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Saturday, January 16, 2016
Current Affairs ... Economics/Business ...

Oil prices are currently hitting historic lows; hard to believe that they were above $100 per barrel not so long ago. Now they are struggling to stay at $30. As late as December, 2011, I said in one of my posts that “unfortunately, oil production doesn’t seem to be growing at all anymore”, and I anticipated that oil prices would remain high. I now need to eat my words.

So what’s going on? Oil production definitely has gotten a boost from new technologies that because usable over the past few years, e.g. fracking and super-deep sea drilling. On the demand side, most analysts cite the economic problems in China, i.e. its serious contraction of growth over the past 3 or 4 years. At the same time, the rest of the world in general isn’t doing so well either; world economic growth is expected to remain less than 3% per year. And then add in all of the energy conservation and alternative energy efforts that were started back when oil was above $100 per barrel. Overall world demand for oil is still rising, but not as fast as before, and less than many people had anticipated.

The classic economics 101 explanation for the oil situation is that there is an oversupply in the market, which has allowed oil users to bid down their purchase price. Under that textbook scenario, the producers will soon stop producing and offering so much oil to users, and the users will then have to start bidding more to get what they need. I.e., prices will rise once again, back to the lowest marginal cost of producing a new barrel of oil under present conditions (which is certainly above $30 at current usage levels, although that cost is much lower than it once was due to technology innovations such as fracking).

That’s the theory. But what appears to really be happening is that a lot of oil producers don’t want to cut back, even though they are losing money right now on most every barrel that they sell (very few existing oil sources can produce a barrel at a cost near or below $30). They have sunk a lot of money into the wells and pumping rigs that are producing all this oil, money that they can’t get back. I.e., this is the problem of fixed costs. They know that things can change very quickly in the oil market, given its international nature. A war in the Middle East might cause prices to spike once again. In a sense, they are like gamblers at a casino who have put up a lot of money in a particular game, and they are now way behind. But they hope that if they hang in there for a few more rounds, they will hit the jackpot and walk away ahead. Sometimes that works, and sometimes it doesn’t.

What makes the oil markets even weirder is that there are a lot of rich speculators involved, and also there is a lot of potential storage capacity for oil. What seems to be happening is that there are currently record amounts of oil in storage, with more and more continuing to be added. In the economics 101 textbook, that wouldn’t happen, as the producers would have already cut back on production, to just the level needed to meet current usage demands (and thus nothing would remain to go into storage). But in the real world, producers gambling against fixed costs; and there is even more gambling by investment speculators, who are willing to put up new money and invest in the excess oil (along with the costs of storage, e.g. more pipelines, tanks and ships). Right now, oil storage levels are at historic highs — because a lot of commodity speculators have taken “long positions” in oil (although this is now declining). Obviously, the speculators think (or until recently thought) that they will eventually be able to sell all of this oil that they have squirreled away, and make a pretty penny on it.

But wait — if the demand for excess oil (i.e., oil being produced but not immediately needed for gasoline, diesel fuel, heating oil, lubricants, plastics, etc.) is so high, then why isn’t that demand bumping the market prices of oil back up? Why did oil prices continued to fall despite record purchases for storage by speculators in late 2015? And if the speculators think that prices will go up, then why don’t the producers just stop pumping so much out of the ground and wait for that to happen?

That’s where it gets even weirder, where everything deviates even farther from the simple world of the textbook. One of the big factors that keeps oil producers from attempting to raise oil prices are the statistics that are published about the amount of oil in storage (such statistics are produced at least every week by energy industry groups and also by the federal government). When the statistics say that a lot of oil is piling up in storage, the producers are afraid to raise prices. It says to them that “real demand” from those who would actually use the oil must be in really bad shape. The continuing bad news coming out of China feeds into this psychology. But it seems likely (to me, anyway) that the storage amounts are going up because a lot of people with real money on the line (the speculators) think that real demand isn’t so bad after all, and is going to soon be increasing.

Well, maybe anyway. There is still another layer of real-world complexity in the oil market — international politics. Saudi Arabia is still the big magilla when it comes to oil, although you sometimes see an article saying that their seemingly Brobdingnagian oil fields are overrated. The Saudis don’t like the fact that new production technology (e.g. fracking) is making a lot of places less dependent on them (e.g. the United States). But they like even less the fact that their main enemy in the Middle East, Iran, will soon be pumping oil again, and Iran’s oil resources are also nothing to sneeze at. Despite falling oil prices, the Saudis have made a conscious decision to keep the oil flowing as though it was still bringing in $100 a barrel.

