Monetary Policy & Commodity Prices
Study Center Gerzensee
23-25 June, 2014
Jeffrey Frankel
Harpel Professor, Harvard University
Lecture I: Monetary Influences
on Commodity Prices
1


Commodity prices have been volatile
in recent years.
What causes swings
such as the 2008 & 2011 price spikes?

The role of real interest rates.

Appendices:


I. Do speculators destabilize prices?
II. Long-term commodity price trends.
2
Oil prices, for example, spiked in 2008,
and reached a 2nd peak in 2011.
The impact on commodity-exporting
developing countries
Developing countries tend to be smaller
than major industrialized countries,
and more likely to specialize in the exports
of basic commodities like oil, minerals,
& agricultural commodities.

So they are more likely to fit
the small open economy model:


price-takers,



not just for their import goods,
but for their export goods as well.
That is, the prices of their tradable goods
are taken as given on world markets.
4
The determination of the export price on world markets
The price-taking assumption requires 3 conditions:




low monopoly power,
low trade barriers,
Homogeneity: intrinsic perfect substitutability
as between domestic & foreign producers –





a condition usually met by primary products
and usually not met by manufactured goods & services.
Besides homogeneity, we will also be assuming storability.
To be precise, not all barrels of oil are the same,
nor are traded in competitive markets.
But the assumption that most commodity producers
are price-takers holds relatively well.
5
A qualification: Monopoly power


Saudi Arabia does not satisfy the 1st condition,
due to its large size
in world oil markets.
If OPEC functioned effectively as a true cartel,
then it would possess even more
monopoly power in the aggregate.
6
The determination of the export price

continued
To a 1st approximation, then,
the local commodity price = (the exchange rate)
X ($ price on world markets).
(sj/c) = (s j/$ ) + (s$/c )
where
s j/$ ≡ spot exchange rate in units of currency j per $,
s $/c ≡ spot price of commodity c in terms of $;

=> a devaluation should push up
the commodity price quickly and in proportion


leaving aside pre-existing contracts
or export restrictions.
7
Why are commodity prices so volatile?



Demand elasticities are low in the short run,
because the capital stock is designed to operate
with a particular ratio of material inputs to output.
Supply elasticities are also often low in the short run,
because it takes time to adjust output.
Because price elasticities of supply & demand are low,
relatively small fluctuations in demand or supply
(due, e.g., to weather) require a large change
in price to re-equilibrate supply & demand.
8
A given rise in demand causes
a small price rise
or
a big price rise
with

high elasticities
Poil
D
with
D'
The increase
in demand drives up
the price
S
{
Supply & demand for commodity

Poil
low elasticities
D
D' S
{
Supply & demand for commodity
9
Volatility, continued

Inventories
can cushion the short run
impact of fluctuations,

but they are limited by storage costs
due to capacity constraints and
 carrying cost (interest rate, insurance, spoilage…)

10
Volatility,


continued
In the longer run, elasticities are far higher,
both on the demand side and the supply side.
This dynamic was clearly at work in
the oil price shocks of the 1970s –
quadrupling after the 1973 Arab oil embargo

doubling after the Iranian revolution of 1979,
which elicited relatively little consumer
conservation or new supply sources in the short run,
but a lot of both after a few years had passed.


11
Volatility, continued
In the medium run,
 people started insulating their houses and
driving more fuel-efficient cars,
 and oil deposits were discovered
& developed in new countries.

This is a major reason why the real price
of oil came back down in the 1980s-1990s.
12
Price of oil, 1970-2007
13
Volatility,
continued
In the medium term, commodities can show
a cob-web cycle, due to the lags in response:


The initial market equilibrium is a high price;
the high price brings forth investment



which in turn leads to a new low price,
which discourages investment,


and raises supply after some years,
2
1
and thus reduces supply with a lag
and so on.
3
4


In theory, if people have rational expectations,
they should look ahead to the next price cycle before
making long-term investments in housing or drilling.
But the complete sequence of boom-bust-boom over the last
35 years looks suspiciously like a cobweb cycle nonetheless.
14
Four explanations for big recent increases
in the prices of oil, minerals & agricultural commodities

(1) global growth


especially China
(2) speculation


defined as purchases of commodities,
in anticipation of gain at the time of resale.
However, this includes:



(3) easy monetary policy


not only possible destabilizing speculation (bandwagons),
but also stabilizing speculation.
reflected in low real interest rates.
(4) financialization:

open position in commodities futures,


by commodity index funds & other traders
esp. since 2005
Monetary influences on commodity prices



