The changing private value of oil in the ground
So oil prices are rising, and, inevitably, a debate is heating up about the role of speculation versus that of “fundamentals”. Ryan Avent makes a point that was commonplace last time our collective heads were on fire about oil prices and it was all the speculators’ fault:
[T]he easiest and most effective way to speculate on the price of oil is to leave the stuff in the ground, and there’s not a thing the American government can do about that.
I thought this was a good point in 2008, the best rejoinder to Paul Krugman’s recurring query that, if it’s speculation, where was the inventory build? But it strikes me as a less compelling point now.
Suppose you are the House of Saud. Like anyone with a position in a traded asset, you face a sell or hold decision. If you expect that the real value of your asset will rise faster than the real value of financial investments you could make at equivalent risk if you sold, then you should hold. Otherwise, you should sell.
But there’s a wrinkle. The House of Saud really must compare the private value of oil in the ground to the private value of alternative investments. Like a middle American muni investor maximizing after tax returns, the House is looking to maximize the value it can actually appropriate. Ordinary taxes aren’t that big a deal to the Saud’s, who after all run the state. But the House of Saud faces a different sort of “tax” on future oil: the possibility that by the time it is exhumed from the desert, it will no longer be theirs to sell. The expected private value of future oil to the House is proportional to the expected future oil price and inversely proportional to the probability of revolution. I’d guess that events of the last few months have significantly reduced their expected private value of oil in the ground, the current oil price spike notwithstanding.
One might even argue that current circumstances amount to a natural experiment by which we might test the question of whether Saudi Arabia in fact has 3.5M barrels a day of spare capacity they can easily bring on line, or whether they’ve basically been running full tilt already. As the probability of revolution — or else a permanent increase in wealth-sharing to forestall revolution — increases, the private value of oil in the ground falls. If flows don’t increase, that could be taken as evidence that the Saudi Arabia is pumping at capacity.
Of course, life is messy, and natural experiments are never perfect. Lots of caveats: The pump-or-store decision should be based on the relative private values of oil and financial investment. If the princes think that, after a revolution, their financial wealth would be frozen by fair-weather patrons in the West, that would tilt things in the opposite direction. The princes might believe that defending their claim to oil in the ground is a better bet than relying upon recently less than reliable Swiss bankers to protect the interests of unpopular clients. (A strange corollary of all this is that if the West wants to maximize current oil flow, it should credibly promise to recognize the House of Saud’s claims on private and sovereign wealth, come what may on the Peninsula. I do not advocate this — I think we should put longer-term interests before concerns about the moment’s oil price. But the logic is clear.)
Also, the princes would have to be mindful of potential backwards causality from pumping decisions to revolution. If it looks like the rulers are ramping production in a panic, that might signal fear and undermine the government’s legitimacy, aiding the revolutionaries’ cause. However, the current price spike and concerns of oil consumers would provide cover. There are lots of reasons besides fear of regime change why the Saudi government might choose to increase production now, if they can.
Obviously, all of this is, um, speculation. Interfluidity is not the The Oil Drum. I know little about the details of oil production or of Saudi politics. But from the perspective of several Middle Eastern regimes, I’d guess that “oil in the ground” seems less of a safe bet than it might have a few years ago.
There are two sides of this coin as well.
The scent of revolution will reduce the potential costs of pumping oil (by reducing the Saudi’s discount rate) but it will also increase the potential benefits of selling oil for more cash, as more money maybe what is require to buy off the population and avoid the revolution in the first place…
March 9th, 2011 at 1:07 am PST
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Good post. I’ve worked in the biz and can say oil companies, much less national oil companies, do not speculate on the price of oil. They are too smart for that and realize they are not capable of predicting the future price. If oil producers were good at speculating over the future price of oil, they wouldn’t be producing oil, they’d be hedge funds.
March 9th, 2011 at 2:19 am PST
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One might even argue that current circumstances amount to a natural experiment by which we might test the question of whether Saudi Arabia in fact has 3.5M barrels a day of spare capacity they can easily bring on line, or whether they’ve basically been running full tilt already. As the probability of revolution — or else a permanent increase in wealth-sharing to forestall revolution — increases, the private value of oil in the ground falls. If flows don’t increase, that could be taken as evidence that the Saudi Arabia is pumping at capacity.
Interesting take. Personally, I don’t think that the chance of revolution in Saudi is all that high… but food for thought nonetheless.
