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Oil and Money Again

Professor Ferdinand E. Banks
ferdinand.banks@telia.com
August 19, 2007

Five energy experts – to include Adam Sieminski of Deutsche Bank – were asked last year for their opinion of the future of oil prices. Four of them – of which one was anonymous – were not particularly optimistic, while the fifth, Dr Leo Drollas of the Centre for Energy Studies (UK), took a position similar to that of Steve Forbes (editor and publisher of one of the best business magazines in the world), who basically feels that the fundamentals are working in favour of a decline in the oil price.

Several years ago Dr Drollas discussed the oil price in a long paper in PetrominAsia, where he made heavy weather of an often quoted aphorism of his employer, Sheikh Ahmed Zaki Yamani, which was that there were still plenty of stones available when the Stone Age ended. Apparently this was intended to warn the producers of oil that they should go easy where the oil price is concerned, because if they didn’t, and the oil age appeared to be approaching its final stages, they might find themselves the not-so-happy custodians of a few hundred million tonnes of a nearly worthless commodity.

As I noted in a following issue of that publication, when I am confronted with this kind of talk, I’m inevitably reminded of Billy Joel’s song ‘In a New York State of Mind’, because wherever people like Dr Drollas may wander, their thoughts are inexorably focused on the next oil price meltdown. Incidentally, such a meltdown is plausible, but one of the reasons why John von Neumann was called the best brain of the 20th century had to do with his informing us that when considering this kind of prospect, some probabilities/odds should be introduced. On the basis of his most recent ‘State of the Nation’ speechs, it seems clear that President Bush and his colleagues have been thinking along this line, and as a result they are no longer disposed to bet the farm on a bear market in oil.

THE HARDER THEY FALL

In December of 2005, on the Swedish TV program ‘Genius Speaks’, a group of new Nobel Prize winners spent a relaxed hour speculating on the human condition in the light of existing and possible scientific advances. As usual, the economics laureates – Edward Prescott of the U.S., and especially Finn Kydland of Norway – revealed themselves to be hopelessly naïve about what is happening in the real world, as compared to the fantasy worlds so prominent in the papers and lectures with which they torment their students. As compared to the other laureates, they displayed an almost bizarre incompetence.

Fortunately, they were not requested to explain what could take place in the event of an escalation in the oil price which resulted in a barrel of oil trading for something in the mid-to-high seventies, or higher. Had they been asked, however, they would almost certainly have responded that a price of that amount, if sustained, would speed up the production of large quantities of synthetic oil from gas and coal, and in addition more effort would be put into exploiting hydrogen and biofuels, etc. What would not have been mentioned is the time factor, because in mainstream textbooks, the huge quantities of synthetic items required to depress the price of conventional resources can virtually appear over night. They would also probably overlook the fact that when the initial millions of barrels of non-conventional oil and motor fuel appeared, they would sell at or near the same price as the real thing.

Something else that was not ventilated is the likely macroeconomic effect of an oil price rise, which is fortunate, because comprehensive explanations of that perplexity are absent from textbooks, and the available presentations are generally without any scientific value. I can mention here, however, that at the present time the oil price is in the danger zone, and given the well known problem with ‘sub-prime’ (and securitized) mortgage loans, a heavy spike upwards would be the worst kind of news for the international macroeconomy.

For this reason it was both useful and interesting to reexamine an article in the Financial Times (February 3, 2006) by Martin Feldstein (of Harvard University), the title of which was ‘America will fall harder if oil prices rise again’. My recent papers contain a few of Feldstein’s observations, but the important thing is that Professor Feldstein – who ostensibly was on the short list of candidates for the position of governor of the U.S. Federal Reserve System – elected to place this article where it will be noticed, instead of in one of those unread tracts gathering dust in our academic libraries.

Feldstein confirms that “the economic slowdown that was widely expected never occurred”. He does not say who was doing the expecting, however on the basis of various written and spoken remarks, Alan Greenspan was almost certainly somewhere in this crowd. Feldstein concentrates his discussion on the effect of movements in the interest rate on consumer spending in the U.S. , primarily via the propensity to refinance existing mortgages. In my recent lectures I have been especially concerned with the impact of a wealth effect that could be attributed to what I picture as an inevitable rise in interest rates that would move these rates closer to some kind of ‘historical’ average. In particular, I noted what this could mean for share (i.e. stock) prices, as well as the behaviour of firms and consumers who are faced with ‘rolling-over’ their loans.