We will show an arbitrage condition between the physical
stock of a storable commodity like oil and the interest rate.
The real price of oil should be high during periods when
real interest rates are low (e.g., due to easy monetary policy),
 so that a poor expected future return
to holding oil offsets the low interest rate.
By contrast, when real interest rates are high
(e.g., due to tight money),
current oil prices should lie below their long-run equilibrium,
 because an expected future rate of price increase
is needed in order to offset the high interest rate.
16
High real interest rates reduce the price of
storable commodities through 4 channels:

¤ by increasing the incentive for extraction today



¤ by decreasing firms' desire to carry inventories


think of oil inventories held in tanks.
¤ by encouraging speculators to shift out of
commodity contracts, and into treasury bills


rather than tomorrow
think of the rates at which oil is pumped, gold mined,
forests logged, or livestock herds culled.
the “financialization" of commodities.
¤ by appreciating the domestic currency

and so reducing the price of internationally
traded commodities in domestic terms
even if the price hasn't fallen in terms of foreign currency.
The mechanisms at work in recent history

Very low US real interest rates boosted
commodity prices toward the end of the 1970s,


high US interest rates drove them down in the 1980s,





especially in $ terms;
especially in $.
In recent years, e.g., 2008, low interest rates
again contributed to high commodity prices.
References by the author include Frankel, 1986, 2005, 2008a,b, 2014;
Frankel & Hardouvelis, 1985; Frankel & Rose, 2009.
Also Barsky & Summers, 1988; and Caballero, Farhi & Gourinchas, 2008.
Barsky & Killian, 2002, and Killian, 2009: many big oil price “shocks”
have in reality been endogenous with respect to monetary policy.
18
Figure 1a: Real commodity price index
(Moody’s) and real interest rates
Figure 1b: Real commodity price index
(Moody’s) and real interest rates
The overshooting theory mechanics

Monetary contraction temporarily raises the real interest rate





whether via rise in nominal interest rate, fall in expected inflation, or both.
Inventory demand falls (<= high “cost of carry”).
=> Oil prices fall.
How far?
Until oil is widely considered "undervalued"

-- so undervalued that there is an expectation of future appreciation,


together with other advantage of holding inventories: the "convenience yield,”
that it is sufficient to offset the higher interest rate

and other costs of carrying inventories: esp. storage costs.

Only then are firms willing to hold the inventories
despite the high carrying cost.

In the long run, the real interest rate & real
commodity price return to equilibrium values.
21
Literature on inventories


We need to include inventories,
E.g.,

and the role of speculation & interest rates.
Some have found evidence in inventory data
for an important role for speculation,

driven by geopolitical fears:



Working (1949); Deaton & Laroque (1996); Ye, Zyren & Shore (2002,05,06)

disruption to the supply of Mideastern oil.
Kilian & Murphy (2013); Kilian
&
Lee (2013).
But the speculative factor is inferred implicitly

rather than measured explicitly.

Empirical innovations of the 2014 paper
Relative to past attempts to capture the roles
of speculation or interest rates via inventories:

How to measure speculation, i.e., market expectations
of future commodity price changes?
Survey data collected by Consensus Forecasts
 from “over 30 of the world's most
prominent commodity forecasters.”


How to measure perceived risk to commodity availability?

Volatility implicit in options prices.
Derivation & estimation of the model

1) The overshooting model



shows the effect of the real interest rate
on the real commodity price,
holding storage costs constant.
We can also show how the local-currency commodity
price depends on the local interest rate too.

2) We can infer storage costs from inventories.

3) The full commodity price equation

Adds to the overshooting model:


inventories / storage costs;
& economic activity / convenience yield.
24
1st assumption: regressive expectations
E [Δq] = - θ (q-𝑞 )
(1)
E [ Δ (s – p ) ] = - θ (q-𝑞 )
(2)
where

q ≡ s-p, the (log) real price of the commodity,

𝑞 ≡ long run (log) equilibrium real commodity price,

s ≡ natural logarithm of the spot price, and

p ≡ (log of) economy-wide price index.
E (Δs) = - θ (q- 𝑞 ) + E(Δp).
(2)
+ 2nd assumption:
speculative arbitrage
E(Δs) + C = i,
where: C ≡ cy – sc – rp.
(3)
=>
- θ (q- 𝑞 ) + E(Δp) + C = i
=> q - 𝑞 = - (1/θ) [i - E(Δp) – C ]

