Reflections on Reflections on Oil

My piece yesterday was never intended to be the finished article.  My goal is to outline a solution to global warming that might prevent the human race destroying the natural world and many members of our own species.  A solution based on how the world is, will, I suggest, be superior to one based on how we would like the world to be.

But I now realise that, lengthy though it was, Reflections on Oil omitted a few points that might be vital to understanding the jigsaw.

Cycles within Cycles

As I write, oil is down 10% from its peak a week or two ago, much to the relief of stock markets around the world.  Is this the turning point marking the end of what I yesterday termed the First Oil Demand Shock?

Who knows?

The trouble is, that, like fleas (which, famously, have little fleas upon their backs to bite them…), markets have long cycles, short cycles, and everything in between.  Each cycle has its own cause, possibly in the “real” world, and may be reinforced or damped by positive and negative feedbacks.  The time element is crucial.  In the UK we see today that, though oil is down, the price to the domestic energy consumer is still going up.  If we’ve seen the oil peak, the price rises yet to be passed on represent more inflation, which could cause higher interest rates, which will reduce economic activity, which could cause the price of oil to overshoot on the way down…

On the other hand, oil might shoot up again.  I wrote a few days ago that the issue of Iran has not gone away.  As I recollect, the talks last weekend gave Iran a couple of weeks to show some movement in its negotiating position.  As many commentators have observed, there’s also a dangerous window between the US presidential election and inauguration.  Particularly if Obama wins.

Then again, I suspect China to have put off any steps to slow its economy until after the Olympics and maybe even to have over-bought oil to avoid any possibility of losing face during the event.

The puzzle deepens because we know that markets know about these factors.  Risks may or may not be fully discounted.

The whole point (as this New Scientist article bleedin’ obviously notes – subscribers only I’m afraid, but it’s worth reading to see that the authors and presumably sub-editors don’t actually know what moral hazard is!) is that any asset is only worth what someone is prepared to pay for it, regardless of its “theoretical” value, so prices are largely determined by the untamed animal that we call the market.

But I don’t believe anything – even the market – is as random as Taleb seems to insist.  Turning points in markets are difficult to predict, but nevertheless we know they will happen.  Prices must, by definition, peak or trough eventually.  Many smart commentators knew the UK housing market was overbought going into 2007, even if the average punter couldn’t detect the signal in all the (often self-interested) noise.

Lumpy oil supply and consumption

The patterns, albeit grossly simplified, that I suggest will (in the event of a lack of or the ineffectiveness of steps to avert global warming) appear in the data of future oil consumption and and hence price, are a result of the effect of nation states on the market.

I never cease to be amazed by the capacity of people’s sense of entitlement.  One might argue that windfall profits (beyond those necessary to incentivise the companies involved) from the extraction of natural resources should accrue not to individual states but be used for the benefit of the whole of humanity.  One would not get very far.  It is the small number of oil-producing countries which allows oil to be rationed to everyone else.  Now that these countries are wealthy, they have little need to compete amongst themselves for the oil market.

I mentioned demand-destruction yesterday, but we should also reflect on how the high profits from oil have led to a global search for new supplies.  But a large proportion of these new suppliers are already oil-producing countries.  Sure, there are pockets of oil and gas being found from Israel/Palestine to Australia, but the new frontier of the Arctic is controlled by Russia, Norway, Denmark and Canada.

Only a few oil-deficit countries, including the US and Brazil, can boost oil-production.  I’m an environmentalist.  I think it should all be left in the ground.  The rest of the world must be wondering, though, why it is only now that the US is prepared to remove restrictions on offshore drilling.  People must be thinking they can’t want it that much if it’s worth less than a few polluted beaches.  Which tends to imply oil could ultimately get a lot more expensive yet.  The US certainly, and likely Brazil too eventually, will soon be able to consume any additional oil they pump.  So, in terms of reducing the long-term oil price increase, it won’t be enough to delay the Second Oil Demand Shock for very long.

As I explained yesterday, this will eventually push up the oil price to extreme levels.

The argument is not changed by the fact that, over time, the population of oil-producing countries will rise, partly because their wealth will permit larger families than otherwise and partly through migration both of the wealthy and of cheap labour, as we see from Dubai to Alberta.  The population increase will simply cause an ever-increasing proportion of oil to be consumed near where it is produced.  George Monbiot laments the fact that:

“The UK’s entire climate change programme is based on a statistical artefact. The only reason our pollution appears to have declined is that we have outsourced our emissions. A fair account of our carbon emissions would include those we import minus those we export: a balance that can only worsen in a post-industrial economy.”

But if some of our highest emitters (F1 racing drivers, say) move to Dubai while we are still able to watch them on TV and British companies continue to profit from their work, then surely that migration also represents an outsourcing of our emissions.

The whole plan is daft.  The idea of rigid emission targets for specific geographical areas (aka countries) is deeply flawed, especially when the rate of reduction of emissions that is proposed is conceivably less than (highly variable) annual rates of migration and changes in trade.  And totally especially when much of the world is outside the trading system!  Doh!

Effect of New Technologies

Today’s Guardian reports on wind power in China.  This is encouraging, but however much wind and solar power is produced it will not in itself keep the fossil-fuel in the ground. We’ll simply use more energy.

And what’s more the price of oil could continue to rise.  There are (at least) two reasons for this:

– cost and price are separate concepts.  The excellent blog post (but where’s the sequel?) I referred to yesterday asked:

“Is there a limit to how high the prices can go? Yes, the price of alternatives. If say solar energy is available for $200 a barrel equivalent of oil, then the price of oil will stabilize at $200 a barrel.”

Just because the cost of production of, say, the production of solar power drops, this will not drive down the price of oil.  If there is not enough energy available in total, then the lucky owners of both the solar power and the oil (as well as those of other sources of energy), will continue to make large profits. (Which will encourage more entrants into the energy market until it once again becomes a buyer’s market – but this could take an indefinite amount of time, impossible to determine in advance).

– oil is a complex product.  Some uses of oil, e.g. to power aircraft cannot easily be replaced with the use of electricity (although this may be possible in the long-run).

There is no real limit to how high the price of oil could rise relative to other goods.  Even if the cost of a plane flight exceeded the median annual salary by many times, some could still afford to fly.  And money is just a way of allocating resources.  We could simply end up with more super-rich people who can afford to fly while the rest of us are stuck on the ground.

Governments distort the economy

Not only do we have a lumpy global economy, we also have huge distortions caused by the bizarre willingness of governments to manipulate prices and engage in all manner of subsidies.  I quoted an FT article yesterday which included the quite staggering statistic that “officials recently estimated [India’s] subsidy bill… at $60bn.”   That’s likely of the same order as they spend on health or defence.  Unbelievable.

Lest anyone think I’m singling out India, I recently came across this FT article which gives some impression of the full horror of China’s currency misalignment.  What this means is that vast resources are being mis-allocated.  That is, millions of jobs have been created which may not be viable in the long-term.  I suspect this will not end prettily.

And in the UK the government now – yes, I’m afraid it’s true – encourages the creation of jobs for which (to maintain a reasonable standard of living) it is necessary to have people pay negative taxation (“tax credits”).  More on that another time.

Against this background we have to deal with the problem of global warming.  Tricky.