This is clearly NOT an economic decision by the Saudis, not in the short run anyway. Pretty clearly the Saudis are trying to put the new high-tech producers out of business (and are doing a pretty good job at that), but more importantly, they are trying to prevent Iran from becoming the big kid on the block with regard to oil. And all of that totally throws the oil markets even more out of whack. The question is, how long can they keep driving prices lower — at some point they themselves need the money (one article said that at $50 a barrel, the Saudis will run out of cash in 5 years; at $29, that will happen even faster).

And so, all while this delusion and geo-political wrangling lasts, the prices for oil will continue to drop, as no producer interested in staying in the game wants to go first in terms of attempting to raise prices. Eventually, though, this “anti-bubble” will burst. Producers will eventually say “ok, this is enough, I’m going to cut my losses”. Prices will start to creep up, partly because of currency effects (still ANOTHER source of complexity in the oil market!), and the speculators will stop buying and start offering their oil to those who need to use it (i.e., the refineries). This flow out of storage will keep prices steady for a while, causing even more producers to quit. One day, however, the speculators will start running out of excess oil, and all of a sudden, prices will ramp up (remember that the producers can’t immediately re-start their drilling and pumping operations once things get better; it takes months and even years to activate mothballed oil fields and open new ones to replace those that have dried up).

So, enjoy the low gas prices while they last. And they might last for a while yet, especially if the Chinese economy can’t catch itself and it contracts into a temporary recession. But at some point, the world economy will probably get somehat better (the low oil prices in themselves will help to boost profitability and consumer demand, although that is balanced against the worsening prospects in places that are dependent upon oil exports such as the Middle East, Russia and Venezuela). Furthermore, the crazy market dynamics in the energy sector could take a sudden and unexpected turn, as in 1999. The problem is, you can’t predict just when this might happen. So, many of the big-money interests stay at the gambling table, while the masses must endure the crazy up and down swings in prices and product availability that they cause.

I have a masters degree in economics, so I have been through a few academic courses in economics in my time. One thing that they DID not teach us was how to gamble. What really needs to be added to the whole academic economics field is a GAMBLING 101 course. The basic free market scenario of multiple buyers interacting with multiple sellers and setting prices that generally reflect real needs and real costs of producing whatever is being sold is very compelling (I myself was quite impressed by the supposed optimization of resource allocation and demand satisfaction that a pure market supposedly causes for society). The markets are supposed to quickly “clear” all of the ups and downs. But how relevant is this scenario in the real world? Yes, there are a lot of things for which market optimization really does seem to occur; e.g. consumer technology like smartphones and such. But as for some the most basic, most important things that society needs — energy, health care, food, housing, banking and loans, education . . . whoa, things get messy very quickly.

In the real world of important human needs, capitalism attracts many layers of democratic government involvement, because of society’s demand to protect the weakest (poorest) participants in the market from being shut out by high prices. And to make matters even more messy, you also get speculators who try to make a quick buck with “in and out” investments that don’t add to the long-term base of productive facilities and technology. And then there’s even more chaos — modern technology encourages more and more producer conglomeration (as the rewards of “bigness” get sweeter and sweeter due to improved communications technology and automation of simple jobs). And that leads to markets dominated by big business, “too big to fail”. And those big businesses learn how to exploit the political process as to get government on their side.

Recall that I just said that democratic governments usually get involved in a nation’s economic markets to help the poor from being shut out from getting basic education, health care, housing, food, etc. But the influence of corporate money in politics often turns supposedly-democratic government into a two-faced monster, one that turns one face to the crowds of voters, promising to help them; while turning its other face to the captains of industry, promising to protect their riches. No monster can serve two masters; but that’s what our hybrid political system has been trying to do for the past 150 years or so. In such a situation, one side is usually going to do better than the other; do you want to take a guess as to which of the two constituencies (the public interest or the profit-making capitalists) does better? And yet . . . as the credo that was once used to open an old TV show called “Slattery’s People” goes, “the alternatives [e.g. communism, socialism, feudalism, facism, theocracy] are so much worse”.

As if a two-faced activist government wasn’t bad enough for the economy. But then we throw in the speculators, perhaps an even scarier monster than the capitalist producers (who, despite their many sins of greed, ultimately provide society with the basic goods and services that it needs to keep going). The speculators are a headache to both the consumer (although most consumers don’t even know of their presence) and the producers (who are often “raided” and “disrupted” by short-term speculators attempting to make a quick buck by re-organizing and then selling off existing production enterprises). Yes, many economists would be quick to point out that speculators do serve useful functions in our system of money and making or doing things. Despite their greed, they might have useful side-effects such as providing liquidity, getting inefficient producers out of the way more quickly, and causing prices to respond faster to real-world changes in resource conditions.