(4) .
q is inversely proportionate to the real interest rate,

if 𝑞 and C are constant.
The overshooting model :
q is inversely proportionate to the real interest rate
Regression of real commodity price indices
against real interest rate (1950-2012)
Table 1
Dependent variable: log of commodity
price index, deflated by US CPI
Goldman
CRB
Dow Jones Moody’s
Sachs
index
Index
index
Index
VARIABLES
Real interest rate -.041*** -.034*** -.071** -.075***
(0.007)
Constant 0.900***
(0.006)
(0.005)
(0.007)
0.066*** 2.533*** 0.732***
(0.017)
(0.016)
(0.011)
(0.018)
Observations
739
739
739
513
R2
0.04
0.04
0.25
0.18
*** p<0.01
(Standard errors in parentheses.)
For a model of commodity prices in local currencies,
combine commodity price overshooting
with Dornbusch exchange rate overshooting.
(sj/c −𝑠j/c)) = (s j/$ - 𝑠 j/$ ) + (s$/c - 𝑠 $/c )
= (pj-𝑝j)- (1/ν)(ij - i$ - [E πj –E π$]) - (1/θ)(i$–E π$ – C)
(q j/c - 𝑞 j/c )
= - (1/ν) (rj -r$ ) - (1/θ) (r$ – C). (9)
where
s j/$ ≡ spot exchange rate in units of currency j per $,
s $/c ≡ spot price of commodity c in terms of $;
pj & p$ ≡ the price levels; πj & π$ the inflation rates;
q j/c ≡ real price of commodity c in terms of currency j ;
r$ & rj ≡ the real interest rates in the US & country j .
The overshooting equation for
commodity prices in local currencies

Equation (9) says the real commodity price
observed in country j is high to the extent that


either the US real interest rate is low,
or the local real interest rate is low


relative to the US real rate.
Equation tests for 8 floating-currency countries:

Local & US real interest rates do have significant
effects on local real commodity price indices
(CRB, Dow Jones, The Economist, Goldman Sachs, Moody’s & Reuters).

Frankel (2008).
29
Regressions of commodity price in local currency on interest rates
Monthly observations
(over largest possible sample of data since 1950)
3a. Log Real CRB Commodity Price Index in Local Currency & Real Interest Rates
Short-term interest rates
Long-term interest rates
Sample
Australia
s.e.
Brazil
1/1950-8/2005
7/65-12/89 & 1/95-8/05
s.e.
Canada
s.e.
s.e.
s.e.
s.e.
-0.063 *
0.055 *
0.001
0.009
Switzerlnd 1/1980-9/2005
s.e.
0.034 *
0.016
1/1950-9/2005
s.e.
-0.047 *
0.013
3/1978-8/2005
UK
-0.024 *
0.006
1/1978-9/2005
NZ
0.006
0.005
7/1997-9/2005
Mexico
-0.023 *
0.007
1/1950-9/2005
Chile
Real
Real interest
US i rate differential
-0.053 *
0.010
-0.076 *
Sample
1/1950-8/2005
0.003
-0.006 *
5/1994-9/2005
1/1950-9/2005
2/1993-2/2004
1/1995-9/2005
1/1950-8/2005
0.007
* significance at 5% significance level.
-0.076 *
-0.092 *
0.006
-0.018 *
0.047 *
0.003
0.000
-0.081 *
0.003
-0.075 *
0.006
5/1953-9/2005
0.009
-0.086 *
-0.073 *
0.001
0.011
0.004
-0.054 *
-0.001
0.014
0.002
-0.067 *
-0.161 *
0.004
0.004
0.004
-0.017 *
-0.067 *
0.019
0.005
-0.021 *
-0.057 *
0.005
0.002
-0.065 *
Real US Real interest
rate
differential
-0.171 *
0.004
-0.095 *
0.013
1/1950-9/2005
-0.106 *
0.012
-0.023 *
0.007
Robust standard errors are reported.
0.006
Derivation of inventory demand equation
E (Δs) + cy – sc – rp = i
or sc = [E (Δs)-i] +cy – rp.
(3)
(7)
3rd assumption: Storage costs rise with the extent
to which inventory holdings strain existing
storage capacity: sc = Φ (INVENTORIES).
Invert:
INVENTORIES = Φ-1 { sc } .
And combine with the arbitrage condition (7):
INVENTORIES = Φ-1 {[E(Δs)-i] +cy – rp}
The carry trade model
(8)
Table 4 --
Oil Inventory Equation (1995-2011) 58 observations, quarterly
Petroleum stocks
Millions of barrels
Carry trade:
EΔs - i
(3)
0.12*** 0.12***
(0.03)
Actual US IP growth
(0.03)
0.56*** 0.56***
(0.15)
US Industrial Prod. log
Forecast 2-yr IP growth
(4)
-0.674**
(0.15)
0.02*
(0.01)
(0.01)
0.02
0.01
(0.08)
(0.08)
0.01
(0.07)
(0.04)
0.003
0.000
(0.318)
(0.146)
(0.146)
0.91***
0.91***
(0.05)
(0.05)
0.004***
0.000
0.000
(0.000)
(0.000)
(0.000)
7.36***
0.65
0.60
(0.01)
(0.32)
(0.39)
(0.48)
0.84
0.84
0.97
0.97
0.004***
(0.000)
R2
0.02*
-0.01
Oil Stocks lagged log
Constant
(2)
-0.671**
(0.318)
Trend
(1)
7.31***
Now put inventories into the commodity price equation
When inventories rise, the commodity price falls.
WEO, IMF, April 2012
Complete equation for determination of price
There is no reason for the net convenience yield, C, to be constant.
C ≡ cy – sc – rp
(3)
q- 𝑞 = - (1/θ) (i - E(Δp) – C) (4)
Substituting from (3) into (4),
q = 𝑞 - (1/θ) [i-E(Δp)] + (1/θ) cy - (1/θ) sc - (1/θ) rp
(5)
Hypothesized effects:
 Real interest rate: negative
 Convenience yield: positive