We were assured by Professor Feldstein that mortgage refinancing in the U.S. has peaked. On this point he was far ahead of his academic colleagues. He says that this follows from the Fed (= Federal Reserve) raising interest rates in order to counter inflationary pressures that remain from the rise in energy costs. I have some reservations about the word “remain”, which implies that in a future where the oil price might continue to rise, these pressures can be permanently removed by a simple boost in the ‘discount rate’. Something that needs to be emphasized here is that things have gone so well in the U.S. that many observers have concluded that the Fed can always attain the (market) interest rates they desire by simply tinkering with the rate at which they loan money to banks, or by somehow influencing the Federal Funds Rate (which is the rate used when banks lend to each other), however this is for the most part an illusion. It is also an illusion that the recent reduction in the discount rate by the Federal Reserve, and the increase in liquidity sponsored by central banks all over the world, will permanently restore the health of the international macroeconomy, to include the share markets. The glitches here have only been papered over.

Considerable attention was also directed by Feldstein toward the large decrease in saving that has taken place, and the concomitant increase in consumption. This rise in consumer outlays more than offset the fall in incomes that (ceteris paribus) might have accompanied the increased payments abroad that are necessitated by higher oil prices. In addition, this unusually strong consumer spending induced a higher physical investment. What Feldstein did not point out though was that this spending involved a large import component, and this might eventually have negative macroeconomic consequences (due, among other things, to the sizable dollar devaluation that might still be taking place).

Thus far much unpleasantness has been avoided because foreigners continued to purchase very large amounts of US bonds, and to purchase them at low interest rates. Professor Feldstein almost certainly understands the interior mechanics of this arrangement better than me, because when I was teaching macroeconomics during the l980s, I assured my students that a regime of very low interest rates, accompanied by a declining dollar, meant that the huge inflow of foreign capital – at that time Japanese – could dry up at any time, in which case the U.S. would be faced with a painful adjustment or even a or a full-fledged recession.

Feldstein used the term “lucky” to describe the escape of the U.S. from the consequences of excessive consumption (and excessive debt), however as he admits “it would not be so lucky if a big oil price increase happened now”.

THE BAD NEWS PRINCIPLE

Two academics who were (and perhaps still are) not worried about any damage that could be inflicted on the U.S. economy by high oil prices are Robert B. Barsky and Lutz Kilian. In one of those unread journals referred to above, they tell us that “disturbances in the oil market are likely to matter less for U.S. performance than had commonly been thought” (2004).

Noting that this conclusion follows an econometric analysis – where the emphasis should usually be put on the syllable ‘con’ – I reminded myself once again that despite some cockeyed opinions to the contrary, empirical work in economics can never take the place of theory. But even so, of the thousands of papers that in one form or another originate every year in academia, this is one of the few that makes a systematic attempt to judge the impact of oil price movements on the macroeconomic price level, employment, productivity and economic growth. I am also generous enough to believe that the reason they concluded that in general the effect of oil price increases tends to be exaggerated, is because over the period of their investigations (1970-2003), with the exception of the first and possibly the second oil price shocks, they were dealing with ‘spikes’ instead of sustained escalations. Of course, a spike from the present oil price (of slightly over $60/b) to the mid-seventies could be devastating for many persons in every part of the world, since changes in the oil price – and particularly upward movements – influences all energy prices.

There is “no support for the notion that increased uncertainty leads to a sharp fall in investment that in turn contributes to a recession”, the two authors tell us. What they mean by that is no econometric evidence, although it might be suggested that intelligent readers of the business press would be wise not attach any merit to econometric game-playing. Thus I suggest that we amend their observation to read ‘increased uncertainty can lead to a sharp fall in investment that – if sufficiently sharp – can contribute to a recession’.

Admittedly, some other conditions might have to be present, such as those mentioned in the previous section, however the economics here is really very simple: uncertainty functions in such a way as to boost discount factors, which as we all know from Economics 102 has a negative effect on physical investment because it means a large reduction in the (expected) present value of distant revenues. It is no more than common sense that investors who could accept a certain (or nearly certain) return of 8%, desire e.g. 11% when confronted with uncertainty because they feel that something might go drastically wrong.

My favourite finance guru is Paul Erdman – beginning with his novel ‘The Silver Bears’ (which was filmed and contained a brilliant musical background), and more germane his pop-finance book ‘What’s Next’ (1988). Erdman’s rather special use of the English language was never far from my thoughts when I was writing my international finance textbook (2001), which I suspect is the reason why an unidentified reviewer accused me of making an easy subject difficult (although I suspect that in his heart-of-hearts, he meant the reverse, which is the worst sin that a university teacher can commit).

In any event, if you read Erdman’s book, which shouldn’t take more than a few hours, you should take care not to miss what he says about the situation in the U.S. before the l987 share market meltdown. This is because, unfortunately, a large part of his comments are relevant at the present time, to include his claim that capital spending is “The most potent force in our economy”. On the basis of what we observe in the automobile industry, as well as Feldstein’s prediction about consumer spending, the (present) movements in the oil price – which Erdman regarded as hardly more than a detail before Black Monday (October 19, 1987) – might prove to be the straw that breaks the elephant’s back.

