source: Coimbra-Esteves 2004

• IEA • DOE • Futures • OPEC • IIASA • EMF • Etc.

Dissenting: Gately (2001, 2004)

Source: Baker, Bergen: Projections are history driven

Economic Explanations

Opec as a profit maximizing cartel Sluggish + convex demand (for OPEC oil)

⇒It is profit maximizing to oscillate between 'high' and 'low' prices Yet the implied high frequency of price changes contradicts observations unless for costs of price adjustments (political?, regulations?)

price

( )( ) ( )( ) τtxtpDdtdx

−=

x(t) = current demand for OPEC oil D(p) = long run (equ.) demand τ = time constant of adjustment

p

∆p ∆p

∆q

∆q

Digression – Energy Demand 1. Major drivers of energy demand?

2. Methods of analysis and forcasting

bottom up vs top down

3. Is the IPCC goal of reducing fossil fuels feasible and at what cost? Is there sufficient conservation potential?

4. Some remarks: Prices are THE instrument. Planning does not work: Hayek/Mises versus Lange, BRD vs DDR Morale high ground but Moses‘ 10 commandments. Hayek (1945): ... an economic actor on average knows better the environment in which he is acting and the probable consequences of his ac-tions than does an outsider, no matter how clever the outsider may be

Energy Demand Analyses

Bottum Up

m2 heating, miles driven etc.

Top Down GDP, prices, …

static Dynamic

Econometric calibrated

optimized Simulated CGE computable general equilibrium

Coefficient of P2 and its two*S.E.bands based on rolling OLS

0 010.000.010.020.030.04

Empirical – D convex?

1970- .0002

1980- .0002

1985- -.003

1987- -.003

Estimated coeff xt = a0 + a1pt + a2pt

2 + a3t + a4xt-1

Rolling regression for coeff. of p2

Coefficient of P2 and its two*S.E. bands based onrolling OLS

Window size 15

-0.010.000.010.020.030.04

198519871989199119931995199719992001200320052005

OPEC

Coefficient of P2 and its two*S.E. bands based onrolling OLS

Window size 15

-0.005

-0.010

-0.015

-0.020

0.000

0.005

0.010

0.015

0.020

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 20052005

Gulf

Coefficient of P2 and its two*S.E. bands based onrolling OLS

Window size 15

-0.005-0.010-0.015

0.0000.0050.0100.0150.020

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 20052005

Saudi Arabia

Rauscher: OPEC is a blend of monopolistic (pm(x)) and competitive (p = mc(x)) behavior (fuzzy relation) depending on revenues p = αpm + (1 – α)mc, α = α(px)∈[0,1], α´ > 0:

Assumption: Sluggish demand for OPEC oil)

A

C

D

quantity, x

monopoly price pm(x)

competitive price mc(x) (marginal costs)

~1986 Recently

Demand, p = P(x), P = D-1

B

( )( ) ( )( ) τtxtpDdtdx

−=

Further Economic Explanations • Cartelization is only sustainable at high demands, Wirl (1988). • Price reaction function • Stochastic process (mean reversion, Pindyck, 1999) • To pre-empt carbon taxes, Rio (1992), Wirl (1994), Gately (2001).

Price reaction functions

80

79

81

77

78

76

88

86

75

87

8284

83

85

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

0.40 0.50 0.60 0.70 0.80 0.90 1.00

capacity utilization

real

pric

e ch

ange

(%.)

Oil price change depends on utilized capacity Gately and Kyle 1977, Powell (1990) and Suranovic (1993)

Rauscher 1988, Wirl 1993

88

8786

0

5

10

15

20

25

30

35

0 5 10 15 20 25 30 35 40 45 50

Time (years, starting 1985)

1980

-$/b

myopic

REH

Implications: • Only transient and damped oscillations are possible • Rational expecations enhance convergence • Yet the current price shock could be a result of past shocks according to the simulations in Wirl (1993):

However, recent realizations (on a monthly basis) are hardly compatible with this hypothesis

How to explain recent oil price shocks?

