[jaws]

When managing a property that generates income the goal of a self-interested owner is to maximize the present value of the property. That is, to maximize the sum of the potential income in the present and the potential income in the future discounted by the rate of interest. For example farmland produces crops by depleting nutrients in the soil. If all nutrients are depleted in the current year the future output of the farmland will be nothing. This would mean that, should the farmer put the land for sale on the market, the most he could get for it is nothing (assuming there are no other uses for the land but farmland). The alternative is to limit the production of crops in the first year and preserve the land's productive ability. This means that the farmland will retain its value on the market. The present value of the farmland is therefore the current year's worth of crop plus the resale value of the land. If additional extraction (marginal revenue) of the resources of the land is less than the loss in resale value of the land, the farmer should restrict his production to maximize his wealth. If he needs more money he is better off either selling some land or taking a loan than he is producing more crops.

The same model can be applied to a forest. The owner of the forest has to cut trees at the rate equivalent to the regrowth of the forest, otherwise the value of his forest will fall, and his wealth will fall with it. The forests of Europe survived through the middle ages, long before anyone thought of ecological protection, because greedy aristocrats knew that it was bad for their estate to cut down everything in them for firewood. The same is true of a fishery, and of any other renewable natural resource.

Things get a little more complicated when dealing with a depletable natural resource like oil. The market value of any exploited oil field is guaranteed to fall as extraction on it continues. It is therefore very important to make sure that the value of the oil extracted is greater than the loss in value experienced. That value is calculated by the future potential income from the oil field, which once again is the sum of production multiplied by price in all future periods, discounted by the interest rate.

Peak oil throws a big wrench into these calculations of value. Every time the market value of oil increases, the future value of an oil resource increases as well. Not only that, but peak oil creates the expectation that prices will continue to increase far into the future.

Suppose that you own an oil field with one million barrels of potentially extractable oil. The current price of oil on the market is 60$. You expect them to be 70$ next year, and 80$ the year after that. The Federal Reserve interest rate has been set at 5%. At this rate, selling your oil at 60$ in year 1 and investing it would gain you a value of 63$ in year 2, while waiting for year 2 would net you 70$ for your oil, and waiting for year 3 would net you 80$! Clearly you would be stupid to produce oil in year 1 and 2. You wait and sit on your oil, earning 'interest' on an appreciating property. You are an oil banker.

I believe that there will come a point soon where those who own oil resources will begin to strictly limit their production, expecting higher prices in the future. The combined actions of all these people will drive prices up even higher, creating a positive feedback loop that will convert more and more oil deposits to banks. This will create a rapid, catastrophic decline in global oil production, earlier than the Hubbert model would predict it. Production will peak at the point before speculative banking becomes commonplace. It will be an induced peak, a product of speculative markets. However, once the initial shock of the induced peak has stabilized, the decline in production will be much smoother, and oil production will last far longer into the future.

The possibility exists that after several years of strictly limited extraction rates due to banking, an alternative technology will emerge that will put the future value of oil into doubt. This will reverse the speculative trend and a glut of oil could follow that would restore the natural Hubbert trend. Oil would by then be in competition with another resource (most likely at a much higher price than today, but much lower than its speculative high) and banking would be less necessary.

[UIUCstudent01]

Isn't this what is meant by a 'super-spike'?

(If not..)

What is different? (Your explanation seems that it may be long-term whilst a super-spike sounds as if it will passing...)

(If so..)

Nice explanation.

[Renfield]

One problem. You assume that a reduction in production will not result in demand destruction. I swear I didn't mean for that to rhym. Imagine Jesse Jackson saying that. Anyhoo, you need to keep as steady a stream going to your customers as possible as cheap as possible while maximizing revenues because, as happened in the oil shocks of the 70's and 80's, if you do not then you will destroy demand and the price of your product will collapse. The last thing the oil companies and producing countries wanted to see were 6 month waiting lists for a prius and SUV sale declines of 30%. The VERY last thing they want is for everyone to move within bycicle distance from work.