Storage costs: negative


Economic activity
Risk of disruption
sc = Φ (INVENTORIES).
Risk premium
 Measured directly: [E(Δs)-(f-s)]
 Or as determined by volatility σ : ambiguous

Measured by actual volatility or option-implied subjective volatility
Estimation of determination for real prices,
commodity-by-commodity, 1950-2012
Table 2a -- 1st half
Commodity:
Real interest rate
(1)
(2)
Copper
Corn
(3)
(4)
(5)
Cotton Live cattle Live hogs
-0.07*** -0.05* 0.01
-0.05***
-0.04***
(0.02)
(0.03)
(0.01)
(0.02)
(0.01)
-0.46
0.62
0.56
2.26
-2.62**
(0.57)
(0.57)
(0.58)
(1.48)
(1.12)
-0.19***
-0.07
-0.13
1.12
0.42*
(0.06)
(0.17)
(0.12)
(0.78)
(0.24)
Spread, %
0.000
-0.006
-0.001
-0.007***
-0.004***
Future-Spot
(0.002)
(0.003)
(0.001)
(0.002)
(0.001)
Volatility: Std.dev.
3.04***
0.94
0.20
-0.27
-1.02
of log price over past year
(0.72)
(0.91)
(0.53)
(0.78)
(0.61)
Linear trend
-0.00
-0.04**
-0.04*
-0.08*
0.05
(0.02)
(0.02)
(0.02)
(0.04)
(0.03)
16.94
-20.26
-14.94
-81.65
74.87**
(17.29)
(16.54)
(17.29)
(51.77)
(33.00)
50
0.55
51
0.66
51
0.76
32
0.51
39
0.80
Log World GDP
constant 2000US$ ; WDI
Log Inventories
Constant
Observations (annual) †
R2
*** p<0.01, ** p<0.05, * p<0.1 (Robust standard errors in parentheses.)
† Some commodities have shorter
Estimation of determination for real prices,
commodity-by-commodity, 1950-2012, continued
Table 2a -- 2 half
Commodity:
Oats
Real interest rate
-0.04**
-0.02
(0.016)
(0.071)
(0.015)
(0.025)
(0.016)
(0.021)
1.56**
-4.42
3.38***
3.63*
0.38
0.33
(0.593)
(4.984)
(0.753)
(2.012)
(0.837)
(0.702)
-0.31**
-2.82
-0.24***
0.01
0.04
-0.45*
(0.13)
(4.43)
(0.03)
(0.11)
(0.09)
(0.24)
Spread, %
-0.015*
-0.002
-0.000
-0.010**
-0.007**
-0.001
Future-Spot
(0.003)
(0.003)
(0.001)
(0.004)
(0.003)
(0.003)
Volatility: Std.dev.
0.91
-0.08
1.10***
5.15***
1.86**
1.81***
of log price over past year
(0.66)
(0.69)
(0.36)
(0.67)
(0.87)
(0.65)
-0.09***
0.17
-0.12***
-0.12*
-0.04
-0.03
(0.03)
(0.14)
(0.03)
(0.06)
(0.03)
(0.02)
-45.54***
156.65
-98.36***
-111.77*
-13.65
-7.09
(16.33)
(142.65)
(22.41)
(60.57)
(24.71)
(20.18)
50
0.63
29
0.34
47
0.73
44
0.62
48
0.71
51
0.74
nd
Log World GDP
(constant 2000 US$);WDI
Log Inventories
Linear trend
Constant
Observations (annual)
R2
(6)
(7)
(8)
Petroleum Platinum
(9)
(10)
(11)
Silver
Soybeans
Wheat
0.08*** -0.02
*** p<0.01, ** p<0.05, * p<0.1 (Robust standard errors in parentheses.)
-0.04** -0.003
† Some commodities have shorter
A panel across all 11 commodities
offers hope for greater statistical power
Table 3a
(492 annual observations)
Real interest rate
Log World GDP
(constant 2000 US$) WDI
Dependent variable: real commodity prices (log)
(1)
(6)
(7)
-0.02*
-0.03**
0.01
(0.01)
(0.01)
(0.01)
0.01
3.45***
(0.24)
(0.77)
Global Business Cycle
7.22***
(HP-Filtered World GDP)
(1.08)
Quadratic Trend
0.001***
(0.000)
Log Inventories
Future-Spot Spread, %
Volatility: Standard deviation
of log spot price of past year
Linear Trend
Constant
R2
-0.14***
-0.14***
-0.13***
(0.03)
(0.02)
(0.02)
-0.003***
-0.003***
-0.003***
(0.001)
(0.001)
(0.000)
1.81***
1.92***
1.77***
(0.52)
-0.02*
(0.51)
-0.02***
(0.47)
-0.19***
(0.01)
(0.00)
(0.04)
0.01
0.32
-101.90***
(7.01)
(0.23)
(22.93)
0.46
0.49
0.51
Panel across all 11 commodities;
First differences guard against non-stationarity
Table 3b
Δ Real interest rate
Dependent variable: Δ real commodity prices (log)
(1)
(6)
(7)
-0.021
-0.001
-0.029**
(0.013)
(0.006)
(0.012)
Global Business Cycle
6.765***
(HP-Filtered World GDP)
Forecast 2-yr.US GDP growth
(Consensus Forecasts monthly)
(1.035)
8.575***
11.365***
(1.978)
(2.178)
Quadratic trend
0.002***
(0.000)
Δ Log Inventories
-0.004
-0.08
-0.008
(0.061)
(0.0481)
(0.056)
-0.001***
-0.002***
-0.002***
(0.000)
(0.0005)
(0.000)
-0.067
0.192
0.068
(0.184)
(0.213)
(0.208)
0.010***
0.002***
-0.024***
(0.002)
(0.000)
(0.005)
-0.314***
-0.043***
-0.271***
(0.068)
(0.009)
(0.071)
Observations
216
486
216
R2
0.22
0.17
0.27
Δ Future-Spot Spread, %
Δ Volatility: Std.dev. of
log spot price of past year
Linear Trend
Constant
In conclusion…

