Tag: oil

On the Oil-Gold Ratio: Why Oil’s Going Higher

A big story to come out of the last G-20 summit was that the Russians and Saudis were talking oil (read: an oil cooperation agreement). With that, everyone asked, again, where are oil prices headed? To answer that question, one has to have a model – a way of thinking about the problem. In this case, my starting point is Roy W. Jastram’s classic study, The Golden Constant: The English and American Experience 1560-2007. In that work, Jastram finds that gold maintains its purchasing power over long periods of time, with the prices of other commodities adapting to the price of gold. 

Taking a lead from Jastram, let’s use the price of gold as a long-term benchmark for the price of oil. The idea being that, if the price of oil changes dramatically, the oil-gold price ratio will change and move away from its long-term value. Forces will then be set in motion to shift supply of and demand for oil.  In consequence, the price of oil will change and the long-term oil-gold price ratio will be reestablished. Via this process, the oil-gold ratio will revert, with changes in the price of oil doing most of the work.

For example, if the price of oil slumps, the oil-gold price ratio will collapse. In consequence, exploration for and development of oil reserves will become less attractive and marginal production will become uneconomic. In addition to the forces squeezing the supply side of the market, low prices will give the demand side a boost. These supply-demand dynamics will, over time, move oil prices and the oil-gold price ratio up. This is what’s behind the old adage, there is nothing like low prices to cure low prices.

The Environmental Lightning Rod Known as Fracking

Of all issues energizing environmentalists, hydraulic fracturing, or fracking, of the subsurface rocks during the production of oil and gas is near the very top of the list.

In spite of this, several recent government decisions and court rulings have come down on the side of fracking. For example, overshadowed in May by Brexit coverage, elected officials in Yorkshire, England gave the thumbs up to fracking operations there in an effort to boost natural gas production. Also in May, the Colorado Supreme Court struck down fracking bans passed by the city governments of Fort Collins and Longmont, in a ruling that upheld the legality of the state to regulate fracking, versus the municipalities’ lack of standing to ban use of the technology.

The Economics of the Saudis’ “Take-the-Money-and-Run” Strategy

As the Financial Times reported on 12 July, Saudi Arabia’s oil-output reached record highs in June 2016. Increasing production 280,000 barrels/day to 10.6m b/d, Saudi Arabia has once again waved off OPEC’s request not to glut the market with oil. 

As it turns out, economic principles explain why the Saudis began, in late 2014, to pump crude as fast as they could – or close to as fast as possible. In fact, there is a good reason why the Saudi princes are panicked and pumping. 

Let’s take a look at the simple analytics of production. The economic production rate for oil is determined by the following equation: P – V = MC, where P is the current market price of a barrel of oil, V is the present value of a barrel of reserves, and MC is the marginal recovery cost of a barrel of oil.

To understand the economics that drive the Saudis to increase their production, we must understand the forces that tend to raise the Saudis’ discount rates. To determine the present value of a barrel of reserves (V in our production equation), we must forecast the price that would be received from liquidating a barrel of reserves at some future date and then discount this price to present value. In consequence, when the discount rate is raised, the value of reserves (V) falls, the gross value of current production (P – V) rises, and increased rates of current production are justified.

When it comes to the political instability in the Middle East, the popular view is that increased tensions in the region will reduce oil production. However, economic analysis suggests that political instability and tensions (read: less certain property rights) will work to increase oil production.

Let’s suppose that the real risk-adjusted rate of discount, without any prospect of property expropriation, is 20% for the Saudis. Now, consider what happens to the discount rate if there is a 50-50 chance that a belligerent will overthrow the House of Saud within the next 10 years. In this case, in any given year, there would be a 6.7% chance of an overthrow. This risk to the Saudis would cause them to compute a new real risk-adjusted rate of discount, with the prospect of having their oil reserves expropriated. In this example, the relevant discount rate would increase to 28.6% from 20% (see the accompanying table for alternative scenarios). This increase in the discount rate will cause the present value of reserves to decrease dramatically. For example, the present value of $1 in 10 years at 20% is $0.16, while it is worth only $0.08 at 28.6%. The reduction in the present value of reserves will make increased current production more attractive because the gross value of current production (P – V) will be higher.

 

So, the Saudi princes are panicked and pumping oil today – a take the money and run strategy – because they know the oil reserves might not be theirs tomorrow. As they say, the neighborhood is unstable. In consequence, property rights are problematic. This state of affairs results in the rapid exploitation of oil reserves.

That Saudi Sinking Feeling

The rate of growth in a country’s money supply, broadly measured, will determine the rate of growth in its nominal GDP. For Saudi Arabia, the following table presents a snapshot of the relationship between the growth in the money supply (M3) and nominal GDP.

 

The chart below shows the course of M3. Following the oil price plunge of September 2014, the growth in M3 has slowed. The rate of nominal GDP growth will follow.

Why is the money supply growth rate declining? Since the plunge in oil prices, the Saudis’ current account has dipped into negative territory. This has to be financed, and the Saudis have used their stash of foreign reserves to do the financing.

