Profile of Professor Banks

Another example might be useful. Serious fighting may be taking place again in Iraq, production trends have been pronounced as weak or downward in Venezuela and Mexico, the oil sector in Nigeria is ostensibly in trouble from well-organized theft, and bad things are happening in Libya, where a war was once started by the NATO ‘president’ to ostensibly protect civilians, but was actually aimed at providing increased access for somebody to the oil in that country, which has the largest confirmed reserves in Africa.

These ‘irregularities’ ostensibly attached a risk premium to the (‘appropriate’ or ‘relevant’ or ‘equilibrium’ or ‘competitive or ‘whatever’) world oil price, causing – in June of 2014 – that price to begin rising at an unexpected rate. A theory has been launched that without that risk premium, and taking into consideration ‘bad vibes’ from the direction of the Ukraine, the (average) world price of oil would or should descend from its present value – whatever that happened to be – to something much lower. Perhaps down to the ‘eighties’. Consequently, we are sometimes told, that the oil importing countries should to everything possible to weaken OPEC, and where weakening OPEC is concerned, Iraq – which is sometimes called ‘The New Prize’ – and shale oil are usually mentioned. This is a good topic for your next lecture, especially if a collection of self-appointed energy experts are sitting in the first row.

With all due respect, I don’t have much confidence in analyses and predictions about shale resources, nor fantasies about the defection of Iraq from The Organization of Oil Exporting Countries (OPEC). That organization may or may not control the oil price, but in the immediate future it has enough ‘juice’ to put a ‘floor’ under the oil price of around $100/b, which at the present time suffices to provide OPEC with an annual income of approximately a trillion dollars (= $1,000,000,000,000 = 10¹² dollars). This might also be the place to quote the often quoted T. Boone Pickens: “OPEC sets the price for oil. Of the 92 Mb produced every day in the world, OPEC is producing a third of it. It is big enough, and it is organized and credible. It is a cartel. 30% of oil can set the price by adjusting their ‘spot’ sales.” Good for you Mister Pickens! This is a judgment that merits the widest possible circulation, and you deserve our thanks, even if it happens that as these lines are being written, the oil price may be falling. There is a reason for that, and readers should be able to determine that reason for themselves.
THE PRODUCTION OF CRUDE OIL
Crude oil is unprocessed oil – or oil in the form that it comes out of the ground. As it happens, Hollywood has provided a dramatic look at production processes in the first part of the 20^th Century with its films ‘Giant’ and ‘There Will be Blood’. In Giant the erratic Jett Rink is a parody of ‘Dad’ Joiner, who in l930 brought in the first gusher of the huge East Texas oil field. As for later activities in the U.S. oil sector, readers should turn to Google and the topics ‘Oil production’, ‘Nodding Donkeys’ and ‘Oil Towers.’ An investment of 20 minutes should provide all you need to know about these expressions.

Dad Joiner and Daniel Plainview (from ‘Blood’) were very different from Edwin L. Drake, a former conductor on the New York and New Haven Railroad, who some observers believe drilled the world’s first oil well in northeastern Pennsylvania (U.S.). Other observers say that the first well was probably drilled in Southern Russia – probably around Baku or Batum. Apparently it was ‘party time’ almost every night in and around those two Russian localities, while Drake had to content himself with the bogus title of Colonel, and a torrent of alcohol that eventually destroyed his health.

As for Dad Joiner, he eventually fell afoul of the machinations of Harold Lafayette Hunt, who in addition to being a billionaire and spectacular poker player, was the father of Lamar and Nelson Bunker Hunt, who both became well-known Americans. The first in professional football, where he founded the American Football League, and the second as the proprietor of a brilliant (but eventually faulty) scheme to corner the world silver market. Bunker Hunt also became involved with oil in Libya, and had to stand helplessly by when his oil properties were nationalized by Muammar (Colonel) Gadaffi.

People like Dad Joiner, or for that matter Jett Rink and Daniel Plainview, would not have much to contribute to the oil scene today. The emphasis now is on skilled engineering and innovative management, and the largest oil firms are among the richest firms (in all categories) in the world. Moreover, a large part of oil production has moved offshore, where the money needed to locate and produce oil is beyond the means of all except the largest enterprises. One point that deserves to be emphasized is that oil should already be considered scarce in relation to the future demand for this commodity. The talk about reducing the demand for fossil fuels thus has a tendency to stress coal and to exclude oil, from which motor and aviation fuels are manufactured.

This situation has undoubtedly been recognized by the OPEC directorate, which explains why they are not making an effort to get their members to expand their (production) capacity. Instead, many OPEC investments are (or will be) directed into the processing of crude oil into oil products (e.g. motor fuels, kerosene, fuel oil, etc), and once these products are available, a portion of them will be used as inputs in the production of petrochemicals.