Oh yea, and then throw in international politics, where nations sometimes compromise their economic interests in order to do something bad to other nations they don’t like. What I’m saying is that the real-world system of economics and finance is a real mess; despite all the textbooks and academic papers, no one can fully grasp it. Not even with the best of computer models. We try to predict where it is going, but our predictions aren’t usually too much better than 50-50 at best (not in the long run, anyway; some people get rich when the prediction models work for a few years, as was the case with the mortgage re-investment market in the lead up to the 2008 financial crisis; but as with the 2008 situation, the real world can take an unanticipated turn or twist, and the whole forecasting system can just collapse).

Not that I’m saying that the economics profession should give up. Far from it. But I am saying that it has a LONG way to go, and thus a bit more humility would do it a lot of good. For starters, those ECON 101 textbooks need to have a warning label about both the basic micro and macro economic concepts of market systems and national economic interactions. I.e., this is a starting point, but for the most part, the real world just doesn’t operate like this. Get ready for an Alice in Wonderland journey into the depths of economic reality!!!

◊   posted by Jim G @ 11:00 am      

  1. Jim, This will be simply a series of tho’ts on the topic of y our post: Yes, I certainly agree with you here that our economic system, no matter the theory, is basically a big gambling system. And the more I think about it (which I admit is not all that often) the more I find myself wondering if, as the planet changes and the economics of the planet change, a whole *new* system might be needed or serious changes in the current system we have must be made. So far, I wonder if there’s anybody thinking about these things. Well, it seems Pope Francis (who’d’ve thunk I’d be quoting Pope Francis!) has tho’t about it; I think it was *his* idea in the first place. I wonder if any economists have done much thinking in these terms.

    The various countries of the world all have their own cultures which influence how they see the purpose of the economy in their own culture. What we seem to have is the 1% and the 99% which is definitely not a happy system and will eventually not work. If one thinks back to the Industrial Revolution, there was the same thing: a 1% and the 99% who did all the work. Eventually, the 99% rebelled and such things as Unions came into existence to protect those who did the actual physical labor. There was some “adjustment” in the economic system and how it worked. But it seems that system has not worked too well (or as well as it had before) for some few years.

    What “adjustments” need to be made in a world economy? I can’t answer since I definitely do not have much education in economics. I find myself wondering what a system based on consideration and care for those who do the actual physical labor would be like. What would a system that included the laborers sharing in the whole thing be like. Yes, I know that Communism was an attempt at that; and only ended up in the less than 1% taking everything for themselves.

    I find myself wondering what Pope Francis would suggest in this situation. Certainly not a system that boils down to simple gambling, which is certainly what our stock market (and various other “markets” are).

    I would think that first the questions that need to be asked must be figured out. Then one can begin to work toward answers.

    On another point: I find myself wondering about “fracking” and the effect it will have on the planet. It’s already caused earthquakes in Oklahoma. Surely, this is an indication that getting oil from the earth to make it cheaper for us may be causing more problems than good. Another “what’s wrong with this picture?” as I see it.

    Then too, I find the whole business of control of storage to control prices an even worse form of gambling than there might be in other situations involving oil. For some time (I’m not sure it’s still being done) the price of gas *immediately* rose or fell with the price of oil, regardless of how much the oil stored had cost. The excuse given was that in the end the difference would be made up. Something about that picture also bothers me. The 1%-ers seem to benefit more from it than anybody else. Perhaps they’ve discontinued the practice at this point where prices are going down; once again; but I notice they don’t speak much about the reason for adjusting prices immediately with the price of oil any more.

    Have you noticed that it’s impossible to buy anything at all that is as good as what you had before? Specifically, any item at all from a piece of clothing to a book, to an item for a pet (I mean anything at all) is never as good as the old one. Once again, our economy at work: Sending items somewhere else in the world to be made at a cheaper (and resulting less good) way to make a larger profit. Here again, our economy at work for the 1% at the cost to the 99%.

    There’s so much wrong with the general world economy (to say nothing of the U.S. economy) that, when the Pope makes public statements regarding the world economy, it seems to me that there’s a seriously real problem that needs some fixing.

    It won’t be a “quick fix” at all. Imagine the turmoil between China, Russia, and the U.S. (to name only 3 countries) trying to agree on one economic system to benefit everybody, not just the benefit of the 1%. Somewhere along the line someone knowledgeable in economics must start some thinking on the subject. MCS

    Comment by Mary S. — January 16, 2016 @ 7:02 pm

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