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Are you afraid of a big bag oil shock, Ferdinand?

Professor Ferdinand E. Banks
ferdinand.banks@telia.com
October 14th, 2014

That is an interesting question, Professor William D. Nordhaus, and thanks for posing it to your many admirers, to include me. But before I answer I should perhaps say something about my international finance students, who assumed that because of their extraordinarily high IQs, they could call me anything they wanted, both in class and at the marvellous parties they sponsored, and to which yours truly was always invited.

As I informed those young ladies and gentlemen, usually at the briefing I present at the beginning of the first class of the new term, but sometimes near a dance floor when Frank Sinatra was singing 'How Little we Know', my name is Ferdinand and I have a PhD, but I prefer to be called Fred or Professor Banks, and if I am called Ferdinand or Doctor, as certain people insist on doing, I might feel compelled to reply with language they would not appreciate.

In any event, in 2007, in an article Professor Nordhaus published in the Brookings Institution Papers titled 'Who's Afraid of a Big Bad Oil Shock?', his answer was that "policymakers should not be afraid of a big bad oil shock!" The argument he offered to support this belief contained some information about what was taking place during what he called an "oil shock", which he alleged took place from the beginning of the new century to 2007, and during which period the oil price was slowly increasing, but output continued to grow, and unemployment continued to fall." This he interpreted as a non-threatening oil shock, and as icing on the cake he accompanied his contention with some econometric results that featured what he called "an oil-shock variable."

The problem here is that - like the vast majority of academics in all faculties - the distinguished professor has an incomplete knowledge of global energy markets, both absolutely and as compared to my good self. The purpose of the present contribution is to clarify for readers what was taking place in the oil market from the end of the century until the middle of 2008, which includes those beautiful days in July of that year when I was preparing and then delivering a brilliant talk on oil to a large audience at the Ecole Normale Superieure (Paris). What I told them was essentially the following:

The genuine oil price escalation that was accelerating while I was strutting my stuff before a whiteboard at the Ecole Normale, was caused by the aggregate oil price falling to under ten dollars during the very hours in 1999 when wine was being purchased in France and elsewhere for the purpose of 'drinking in' a prosperous new century. Like Professor Nordhaus I have also taught econometrics, but I did not require an 'oil-shock variable' to tell me what was going on in the oil market, nor what was going to take place. I knew that OPEC was not going to accept what had happened with the oil price during the last decade of the 20^th century, and made this clear in my lectures at a dozen conferences, nor did they intend to accept the 'creeping' pace at which the oil price was rising during the early years of the new century, nor the ignorant predictions of OPEC detractors who informed friends and neighbors that the price of a barrel of oil would soon be as low as the price of a bottle of coca-cola. A pace that Nordhaus spoke of as an "oil price shock" and which even a more credible researcher referred to as a 'slow motion oil price shock'.

As you may or may not remember, Professor Milton Friedman told his students that cartels cannot succeed because of the 'human factor', which was his euphemism for greed. This is partially true I suppose, although I prefer the opinion of John von Neumann and Oscar Morgenstern (1944), which claims that when the formation of a cartel is legally possible, it should and would always appear if decision makers on the 'sell' side of a market were rational.

Where energy matters are concerned, rationality has a way of being in short supply, and I can remember hearing an argument presented by a member of the OPEC directorate several decades ago that that organization should be liquidated, and instead of trying to manage the oil price, that commodity should be sold using long term contracts. I don't know if other members were thinking in those asinine terms, but the sharp oil price decline during the 1990s, and the slow recovery early in the new century (that Nordhaus termed a shock), concentrated the minds of OPEC members, and dispelled sub-optimal approaches to the pricing of 'crude'.

The Oil Minister of Nigeria once said that shale oil - particularly in North America - is the worst enemy of oil exporters like the OPEC countries, and he also announced that his country will no longer export crude oil to the U.S. Frankly, the shale oil story is not as simple as generally told, nor Mr Minister thinks. A brilliant short article on the site 'Talk Markets' (originating with EconMatters.com) claims that the same thing might be taking place in the great world of shale as took place in the electric market during those halcyon days when the large corporation Enron was riding high. Riding high before its top executives ended up in prison for spreading lies to investors. It is far from unthinkable that now a few lies might be disseminated about shale reserves.

In an elementary book I am still 'polishing up' called ENERGY ECONOMICS: A MODERN FIRST COURSE (2014), I try to make it clear that strange things have happened in the shale world, and 'Bloomberg' publications have not hesitated to cite and investigate some of these 'oddities', going so far as to suggest that there has been an overconsumption of certain beverages by shale enthusiasts. 'Kool Aid' was the one they mentioned, but I can think of a few more.

Finally, we can turn to the question in the title of this note. Yes Professor Nordhaus, I am ready to confess I am afraid. I am afraid because like the leading oil economist in the U.S. - Professor James Hamilton of the University of California (San Diego) - I know that the macroeconomic meltdown that began in 2008 was caused by oil demand 'outrunning' oil supply, with the result being that oil price quickly climbed to the highest point in modern times ($147/b), with many seasoned and certifiable experts predicting that it was on its way to $200/b, or more.

Furthermore, and more important, the thing that my students must be totally aware of - but which their energy economics teachers generally fail to inform them - is what happened when the oil price not only fell from $147/b, but reached $32/b. On that occasion a few meetings took place in OPEC's Vienna headquarters, and it was not long before the oil price was again approaching $100/b.

Given the growth of global population, and on the basis of what I believe to be the power of OPEC where the oil supply is concerned, the same thing could happen again, although hopefully later rather than sooner. Yes, I could be wrong about OPEC's power due to the change in the oil reserves background that may - may - be caused by shale resources, although at the present time I think it appropriate to regard the Talk Markets/EconMatters articles as salubrious wake-up calls.

REFERENCES

Banks, Ferdinand E. (2015). Energy Economics: A Modern First Course. (In Process)

______. (2014). Energy and Economic Theory. Singapore, London and New York: World Scientific.

EconMatters (2014) 'Selling the Shale Boom: It's all a matter of reserves'. Talk Markets (October 10).

Neumann, John von and Oscar Morgenstern (1947). Theory of Games and Economic Behavior. Princeton: Princeton University Press.

Nordhaus, William D. (2007). 'Who's afraid of a Big Bad oil shock?' Brookings Papers.

Professor Ferdinand E. Banks
ferdinand.banks@telia.com
October 14th, 2014