[Renfield]

I apologize, but I had to do this after my last post.


"You must not see reduction of oil production or reduced cunsumption and demand destruction will result in oil use annhiliation in the next generation of every nation."

[seldom_seen]

$this->bbcode_second_pass_quote('jaws', 'T')he possibility exists that after several years of strictly limited extraction rates due to banking, an alternative technology will emerge that will put the future value of oil into doubt.

[MrBill]

It is an interesting argument and one similar to that advanced by Eric Kraus at Slovlink Securities in his Truth & Beauty market commentary.

$this->bbcode_second_pass_quote('', 'r')esearch@sovlink.ru

[seldom_seen]

I think Jesse Jackson, I mean Renfield makes a good point. Oil producers want to keep the production flowing to prevent a collapse in demand.

With demand destruction always a possibility, producers have no guarantee that prices will indeed be higher in the future. Furthermore, oil wells/rigs/platforms are viewed as investments. Stakeholders want to see oil produced based on money invested in exploration and drilling as well as maximizing shareholder value in the case of publicly traded companies. So I'm doubtful that oil producers are sitting on their wells.

Someone recently posted a WSJ article that mentioned the big oil companies are using price controls to try and squeeze out independent gas retailers. Which is funny because much of the general public consensus is often expressed in terms of "them oil companies are price gouging." When in fact they are actually capping the price to force out competitors.

[MrBill]

$this->bbcode_second_pass_quote('', 'S')takeholders want to see oil produced based on money invested in exploration and drilling as well as maximizing shareholder value in the case of publicly traded companies. So I'm doubtful that oil producers are sitting on their wells.

[MrBill]

oil companies not recovering their exploration costs

An interesting article on the problem oil companies are having to replace their current production.

[shakespear1]

That is my big laugh of the day

$this->bbcode_second_pass_quote('', 'T')he U.S. is the only country in the world that encourages people to drive themselves to work in Army vehicles.

[pup55]

$this->bbcode_second_pass_quote('', 'w')ho own oil resources will begin to strictly limit their production

[Renfield]

But maximized revenue doesn't include just price. It also must include volume. An example with arbitrary numbers - isn't it better to sell 10 million barrels/day at $30.00 ($300 million/day) than 2 million barrels/day at $70.00 ($140 million/day)? Especially if restricting output risks demand destruction?

Also, I am devious about wanting to make sure that you protect profitability too far out into the future. People tend to want a Ferrari for themselves now rather than for their grandkids later as evidenced by the fact that so many state lottery winners take the big money up front at a 30% - 50% loss rather than the slow payout over 20 years.

[aahala]

jaws, a very inciteful post.

I agree that's the rational approach, but the system may not be rational.

Secondly, the majority of producers may be rational, but a handful
of important producers may trump their best laid plans. We've seen
production stopped for political reasons in the past and it may happen
in the future.

I also wonder if the estimates of oil reserves, the future price/demand
data and the appropriate discount rate are matters that independent,
rational decision makers can converge on. I can invision two producers
who believe they have the same remaining, pumpable reserves take
opposite decisions on how much to produce now, as they view of the
future conditions are different.

Circumstances such as that will tend to cancel out the rationality of
the system. All the producers could use the net present value approach
but total production may not exhibit rationality.

Edit-Whoops, I meant to say insightful but it was pretty inciteful as well.

[FatherOfTwo]

Jaws, your post assumes that the owner of the resource knows his oil has no replacement. I don't think that is the case because as we know, OPEC hasn't acted this way. It is well known that OPEC had the shit scared out of them when nuclear power plants first started coming on line. "It's going to be so cheap they won't even meter it." Even to this day they (appear) to be worried about oil becoming too expensive and some other alternate replacing it. If that happened, their economy would be destoyed.

OPEC's whole mantra has been "keep the price stable so that we earn a good price for our product. If the price gets too low, restrict flow. If the price gets to high, open the taps."

And indeed, politics is another reason to keep the price stable. Have it go too high and the US will liberate you.