It has now become clear to a large number of concerned observers that October, 1973, and the nationalization of many oil properties by OPEC countries, was a turning point in modern economic history. Aside from the near panic that accompanied these nationalizations and the following oil price escalation (or ‘shock’ as it is usually called), perhaps the most vivid recollection of that dramatic period was the general failure by economists and politicians to comprehend the character and significance of OPEC, and what the logical and legitimate ambitions of certain key OPEC countries could or would eventually mean for the politics, philosophy and economics of virtually every country in the world, regardless of their access to oil or other energy resources.

Somewhat earlier, Enrico Mattei had coined the phrase “the Seven Sisters” to describe the petroleum world’s ‘movers and shakers’. (Petroleum is oil, but sometimes it means oil and natural gas.) The Seven have now morphed into Four – ExxonMobil and Chevron of the US, and Europe’s British Petroleum (BP) and Royal Dutch Shell. According to a recent article in the Financial Times (March 12, 2007), there is a new Seven that deserves at least a modicum of attention: Saudi (Arabia) Aramco, Russia’s Gazprom, CNPC of China, NIOC of Iran, Venezuela’s PDVSA, Brazil’s Petrobras and Petronas of Malaysia. These are important enterprises, and CNPC and Petronas are – or have been – particularly aggressive, but with the exception of Aramco and Gazprom, not quite in the ‘class’ of the Big Four.

According to the International Energy Agency (IEA), ninety percent of new oil supplies in the next 35 or 40 years will come from developing countries. Ordinarily this could be regarded as a cheerful piece of news, however careful readers have learned to ignore the often flawed IEA prognoses that are taken so seriously by reporters, certain news magazines, and of course television outlets such as CNN and BBC. I suggest that you should be careful with those sources, because their ‘experts’ are often prone to confuse gossip with economic logic.

For example, Saudi Arabia (owner of a large slice of world oil reserves) once convinced the IEA and a few other organization that they would boost production capacity to 15 mb/d, or thereabouts, and would do so in the not too distant future. It was obvious that this was not going to happen, because since the first oil price shock the governments of that country have assured all who are interested that their production will never exceed 10 or 11 million barrels of oil a day, and even if they occasionally exceeded this number, it would not make the forecasts of the IEA and the United States Department of Energy (USDOE) more palatable. In the executive suites of Big Oil, an implied or shouted belief by OPEC that they will greatly increase their sustainable output of conventional oil in the near or distant future is regarded as being without any economic, geological or political feasibility, regardless of what spokespersons of e.g. the ‘Big Four’ say when the TV cameras are turned in their direction.

It has been suggested to me that a portion of this book should be devoted to arguing that more attention should be paid the macroeconomic and political situations that could unfold in the event of explosive oil price rises of the kind that took place in 2008, when the demand for oil ‘outran’ the supply, and some predictions about future oil prices were literally unreal. (For example, up to $250/b). I have lectured on this extensively, and in my opinion the key point is that the price of oil determines the price of most energy resources, and definitely the other fossil fuels – natural gas and coal.

And surprisingly for some, though not for me I must confess, when the oil price escalates, the thoughts of intelligent politicians turn toward nuclear. As far as I can tell, this always happens, and it happens because an abrupt energy price escalation could have a sharp impact on productivity, and thus employment and the incomes of voters. It might also lead to a belief by large numbers of voters in the energy importing world that military action launched to obtain energy supplies is preferable to a decline in their living standards that has the possibility of being irreversible.

Something else that it could mean is an additional resort to coal that would cancel out all the fine theories and intentions expressed in the Kyoto Protocol and its spinoffs. The USDOE has estimated that electricity demand in the US will increase by 45% between now and 2030. Coal usage is scheduled to grow by between five to ten percent because of its availability and price, but a sustained escalation of the oil price would be certain to boost the price of natural gas, which according to a study by Sanford C. Bernstein & Co., already costs more than coal on the U.S. electricity generation front, even if the cost of suppressing a fraction of carbon emissions is taken into consideration. Coal might then attain more than 50% of the energy mix, with ‘clean coal’ playing only a minor role. As for the kind of coal-burning scheme called ‘FutureGen’, which would trap carbon dioxide before it reaches the atmosphere and bury it below ground, if it corresponds to the efforts associated with operations by the Swedish firm Vattenfall in Germany, it is just another fraudulent play for the gallery.