• Demand push • Uncertainty

Demand shock instead of

supply shocks in the -70ies

Recent Approaches mostly VAR

Lutz Kilian in many papers, Luciana Juvenal and Ivan Petrella

zt = % change in global crude oil production, a global real economic activity the real price of crude oil

Responses to one-standard deviation structural shocks with one- and two-standard error bands

What about speculation? • Many claim that ‘high’ oil prices in the past, in particular during 2008 with records

> $140/b during July, and lows around $40/b are due to speculation. • Yet this smells of conspiracy theory:

Krugman: “Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.” Krugman led up to this with an even more provocative example: Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil – the actual price people pay to have a barrel of black gunk delivered? The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference. Banks: “in 2008, when the price of oil was going into orbit, and threatened to ruin the global economy, President George W. Bush did not take a helicopter or bus to New York and Wall Street, and lecture the young ‘masters of the universe’ (as they are sometimes called) on their irresponsibility or incompetence. Instead he took Air Force 1 to Saudi Arabia, where his visit probably ended with the famous Turkish adieu, ‘smiling may you go, and smiling may you come again’, even if with all this smiling little or nothing was said or done about increasing the flow of oil.”

Oil price 2008 & speculation • Hamilton James D., Understanding Crude Oil Prices, Energy Journal 30/2, 179-

206, 2009: “ $140/b and 40 during 2008 cannot be compatible with the same fundamentals.”

• Büyüksahin Bahattin and Jeffrey H. Harris, Do Speculators Drive Crude Oil Futures Prices? The Energy Journal Vol. 32, No. 2, 167-202, 2011: The coincident rise in crude oil prices and increased number of financial participants in the crude oil futures market from 2000–2008 has led to allegations that “speculators” drive crude oil prices. As crude oil futures peaked at $147/bbl in July 2008, the role of speculators came under heated debate. In this paper, we employ unique data from the U.S. Commodity Futures Trading Commission (CFTC) to test the relation between crude oil prices and the trading positions of various types of traders in the crude oil futures market. We employ Granger Causality tests to analyze lead and lag relations between price and position data at daily and multiple day intervals. We find little evidence that hedge funds and other non-commercial (speculator) position changes Granger-cause price changes; the results instead suggest that price changes precede their position changes

Luciana Juvenal and Ivan Petrella Speculation in the Oil market

Remark on speculation • Markets as any human construct can never be 100% error free and I think no sensible person has ever

made this claim that markets work perfectly. • Taleb’s remarks on volatity (infragility). • Joseph of Egypt • Two examples from an energy related market, that of emission permits, document the range how

markets can solve valuation problems. First, the US permit market for sulphur got it right almost from the beginning (Ellerman, Joskow, Schmalensee, Montero, and Bailey (2000)), when the experts expected much higher prices after running their huge models (but as we should remember from von Hayek, the marginal cost is the outcome of market interactions and not of calculations on paper). In contrast, in the case of the European Emission Trading Scheme (ETS) for carbon permits, it took 18 months (and thus half of the running time) until the market discovered the true value of the permits (namely close to zero). In other words, bubbles are almost always only recognizable as a bubble after bursting (otherwise, we all could make money, actually huge amounts of money). Indeed, I have heard no one claiming in time that €30 per ton CO2 was a bubble or due to speculation, when it was presumably just due to plain uncertainty in a such virgin cross border permit scheme.

• However, it is the best information processing machine we have and no assigned individual or committee would do better. Let me give another concrete example related to the ETS mentioned above how markets can correct experts opinions: CO2 certificates have been handed to utilities free of charge with the opinion that this will ensure that the electricity price will not increase. However, electricity prices responded to the permit prices and as a consequence, German politicians and top lawyers and judges wanted to sue the utilities for increasing the price of electricity referring to the freely allocated permits. While this sadly expresses the economic ignorance of politicians and the legal profession, stock markets indicated from the very beginning that contrary to the claims of their executives[1] that emission trading coupled with grandfathering will not hurt the power utilities (Veith, Werner and Zimmermann (2009)).