Perhaps a new twist in the “call on OPEC” tale?
March 9th, 2011 at 1:12 pm PST
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What about good ol’ demand and supply? if OPEC opens the tap, being a monopolist, it will not necessarily increase profits. Or did I miss something? (I’d like to hear your ideas on this).
March 9th, 2011 at 9:25 pm PST
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“I thought this was a good point in 2008, the best rejoinder to Paul Krugman’s recurring query that, if it’s speculation, where was the inventory build?”
I think Krugman was thinking of oil left in the ground basically as inventory.
March 10th, 2011 at 12:31 am PST
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Zac — Agreed. Even if you think the odds of revolution in Saudi are quite low, the odds that political pressure will soon force greater sharing of the oil wealth may be quite high. So, that tilts towards “pump soon”. However, if continued rule depends upon continual sharing of the oil wealth, and if the House of Saud values its rule of the the Peninsula above and beyond the oil wealth it provides, and if they value longevity of rule with a low discount rate (that is, they are willing to make sacrifices now to increase the probability of continued rule in 20 years), that might cut against pumping now. I’m skeptical of the latter case — I think long term rule by the incumbents is too uncertain a proposition to justify a very certain and permanent loss of wealth. (Wealth-sharing permanently reduces their take. Slow pumping pushes extraction into the greater wealth-sharing period, and in expectation reduces total pumped while incumbents remain in power.) Still, it’s a case that could be made.
dirk — It’s pretty clear that state oil producers don’t always view their role as nonspeculative market pricetakers. After all, OPEC has in the past succeeded ostentatiously at using market power to affect oil prices. There’s a good case to be made that their ability to do so is now diminished (both because the cartel is noncohesive and because total production relative to oil producers’ revenue needs is now lower than in the past). But I think it’s too simple a claim to imagine that the Saudis simply pump all they can all the time, regardless of price or politics.
Plus, the difference between speculating and hedging can be unfortunately complex. The Saudi princes choice isn’t to “speculate” on risky oil or accept market prices and shed risk by selling. To a first approximation, they face the choice of two risky assets, in both of which their portfolio is already overconcentrated. They can hold oil, or exchange it for financial claims on foreign assets. Their situation is very different from a household, which has many means of converting cash into assets that reduce overall portfolio risk. If I’m an Exxon shareholder, Exxon’s choice to sell at market and distribute cash to me allows me to hedge my short position in housing by purchasing a home, to shed my short position in retirement savings by purchasing Treasury bills, etc. The Saudis already have a portfolio large enough to hedge basic consumption risks, but they still face unhedgable systemic risks, and moreso than the American investor. The US investor might lose the real value of her IRA in a dollar crisis, but her housing hedge would stand. Further, the US investor faces little political risk from holding dollar assets, and even in a great inflation, her position is hedged in part by the fact that her liabilities are also in dollars. The Saudis can hedge few real risks with incremental cash, they face the same dollar (or Euro or Yuan) risks that any investor faces, plus they face political risks that may be nondiversfiable (if the winds of global finance turn against them, dollar, yuan, euro, and FDI assets may all be confiscated). The Saudis liabilities are real rather than nominal, to their people and made up largely of foreign produced goods. So they face terrible foreign currency risk. During the last oil spike, the Saudis spoke of these issues fairly candidly (although you could say they were bluffing), musing aloud about whether it made sense to sell their providence for paper assets of which they already had plenty. They do have some other options — they could use cash to develop real domestic assets, as well as FDI in places whose politics are less likely to correlate with Euroamerica. I think they do all of this, they diversify heavily, their sovereign wealth funds develop domestic projects but also seek diversified direct investment everywhere. But given the scale of their wealth, they are constrained by diminishing returns on real investment ideas. (It is generally true that investment fund performance faces diminishing returns to scale. Warren Buffet once said that smart managers can compound $1M at 50% annually, but no one can generate those kinds of returns at reasonable risk on funds at the scale of Berkshire Hathaway.)
On the other side of all this, of course, is the fact that the Saudis hold a very concentrated portfolio in oil. So, by ordinary portfolio theory reasoning, they’d want to diversify. But given a poor menu of domestic assets in which to diversify and correlated risks among foreign assets, their tolerance for a concentrated portfolio in domestic oil might be pretty high. (Plus, they may not be as overconcentrated as they look, if skeptics are right about overstatement of their reserves.)