Barsky and Kilian take a cavalier view about physical investment, citing among other things their disbelief in Professor Ben Bernanke’s ‘bad news principle’, which the future Federal Reserve boss applied to oil price shocks (1983). What this comes down to is firms postponing investment “as they attempt to find out whether the increase in the price of oil is transitory or permanent”.

Although Barsky and Kilian say that evidence exists that Bernanke’s “waiting” effect is small relative to the magnitudes that need to be explained, I doubt whether this contention deserves to be treated with excessive respect when trying to assess the present economic future. The real price of oil (as compared to the money or nominal price) has been constant or falling for the last 30 years, and until recently the great majority of energy professionals interested in oil have preached from every soapbox between Lapland and the Capetown Navy Yard that both real and nominal prices of oil were certain to decline. As a result many firms have been quick to take advantage of what they judged to be decent investment opportunities. In the light of oil price increases over the past two years, however, many or most of these firms are going to be much more careful, which will tend to give extra weight to expected bad news about energy prices.

Incidentally, Bernanke actually said that “of possible future outcomes, only the unfavourable ones have a bearing on the current propensity to undertake a given project”. This kind of thinking ties in with a key postulate of real options theory: when waiting is possible, downside risk is always the major factor.

WILL WE ENJOY AN UNDULATING PLATEAU?

A friend sent me a recent article by Ken Silverstein in EnergyBiz Insider (2006) that dealt with the ‘peak oil’ issue. Anyone desiring an insight into this topic should examine the easily read contributions on oil in EnergyBiz and EnergyPulse (www.energypulse.net), to include the many comments on these articles that are also published.

Perhaps the most provocative information recently offered in that communication concerned the Cambridge Energy Research Associates (CERA), whose director – Daniel Yergin – is a well known energy commentator as well as a winner of the Pulitzer Prize (for a book about oil titled ‘The Prize’). Apparently CERA doesn’t believe in a global peaking of the oil production, but instead claims to have theoretical and/or statistical proof that we will eventually experience an undulating plateau. (Let me note though that as a veteran teacher of game theory, I recognize the possibility that in reality they may believe in a distinct peaking of the world oil production even more than I do.)

In any event, there were no undulating pleateaux in the U.S., UK, Russia, etc, and so the question should be asked why should one be expected on a global level? The answer to that query is that even if one is unlikely, it is still hypothetically possible, but under no circumstances should anyone believe that a statistical or econometric model can be constructed which is capable of making this outcome explicit. Half-baked, but well remunerated deception is what we are dealing with here – unless, possibly, some political elements are put into the equations. This extension cannot be broached in the present short paper, but it should not be overlooked that the owners of Middle East oil now understand that from a purely economic point of view, they are at long last in the driver’s seat, which has or will offend some very serious clients. Ignoring this departure, both geological and economic logic point toward an eventual peak in Middle East output, which in turn will ensure a peak in the global output.

Somewhat like Lee Strasberg in Godfather 2, I am a partially retired teacher living on a small pension. In contrast to that gentleman, however, I am not concerned with the ambitions of the Corleones, or even the pretentious research mafia languishing in certain faculties of economics in this country. My attention just now is focussed on my modest portfolio. Along with Paul Erdman, I became aware in the mid-1980s that a Black instead of a Green Trading Day was on the horizon, and like the best financial journalists in today’s media, I’m certain that a less drastic replay of that trauma should not be excluded.

As pointed out above, it appears that an economist with the prestige of Martin Feldstein has also become a Cassandra. (In case you don’t remember, Cassandra really did have the gift of prophesy, but it was her fate not to be believed.) It thus seems useful to call attention to what happened in l982, following the Iranian Revolution: unemployment in the U.S. reached 10%, employment actually fell for a few months, and some interest rates briefly exceeded 20%. Accordingly, some of us neither want to suffer or witness again the kind of unpleasantness that bad economic luck is capable of imposing.

Professor Ferdinand E. Banks
ferdinand.banks@telia.com
August 19, 2007

REFERENCES

Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory

Textbook. London, New York and Singapore: World Scientific.

Banks, Ferdinand E. (2001). Global Finance and Financial Markets. London, New York,

and Singapore: World Scientific.

_____ . (2000). Energy Economics: A Modern Introduction. New York: Kluwer Academ.

Barsky, Robert B. and Lutz Kilian (2004). ‘Oil and the Macroeconomy since the l970s’.

Journal of Economic Perspectives (Fall).

Bernanke, Ben S. (1983). ‘Irreversibility, Uncertainty, and cyclical investment’.

Quarterly Journal of Economics. (February).

Erdman, Paul (1988). What’s Next? New York: Bantam Books.

Feldstein, Martin (2006). ‘America will fall harder if oil prices rise again’. Financial

Times (February 3).

Silverstein, Ken (2006). ‘Peak oil: real or not?’. EnergyBiz Insider. (February)