The above themes will be touched on later in this book, but before that readers will be offered two analytical challenges. Despite appearances, these are mostly on the Economics 101 level, and mastering them is both important and easy.
INVENTORIES (= STOCKS) AND SHORT RUN PRICING
The first genuinely analytical challenge offered readers of this book, regardless of their academic level, begins with a very careful look at Figure 1-3. At the same time remembering that Figure 1 is NOT related to the diagrams in your favourite electrical engineering textbooks, although I can remember a lecture that I gave at the business school in Grenoble when the director of that establishment pointed out that there was a feed-back circuit in the diagram that corresponded to a first-order ‘servomechanism’.

p^e = f (p)

h

s

Income (Y)

AI

DI

p

p^e, r

Figure 1

s: flow supply

h: flow demand

p: price

AI: actual stocks

DI: desired stocks

r: interest rate

p^e: expected price

Commodity (oil)


If you studied Economics 101, then you know about s and h. These are flow supply and flow demand variables respectively, and ‘h’ is used instead of ‘d’ because when using mathematical symbols, ‘d’ has a special function. As for the units of s and h, these were alluded to earlier: they are barrels per day (b/d). In Economics 101, as well as advanced courses, we use s and h to obtain what is called the equilibrium price, and income Y (which is in the box to the right of h) sometimes enters the discussion as an influence on consumption. In physics equilibrium generally signifies a ‘state-of-rest’, while in game theory it signifies the best response by each of the set of players to the actions of the others.

In your earlier microeconomics courses, where you mostly worked with flow models, equilibrium was obtained when flow supply is equal to flow demand, but in the present analysis equilibrium is determined when actual stocks (= inventories) AI are equal to desired stocks (inventories) DI, or AI = DI. Note what we are saying: even if flow supply equals flow demand, we have an equilibrium only when the demand for inventories is equal to the amount in possession of inventory holders. Instead of having a flow model, we have a stock-flow model, where the extension here is derived from the work of the brilliant MIT econometrician Franklin Fisher. In case you want a taste of the relevant mathematics for the present discussion, let me suggest the first chapter in the book Mathematical Economics by R.G. D Allen (1960).

And please note something else before we continue: if you look at actual statistics of flows and stocks, these are estimates (approximations), and often not perfect. However as one of the great mathematicians of the 20^th Century, Bertrand Russell once pointed out, ”Although this may seem a paradox, all science is dominated by the idea of approximation”.

Accordingly, we arrive at the position of having to manipulate a stock-flow model instead of the simple flow model you learned to love in Econ 101. Before we continue, we should note the variable expected price (p^e). You should have no difficulty understanding the part that this item plays. If, for example, consumers of oil believe that the price of oil will greatly increase, many of them will increase their inventories (= stocks). This kind of reaction is perfectly understandable. Consumers here are mostly industries and not households, but also speculators who, if possible, put large numbers of barrels of oil into storage (which are extracted when the oil price rises). Similarly, observing the heavy arrows leaving and going into AI, if it is believed that the price of oil will fall by a large amount in the near future, many inventory holders will sell some of the barrels of oil they are holding. You should think about and elaborate on this kind of behaviour!

In Figure 1 just above, expected price is shown to be influenced by the present price. Even better, recent changes in price might be important where this variable is concerned, and also income (Y) or expected income. As this is being written, serious fighting has broken out in Iraq, and this could have and maybe has influenced p^e. There is also some tension in and around the Ukraine, and some observers are claiming that this has an effect on the oil price. Would you like to comment on this?

As an exercise, readers should think about the adjustments necessary in Figure 1 to account for contingencies such as the expected price being influence by the income, or for that matter changes in the income. (The mathematical symbol for changes in income is You can also observe the situation around ‘p’ and DI. In the terminology of electrical engineering, what we have here is a feedback circuit, or as I was informed when I lectured in France a first-order servomechanism. This influences the movement of prices, and often leads to large oscillations. Dealing with this issue has no place in the present book, and in fact too much is often made of it in mathematical economics textbooks. What readers should do now is to make sure that they understand the discussion just above, and aim at always being able to draw Figure 1 from memory.

Please notice that what we are talking about is short-run pricing. Then what about long-run pricing? Long run pricing is a function of the movement of flow supply (s) and flow demand (h) over time. In your courses in Economics 101 you had in algebraic form s = s(p) and h = h(p), although it might be better to write s = f(p) and h = g(p), since e.g. (for example) s and h are dependent variables, and not (as in mathematics) ‘arguments’. The arguments here are represented by ‘f’ and ‘g’, and these can be very simple or very complicated. In any event, as time passes we expect both the demand and supply of oil to gradually increase, but in the period 2007-2008 demand began to increase much faster than supply, and as a result the price ‘escalated’. The effect of this oil price escalation on the global macro-economy was devastating (as you probably know).