[jaws]

One point about demand destruction. It is not true that demand destruction from increasing oil prices will lower the price of oil because by definition demand destruction is caused by a price increase. If oil prices increase by 100% and demand falls by 10%, the price stays there. Should it go back to its original level, demand would come back.

When oil hit its historical price peak in the early 1980's there was severe demand destruction. There were also speculators buying up oil and waiting for the price to increase. When the Iraq-Iran war flooded the market with oil the price came down, and demand came back.

[Renfield]

That's contrary to everything I understand about economics. While I'm not an economist my understanding is that while demand destruction may result from high prices, what happens is that producers now have a smaller pool to sell to and must compete with each other for sales. This results in the opposite of a bidding war where producers compete with each other by lowering their prices. In every scenario I am aware of a decrease in demand for a product results in lower prices for that product even to the point where producers may have to take a loss because they have product on their hands that is better to sell at less than cost than to not sell at all. Both the oil embargo and the Iranin-revolution-inspired oil price hikes resulted in price collapses just a couple years later. This, in fact, is why they do not do it again. In both cases the price collapse resulted from both conservation measures (switching from fastback Mustangs to Toyoto Corollas) and new oil from other sources (Alaska and the North Sea) but both could have resulted from conservation alone.

[jaws]

The price collapses were caused by new oil coming to the market. Conservation could not have created a price collapse by itself, it only improves the efficiency of the oil that people can already afford.

There's a hook effect involved in the process. If the market was perfectly flexible then the elasticity of oil demand would be much greater and we wouldn't really talk about demand destruction as a process in time. The price would go up, demand would fall and the market would stay there. The problem is that adjusting to the new prices takes time and in the interim you have to keep buying more oil than you really want. This bids up the price even higher than it would under perfect flexibility. However as people adjust their habits demand and price levels back down, and returns to the point in demand and price that would have occurred under perfect flexibility.

Price has still absolutely gone up and demand has fallen, it just takes a detour before getting there.

[Renfield]

I think that absolutely depends on the size of the spike. An extreme spike of say, $70.00 to $150.00 in a few months may destroy demand so quickly an entire economy collapses. If that happens demand may never return to what it was. Also, you still have to deal with the fact that in order for this to happen you have to have broad collusion in the market among producers, something I doubt you will see. Even in OPEC they have never really been successful at keeping their members in check as far as quotas are concerned. Then there's the question of wanting it now, not later. People want to get all the hot chicks and the fast cars right now, screw their grand kids. A look at the US federal budget deficit can illustrate that. Finally, revenue is not maximized by price alone. It is maximized at a certain price and volume. It is better to sell 10 million barrels/day at $30.00 ($300 million/day) than to sell 2 million at $70.00 ($140 million/day) arbitrary numbers, I know, but the concept combined with wanting things now and lack of collusion add up to no holding back production in favor of waiting for a possible price spike later especially if you don't know wether or not you'll be alive, in power, be able to still get it up, a super volcano blows up...

[bobcousins]

Sorry, this oil banking idea is a non-starter. Competition totally blows it away. Theory, and all the evidence shows that companies exploit the highest margin product first and seek market share by selling in volume. The only way to control that is have a cartel to set volume and price : OPEC. It can only work if ALL players are on board, which is why OPEC lost control due to countries like Russia.

Oil is like champagne, it is bottled to drink, not to keep.

Now, in a different market, de Beers have a stranglehold on diamond supply. They can genuinely control price and volume, and "bank" their diamond reserves. They have trillions of dollars of diamonds. Any player that tries to buck the system gets stomped on.

Banking only actually works with real money.

[jaws]

You missed a key issue. Collusion is not necessary for oil banking to take place. It is not the same as a cartel, where the goal is to collude to increase prices. Oil banking is not an attempt to increase prices, it follows from an expectation of higher prices in the future. Prices are increasing because of higher demand and smaller supply, and peak oil theory says that supply will keep falling, therefore that prices will continue to increase. This means that, regardless of what all your competitors are doing, you should stop producing and wait.