Explicit Modeling of OPEC Behavior

• OPEC plays in prices • OPEC plays in quantity (adjustments) • Politico-economic objectives

Assumptions

• Dynamic, stochastic demand (x)

• OPEC (or a subset of) maximizes profits • Ignoring costs and resource constraints • Non-concave demand • (but concave revenues)

( ) ( )( ) ( )[ ] ( )( ) ( )tdztxdttxtpDtdx στ

+−=1

Convex demand, concave revenues

010203040506070

20 70 120

$/b

Exp

ort

s (

mb

/d)

0

200

400

600

800

1000

1200

0 20 40 60 80

bill

$/a

Given the stochastic, dynamic demand for OPEC oil (exports) with a convex or linear equilibrium demand (D(p)), the optimal OPEC price policy is to charge either a high or a low price depending on whether actual demand exceeds or falls below a threshold. Thus LOW & HIGH prices are compatible with cartel behavior. OPEC Gulf Exports

0

5000

10000

15000

20000

25000

1970 1980 1990 2000 2010

1000

b/d

demand

price

critical

high

low

Critical?

OPEC plays in prices

Economic Reason for volatile prices under dynamic demand

Opec as a profit maximizing cartel Sluggish + convex demand (for OPEC oil)

⇒It is profit maximizing to oscillate between 'high' and 'low' prices Yet the implied high frequency of price changes contradicts observations unless for costs of price adjustments (political?, regulations?)

price

( )( ) ( )( ) τtxtpDdtdx

−=

x(t) = current demand for OPEC oil D(p) = long run (equ.) demand τ = time constant of adjustment

p

∆p ∆p

∆q

∆q

Rolling reqression (window size 15) for the quadratic coefficient and ±2standard error fitting for fitting () to OPEC oil exports based on BP 2011 complemented by OPEC’s Annual Statistical Bulletin

2011 for information in BP (2011) missing on some OPEC member countries’ consumptions.

Optimal policy functions for (either convex or concave) equilibrium demand (16): D(p) = 30 - 0.205p + ½εp2,

ε = 10−4 (convex, bold) or ε = −10−4 (concave, bold) and other concave examples (ε < 0).

-

-

-

-

- -

- -

ε = +10-4

Extends to weakly concave demands

OPEC plays in quantity adj.

• Demand as above • Additional supply uncertainty

• Strategy – adjusting output (twice/a) • Let markets clear for prices

(all short run factors are amplified by τ)

( ) ( )( ) ( )[ ] ( )( ) ( )tdztxdttxtpDtdx στ

+−=1

20 40 60 80

2

1

1

2

Bang-bang optimal adjustment policy (u = ±um) from exponential demand example compared with linear demand assuming costs of $2 per marginal barrel at 1mb/d expansion; demands are as shown in Fig. 1 and the interior adjustment policy is based on Wirl (2010).

u (mb/d)

exports (mb/d)

um

-um

Deterministic, adjustment costs & linear demand OPEC

as cartel as duopoly

y

exp. demand & stochastic

Comparing (real) oil price changes along OPEC’s price and quantity policy. Source BP (2012).

price policy (official selling price) (recent) quantity adjustment policy

-50%

0%

50%

100%

150%

200%

250%

1970 1972 1974 1976 1978 1980 1982 1984

year

oilp

rice

chan

ge

-50%

0%

50%

100%

150%

200%

250%

2000 2002 2004 2006 2008 2010 2012

year

oil p

rice

chan

ge

Implication: Less drastic price changes under quantity adjustments

Two conflicting Theses

• Economics rules the World (and thus determines political actions)

• Economics is only weak constraint to political decisions.

Adelman, Not as Arabs or Muslims or some other irrelevancy, but as rational economic actors, the OPEC countries must take the money and run.