Economic Lessons from Muhammad Ali

Since the passing of Muhammad Ali, the establishment has been working in overdrive to convince us that the great boxer was a member of their club. In doing so, the wisdom and wit of Ali has been on display.

Muhammad Ali’s lessons on economics, however, have been absent. Economics? Yes. The lessons were developed in a most edifying book by Donald Sull, The Upside of Turbulence: Seizing Opportunity in an Uncertain World. New York: Harper Collins, 2009 – a book that Mohamed El-Erian recommended to me.

The economic lessons are summarized in “The Boxer Matrix.” A boxer’s fate is determined by a combination of his absorption capacity (read: can he take a punch?) and agility (read: can he avoid a punch?). In the Boxer Matrix, the ideal position to be in is the Northeast quadrant: where Ali and Joe Louis boxed. But, while Ali always had terrific agility, he had to train and think his way to an above average absorption capacity. This capacity was on display in his “Rumble in the Jungle” bout with George Foreman. It was then that Ali’s “rope-a-dope” tactic was executed to perfection.

This brings us to Ali’s message on economics, with particular reference to countries that are heavily dependent on the production of oil. In turbulent times (read: oil price plunges), countries like Saudi Arabia, Venezuela, and Nigeria experience a great deal of pain because their oil-dependent economies aren’t diversified. In short, they lack agility. This is reflected in their position in the lower half of the Boxer Matrix.

Upcoming Book Forum: Blood Oil: Tyrants, Violence, and the Rules that Run the World

On Wednesday January 13 at noon, Leif Wenar will be at Cato to discuss his new book, Blood Oil: Tyrants, Violence, and the Rules that Run the World. The book explores one of the great moral challenges of our time. That is, the massive benefits from development and global connectedness—in which we are all inescapably complicit—also enriched, enabled, and emboldened people who systematically made the lives of others desperate and miserable.

This cycle rolls on seemingly unabated. Indeed, the world’s dependence on oil and other natural resources continues to fuel violent conflicts and fund a large fraction of the world’s autocrats. But Wenar provides hope. After detailing the myriad negative consequences of resource wealth, Blood Oil outlines how “citizens, consumers, and leaders can act today to avert tomorrow’s crises — and how we can together create a more united human future.”

The Failure of Sanctions on Russia

On Friday, European Union envoys agreed to extend sanctions on Russia, continuing the restrictions placed on Russian businesses and citizens following Russia’s 2014 invasion of Crimea and aggression in Eastern Ukraine. The sanctions prevent some of Russia’s largest companies from raising capital in the West, restrict the export of technology and technical services for unconventional oil and gas drilling, and freeze the assets and travel of Russian elites.

Unfortunately, as I show in a study published in the January/February edition of Foreign Affairs, sanctions on Russia have been largely unsuccessful. The Russian economy is certainly hurting, but most of this damage was done by the extraordinary drop in oil prices over the last year:

The ruble’s exchange rate has tracked global oil prices more closely than any new sanctions, and many of the actions taken by the Russian government, including the slashing of the state budget, are similar to those it took when oil prices fell during the 2008 financial crisis.

And economic damage itself isn’t necessarily the best measure for sanctions success. Ultimately, sanctions are a tool of economic coercion and statecraft. If they do not cause a policy change, they are failing:

After the initial round of sanctions, the Kremlin’s aggression only grew: Russia formally absorbed Crimea and upped its financial and military support for pro-Russian rebels in eastern Ukraine (including those who most likely shot down the Malaysia Airlines flight).

The performance of modern targeted sanctions –which promise that damage will be narrowly focused on elites rather than the population in general – is also questionable in the Russian case, where the Kremlin has effectively redirected the economic burden of sanctions onto the population:

By restricting access to international financing during a recession, the sanctions have compounded the fall in oil prices, requiring Moscow to slash spending on health care, infrastructure, and government salaries, which has created economic hardship for ordinary Russians. The crash of the ruble, meanwhile, has not only destroyed savings but also increased the monthly payments of those who hold mortgages denominated in foreign currencies.

Perhaps worst of all, the sanctions are costing US and European companies billions of dollars in compliance costs, lost business and broken contracts:

The brunt is being borne by Europe, where the European Commission has estimated that the sanctions cut growth by 0.3 percent of GDP in 2015. According to the Austrian Institute of Economic Research, continuing the sanctions on Russia could cost over 90 billion euros in export revenue and more than two million jobs over the next few years. The sanctions are proving especially painful for countries with strong trade ties to Russia. Germany, Russia’s largest European partner, stands to lose almost 400,000 jobs. 

Ultimately, as I argue in the article, the success of sanctions can be judged by a variety of standards. Yet by virtually all of them, they are failing. This is a blow for those – myself included – who seek restrained policy options to resolve the crisis in Ukraine. Yet given the costs to U.S. businesses, it’s probably time for policymakers to consider whether continuing sanctions on Russia is really the best option, or whether there are more effective diplomatic or economic policy tools we can use instead.

You can read the whole article, with more data and policy recommendations, over at Foreign Affairs