A much less drastic example of the same happened during the Libyan crisis. Demand suddenly speeded up as consumers moved to increase their inventories, while the supply of Libyan oil (about 1.7% of the global supply) fell to almost zero. The global price of oil immediately increased by between 15 percent and 17 percent. Readers should ALWAYS have these numbers at their disposal because they are important. Now to conclude this discussion: s and h are flows whose units are the same as in your Economics 101 textbook (e.g. barrels/year, or perhaps metric tons (=tonnes) per year, where 1 tonne = 1t = 7.33 barrels). AI and DI are stocks (i.e. inventories), and do not contain a time dimension. For instance, they might simply be barrels (or tonnes) of oil.

Suppose that something happens so that DI > AI (desired inventories are greater than actual inventories). For instance, word goes out that oil prices are certain to skyrocket, and it would be nice to have more barrels of oil to sell when that happens. As indicated, the ‘stock’ market is out of equilibrium, and to restore equilibrium (by increasing AI ), a ‘gap’ must be created between flow supply and flow demand, or (s > h) which signifies that a portion of current production goes into inventories instead of being consumed. To bring this about – with s = f(p), and h = g(p), the oil price must rise. This is the explanation that all students should understand and be able to repeat verbatim, and if I were their teacher, they should not allow me to rest until I explained it so that they and their colleagues understand it perfectly.

Notice something else, if s = f(p) = a + bp, we have a linear (flow) supply curve that ‘goes up’ to the right, with ‘b’ as its slope. The intersection of this curve with the vertical axis is called ‘a’. Now draw this curve, and provide a full explanation of ‘b’. The variables in this case are s, the dependent variable, and p the independent variable. ‘f’ in this case signified a linear supply curve, although it could have signified something more complicated, such as s = f(p) = a + bp². Make sure you comprehend that although we changed the argument from a+bp to a+bp², we still use f(p), which in the second case indicates a quadratic supply curve. The slope of this curve though is not ‘b’. (From the calculus we calculate that it is 2bp.)

Readers should now assume that DI is less than AI – that is DI < AI. They should then go through an argument of the sort given above, preferably standing in front of a black or white board, with a piece of chalk in your hand, and a smile on your face, because this is not a difficult assignment, regardless of what you and your colleagues think that it is. As strange as it sounds, my students in Sweden were always willing to go to the black or whiteboard, but not my students in Singapore. They were more modest.
THE OIL PRICE GOES INTO ORBIT: 2008 AND BEYOND

“…in order to keep prices up the Arabs would have to curtail their

output by ever larger amounts. But even if they cut their output to

zero they could not for long keep the world price of crude at $10 per

barrel. Well before that point the cartel would collapse….World oil

prices are weakening. They will soon tumble.”

– Professor Milton Friedman (Newsweek, 4 March, 1974)

If you happened to be in Paris (France) in 2008, and you were reading French newspapers, and watching French television, you might have concluded that the end of the world was approaching. The slow-motion oil price escalation that began about 2005 and continued into 2007, suddenly accelerated, and it was not long before the price was almost at $150/b. Certified oil experts were talking about it exceeding $200/b.

In case you are interested, the global macro-economy could not function at that time with an oil price above $200/b, nor could it function at the price it eventually reached on July 3, 2008, which at $147/b was probably the highest in modern times. But what I call the moment of truth had not arrived. That price ($147/b) threw the global macro-economy into disarray, which in turn caused the average global oil price to eventually fall to about $32/b. Students, colleagues, and soul brothers and sisters of Professor Friedman pictured it descending to the price of a barrel of Coca-Cola, and it was then that the moment of truth appeared in what some of us considered an unmistakable form, even though others still have not got the message. OPEC sponsored a program for disbelievers that they never thought they would or could experience: they cut their production by an amount that cannot be mentioned in this book, because neither I nor anybody else in the major oil consuming countries has the ability to say, except possibly the CIA, and the oil price was soon above $70/b, and slowly climbing.

There is little or no doubt in my mind that Professor James Hamilton is an outstanding oil economist, and his belief that income rather the price of oil is the key determinant of the quantity of oil demanded is worth consideration, but it was not income changes that led to the near recession in the global economy that followed the oil price escalation in 2007-2008. It was the volatile effects of an oil price driven by expectations, as well as OPEC’s proved ability to defend their ‘turf’ that accounted for the outcome, and when the non-linear feedback effects implicit in the servo-mechanism circuit shown in Figure 1-3 reached a certain amplitude, my residual knowledge of differential equations told me that oil consumers were in a lot of trouble.

What was not understood by Professor Hamilton, nor many others, was that OPEC has the right medicine for dealing with persons and governments who attempt to put them in their place. They did not resort to pretentious statistical exercises (i.e. econometrics) to formulate their strategy, nor did they encourage their governments to respect President George W. Bush’s wishes, and increase production. They already knew what the rest of us only fully grasped years later at the time of the Libyan ‘war’, when the loss of Libya’s output of about a paltry 1.7 percent of the global oil production caused the global oil price to increase by almost 17 percent.