Politico-Economic Reasons

• Traditional Economics: Politics has little influence, economics rules the world.

• Public Choice: Politicians have private interests. John Stuart Mill, "The very principle of constitutional government requires it to be assumed, that political power will be abused to promote purposes of the holder; not because it is always so, but because such is the natural tendency of things to...“ Buchanan-Tullock on the assumptions in (welfare) economics: “.. that the individual must somehow shift his psychological and morale gears when he moves between the private and social aspects of life.”

• Politics dominates economics up to the medium term and economics is only a weak constraint. Proof: former Socialist economies.

• Political constraints imply short run oriented policies, in particular in the Middle East

Adelman: Not as Arabs or Muslims or some other irrelevancy, but as rational economic actors, the OPEC countries must take the money and run Exception: the dynasty of the Saud´s? Olson - staying vs. roving bandits, Dawkins – parasites and hosts

• Assumptions: - Sluggish demand is crucial - Anti-Western sentiments (Pareto) - rational politicians.

Homo oeconomicus politicus: embargoes or high prices

+ Short term revenues increase, possibly dramatically + Political payoff due to humilating the arrogant West

(the Satan, the stupid and greedy Yankees). - Long term profit suffers Σ + High prices are optimal for political-economic

reasons at least at high demands, no matter what the long term costs are.

Assumption: High current and sluggish demand

Models ( ) ( ) ( ) ( )[ ]dttxxtxtpe rt∫

∞− −

0

max ϕ

Instruments: either price, or output adjustments (y):

subject to dynamic demand

Further extensions – Uncertainty: •Stochastic demand (diffusion) •Political shocks (Poisson).

( )yxDpyx τ+== −1,

Results: Interior policy for convex demands are possible Thresholds exist (kill the goose that lays the golden eggs)

• The above temptations are hard to resit (just listen to Chavez, Morales, etc.)

• Hence, the economist´s optimism must be lowered in the real & political world.

Adam Smith (1777) "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their humanity but to their self-

love and never talk to them of our own necessities but of their advantage." • Aggressive pricing should concentrate in periods of

high demand, again for economic and political reasons.

• Yet they cannot explain the 2004-2008 evolution (and also not today´s high prices)!

• This raises also doubts about past references to politics

• Yet they cannot explain high prices in 2008 due to the experience during Israel‘s invasion of Lebanon in 2006*.

• This raises also doubts about past references to politics

in the first chart (see below).

55575961636567697173

23.0

6.20

06

30.0

6.20

06

07.0

7.20

06

14.0

7.20

06

21.0

7.20

06

28.0

7.20

06

04.0

8.20

06

11.0

8.20

06

18.0

8.20

06

25.0

8.20

06

01.0

9.20

06

08.0

9.20

06

15.0

9.20

06

22.0

9.20

06

$/b

OPEC Basket Price weekly during the Lebanon invasion

The conflict started on 12 July 2006, and continued until a UN-brokered ceasefire went into effect in the morning on 14 August 2006, though it formally ended on 8 September 2006 when Israel lifted its naval blockade of Lebanon.

July 12th Aug. 14th

Implied Hypotheses • Combining the 2006-2008 experience and the results from the above

model suggests the following hypothesis rewriting history:

• The at-first-sight decisive political event in 1973 could be reduced to that of only slightly advancing this price increase.

• Explanation: rapid growth of world oil demand before 1974 at an average of around 8%; demand for crucial OPEC countries grew even much faster accelerating 1971 – 1973: 1965-1970 +13% for OPEC 10% +17% for OPEC Gulf 10% +27% for Saudi Arabia 12%.

05000

10000150002000025000300003500040000

1965 1975 1985 1995 2005

10

00

b/d

Demand Uncertainty - Facts

Growth in Oil Demand Surplus Capacity OPEC without Iraq

Sources: IEA, Rech (2006)

-2%-1%-1%0%1%1%2%2%3%3%4%4%

1985 1990 1995 2000 2005

year

mean + 2σ

Speculation? Hamilton ‘$140/$50 cannot both be compatible with fundamentals’ Wrong!

