Does the market price of oil reflect a recognition that the resource is fundamentally limited?
Dave Cohen, writing at the Oil Drum, has been doggedly wading through the writings of economists on resource scarcity, going the extra mile (and then some) trying to understand how those on the other side of the river from him have thought about the issue of resource scarcity.
As Dave nicely explains, the traditional Hotelling model reasons that market forces will cause there to be a “scarcity rent” incorporated in the price of an exhaustible resource. The observation is that someone who sells a disappearing resource today is thereby surrendering the opportunity to sell that commodity in a future market in which it might be more highly valued. As a consequence of owners bringing more or less of the product to the market at each date on the basis of such calculations, the theory predicts that the scarcity rent should rise over time at the rate of interest.
Dave then runs into the same stumbling block as anyone else who has tried to apply this elegant theory to reality– if you look at the inflation-adjusted price of what should be exhaustible commodities over the last century, there’s no hint at all of an upward trend:
Dave concludes that sellers have been regarding the day of exhaustion as so far off in the future, that, given also advances in the technology of extraction, a scarcity rent has made essentially no contribution to the price. But Dave’s geological assessment is that in the case of oil at least, declining annual production rates in fact are going to come relatively soon. He concludes that perhaps the scarcity rent is not making the contribution that it should for oil due to possible factors such as investors too heavily discounting even relatively near-term events, or deliberately misleading data provided by oil producers such as Saudi Arabia in a strategic game to prevent investments in alternatives to conventional oil reserves.
My own view is that, for most of the past century, Dave’s inference is exactly correct– the resource exhaustion was judged to be sufficiently far off as to be ignored. However, unlike those whom Dave terms the Cornucopians, I do not infer that the next decade will necessarily be like the previous century. Certainly declining production from U.S. oil reservoirs set in long ago. And if one asks, why are we counting on seemingly geopolitically unreliable sources such as Iraq, Nigeria, Angola, Venezuela, and Russia for future supplies, and transferring vast sums of wealth to countries that are covertly or openly hostile to our interests, the answer appears to me to be, because we have no choice. Resource scarcity in this sense has already been with us for some time, and sooner or later the geological realities that governed U.S. oil production are also going to rule the day for the rest of the world’s oil producing countries. My expectation has accordingly been that, although scarcity rents for oil were irrelevant for most of my father’s lifetime, they would start to become manifest some time within mine. And I have been very interested in the question of when.
If Dave had gazed not at a century of prices but rather at just the last 15 years of the price of oil relative to the PCE deflator, would he have drawn the same conclusion? If all we had was the graph above, it would seem quite natural to conclude that a rising scarcity rent could well be one factor in the recent behavior of this commodity price.
To be sure, there are some facts that fit a bit messily into that picture. One is that, over the last several years, oil futures prices have exhibited backwardation at some horizons. This is less dramatic now that it was a year ago, with the six-year-ahead contract price of $64 a barrel now above the current $59 1-month-ahead price. It is not obvious how to reconcile the behavior of futures prices over the last several years with a scarcity-rent explanation, though possibilities to investigate might be option valuation, adjustment costs, or hedging or other risk premia.
A separate set of doubts of course arise from the dramatic plunge in oil prices over the last few months, which at a minimum must reflect either some substantial new information about the long-run fundamentals or else confirm that some factors other than scarcity rent have been contributing to the oil price peak of the last year.
Despite these observations, I am not at all prepared to dismiss the hypothesis that scarcity rents have indeed started to make a contribution to oil prices over the last five years, and will become more apparent over the next five. For example, the announced intention of OPEC producers to cut back production as the price goes below $60 might be most naturally interpreted from that perspective– producers don’t see it as being in their interests to sell for less, given what the oil will be worth in the future.
Admittedly, if the oil price should fall from here down to $30, then I’ll have to conclude that scarcity rents have had nothing to do with the recent price moves.
But if Dave is right about the geology, oil is not going to $30.