March 10th, 2011 at 1:37 am PST
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Mattia — These issues are largely distinct from the Saudis exercise of monopoly power to maintain pricing.
Suppose that Saudi Arabia is actively suppressing production to maximize profit by reducing volume and increasing price. At the margin, an increase in the probability of revolution makes withholding production less attractive: If they are behaving as monopolists, the Saudis are likely sacrificing current revenue, but maximizing current profits, by selling less oil than they otherwise could. The wedge between profit and revenue is their cost, which is largely the opportunity cost of future oil sales they sacrifice by pumping now rather than pumping later. If they expect proceeds of future oil sales to be expropriated by others, that opportunity cost drops, and the profit maximizing volume of sales increases. They might still pump less than they would if they were price takers, but they’ll pump more than they would have absent the prospect of revolution.
March 10th, 2011 at 2:14 am PST
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Richard — Sure. Hoarding current inventory in anticipation of higher future prices is a form of speculation, pulling in supply and leading to an increase in price as surely as if third-party speculators shift out demand by purchasing for storage.
Krugman acknowledged this possibility in 2008, but he wasn’t persuaded by it. I was mostly persuaded by Krugman’s view at the time, but I am less so now. If oil is inelastic in both supply and demand in the short-term, than the physical storage “wedge” might be very small and still affect the price for a while. Over the long term, either physical storage would have to increase or the speculative price difference would collapse. Of course the speculative price difference did collapse last time, but you might attribute that to despeculation and demand collapse in the face of the recession rather than longer-term elasticities coming into play.
March 10th, 2011 at 2:27 am PST
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We could take the very long view too, say, out past 2050 and/or whenever the rapid annual decrease in petroleum production occurs, as it has already long-developed fields in the US and Europe, and must eventually occur everywhere. You can’t eat or drink oil in the ground. The price may go up high enough in real terms, but I’m going to assume that it will hit a cap at some point based on the price of technological alternatives – not necessarily new ones as we’ve got feasible solutions now (like coal-to-liquids) that simply await the proper price environment. Like the Saudis say, “The Stone age didn’t end because the ran out of stones.”
In the last 40 years, the Saudi population increased by a factor of 4.5. I don’t expect that to occur in the next 40 because their total fertility rate has collapsed from 8 to 3, but let’s say they almost double to about 50 Million. They’ll still need to import almost all their food and use tremendous amounts of exportable-energy to pump and produce desalinated sea-water, which, for example, is the nearly exclusive source of water for the 7 million residents of the Riyadh Metropolitan area.
What the Saudis will continue to have in 2050 after most of their oil is gone is plenty of wind and solar potential (though I don’t know how much of a challenge to this is presented by the blowing microscopic dust that immediately clings to and corrodes everything including slick metal and glass surfaces).
What that seems to imply to me is that public-spirited, posterity-focused, over-the-horizon strategic Saudi policy makers should be leveraging their current ability to extract huge amounts of oil wealth ($1 Billion/day) into investing into the equally huge amounts of capital-intensive projects they’ll need to sustain the basic necessities of life for their not-too-distant and immensely-populated future generation.
But now getting to your point about the oil wealth being substantially privatized and there being more than even the usual short-term focus because of the risk of upheaval and revolution, I wonder if these investments will ever get made. If things get bad in the future because of this kind of problem and there is an uprising, it will be of little help because the money that could have been used to build these projects will have been frittered away. I hope this all doesn’t end in tears.
March 10th, 2011 at 10:55 am PST
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March 10th, 2011 at 11:36 am PST
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“Warren Buffett once said that smart managers can compound $1M at 50% annually, but no one can generate those kinds of returns at reasonable risk on funds at the scale of Berkshire Hathaway.” How scarce are “smart managers”? One could compound $100 billion at 50% if he could hire 100,000 of them, giving each $1 million. But maybe there aren’t 100,000 of them altogether; indeed, maybe that’s why the few there are would be so successful–they wouldn’t face a lot of capable competition.
March 10th, 2011 at 12:20 pm PST
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Steve, I think Abdullah @ over $20B is fine with his private oil wealth. The house of saud would like 2 c oil in the mid 70’s to maintain it’s long term viability. Of course they r fighting “the bernank” and medium term supply constraints. They can easily pay off their uppity easterners. .But If things do get out of hand they can count on their good Chinese friends to send in their tanks and drivers….that’s what friends r 4, right?
March 10th, 2011 at 7:52 pm PST
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