Economics and Business of War: Liberating Kuwait

Background: •Iraq invades Kuwait 1990, •liberated by the Allied Forces (US) 1991 •Claim: due to oil. •The same claim applies to the current situation in Iraq Question:

Has the above claim an economic underpinning? That is, how much are oil prices going to be lowered if this

“cartelization” can be avoided?

Economic consequences of a large Iraq

Model: •Nash Cournot Competition among OPEC Members •Linear Demand for OPEC Oil P(q, t) = 39.4 – 1.38q + .38t •Economic objective (maximizing NPV of profits), i.e. each OPEC member:

( )∑= txtq i)(

Assumptions: Reserves, costs, discount rates, population

bewiesene Reserven 10^9 Fass

Kosten 80-$/b

Diskontraten jährlich

Bevölkerung (Mio.)

Reserven je Bevölkerung

b/cap.Algerien 8,40 3,00 0,15 24,60 342,00Ecuador 1,40 3,00 0,15 10,50 133,00Gabon 0,50 3,00 0,15 1,10 446,00Indonesien 8,30 3,00 0,15 178,20 47,00Iran 92,90 2,00 0,10 54,00 1.722,00Iraq 100,00 2,00 0,10 17,80 5.632,00Kuwait 91,90 2,00 0,05 2,10 44.829,00Libyen 22,00 2,00 0,05 4,40 5.023,00Nigeria 16,60 3,00 0,15 128,30 125,00Qatar 3,20 2,00 0,05 0,30 9.697,00Saudi Arabien 170,00 2,00 0,05 14,40 11.781,00V. Arab. Em. 96,20 2,00 0,05 1,60 62.065,00Venezuela 58,10 3,00 0,10 19,30 3.018,00

OPEC 676,10 2,50 0,10 456,40 1.481,00

Kuwait + Irak 191,90 2,00 0,10 19,90 9.643,00Arab. Golf(a) 461,30 2,00 0,08 36,20 12.743,00

Oil production under different members competing

Oil Prices and Competition within OPEC

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

0 10 20 30 40 50 60 70

time (t = 0 corresponds to 1990)

1980

-US$

/bar

rel

Monopoly

United Arab

OPEC (13)

Iraq + Kuwait

Resulting prices

Oil Prices under different hypothesis of competition within OPEC

0.0

5.0

10.0

15.0

20.0

25.0

30.0

0 2 4 6 8 10 12 14 16 18 20

time (t = 0 corresponds to 1990)

1980

-US$

/bar

rel

Monopoly

United Arab

OPEC (13)

Iraq + Kuwait

Summary

Given the small impact on oil prices in such an economic world, neither liberating Kuwait nor the recent Iraq war justify the economic price, which is presumably hefty (Nordhaus).

Final Remarks I • OPEC remains an important player

except (but very unlikely) Global Warming over-rules everything and even here, OPEC may gain!

• Price oscillations can maximize profits. • Myopic consumers may sustain cycles (S-supply, PRF). • Politically motivated price jumps:

Strong incentives for politicians to exploit high demand for political means - in particular if coinciding with political events - even at longterm economic costs, + short term economic rents (increase in revenues)

• Thus output cuts/embargos are NOT unlikely! • However, politics DOES NOT explain recent prices.

Final Remarks II • Demand shocks (first pressure, then recession) explain the

recent and current prices. • One should not expect for all the above reasons a smooth

oil price evolution (but this is still done). • What about a revolution in SA and sluggishness?

The Iranian one reduced output by 75% immediately, only returning by 1990 to ½ and today to 2/3 (of 6mb/d).

• Proposed counter policies – like reduction of taxes (all US presidential candidates! Sarkozy, NL, NZ, …) – are absurd (but reasonable as environmental policy due to reduced externality!).

• Exhaustible resource (asset value, financial markets).