Now that crude oil prices are down to $50 a barrel from the stratospheric highs of 140 just four months back, a research paper titled ‘Understanding crude oil prices’* may not be the ‘in’ thing to talk about. Financial stability and growth are of course the urgent issues. But there is a very good reason why crude oil should not go off anybody’s radar and this new paper at NBER by James Hamilton helps in reminding us that the oil prices can just as easily flare up again.
The paper is a comprehensive one, and a short article like this one can only bring out part of its flavour. First, Hamilton examines the statistical regularity of prices using quarterly data from 1970 to 2008. Lagged variables of real oil prices, US nominal interest rates and US growth rates give no explanation for changes in real oil prices in his model. He then looks at levels of prices and finds that ‘the real price of oil is not easy to forecast’. Admitting that more detailed specifications over shorter periods might yield better results, he points out that given the $115 price in Q1 2008, the 95 per cent confidence interval for Q2 would range from $85 to $156 — so ‘the wild swings’ seen this year are well within the normal range. Four years down, oil prices can well be as low as $34 or as high as $391. Fortunately, the paper leaves statistical testing at this point and looks at various theories, which go a long way in explaining why such swings are ‘normal’.
The paper examines theories such as storage arbitrage, futures contracts, looks into the role of speculation, the problems of estimating price and income elasticity of demand etc. But the most important point brought out is the issue of supply and demand mismatch. Global production has stagnated over the last three years and the strong increase in demand from China, oil exporters and other emerging countries needed a big increase in price to maintain an edgy equilibrium. The key question, he asks, is why did supply fail to increase? There are a host of factors here but most important is the conjecture that the excess production capacity of Saudi oil has been eroded. Conjecture because of the opacity of data regarding Saudi oil wells but the fact is that the decline in Saudi production since 2005 goes against the traditional role it has played in varying production to help maintain prices within a generally accepted band, within the comfort zone for both consumers and producers. The problem with oil production is that depletion in old wells can only be offset by production from new wells, those have long lead times from discovery to commercial exploitation.
Hamilton’s analysis shows that till 1997, ‘future supply prospects were sufficiently strong, and the perceived date at which the limit of ultimately recoverable reserves would begin to affect decisions was sufficiently far into the future’. Since then, the surprisingly strong demand growth despite vaulting prices and the realisation of the limits to expanding supply have led to a volatile scenario. The problem though is that, as he concludes, “The $140/barrel price in the summer of 2008 and the $60/barrel in November of 2008 could not both be consistent with the same calculation of a scarcity rent warranted by long-term fundamentals. … the algebra of compound growth suggests that if demand growth resumes in China and other countries at its previous rate, the date at which the scarcity rent will start to make an important contribution to the price, if not here already, cannot be far away.”
Though Hamilton does not say this explicitly, swings in crude oil prices will continue, as they are reflective of a market for exhaustible resources, a market which is near capacity and under stress. However, with such oscillations, there are no clear signals for investment in technology change, nor do they induce a search for alternatives to reduce dependence on fossil fuels. This compounds the problem in the long run. This is why a fall in the oil price should not lull people into complacency. This is why understanding crude oil prices is important.
*James D Hamilton, November 2008 http://www.nber.org/papers/w14492