The model can accommodate each of
the explanations for recent increases
in commodity prices:
economic activity, speculation, and easy
monetary policy.


Based on “carry trade”: arbitrage relationship
between expected price change & costs of carry:
interest rate, storage costs & convenience yield.
And on “overshooting”: prices are expected to
regress gradually back to long-run equilibrium
40
Appendix I: Do speculators
destabilize prices?

Yes, speculators are important
in commodities markets.
The spot price is determined in markets where
participants typically base their supply & demand
in part on their expectations of future increases
or decreases in the price.
 That is speculation.
 But it need not imply
bubbles or destabilizing behavior.

41
Are speculators bad?

Speculators often fulfill useful functions:




continued
If they know the price is temporarily high, they
sell short, thereby moderating today’s high price.
If they have reason to think there will be a future
increase in demand, they go long,
thereby driving up today’s low price and sending
the market signal needed to spur investment.
In these cases they are the messenger delivering
the news about economics fundamentals.
Admittedly, there are sometimes speculative
bubbles, a self-confirming movement of
the market price away from fundamentals.
42
An example of commodity speculation



In the 1955 movie version
of East of Eden, the legendary
James Dean plays Cal.
Like Cain in Genesis, he
competes with his brother for
the love of his father.
Cal “goes long” in the market
for beans, in anticipation of
a rise in demand if the US
enters WWI.
An example of commodity speculation, cont.


Sure enough, the price of beans goes sky high,
Cal makes a bundle, and offers it to his father,
a moralizing patriarch.
But the father is morally offended by Cal’s speculation,
not wanting to profit
from others’ misfortunes,
and tells him he will have
to “give the money back.”
An example of commodity speculation, cont.

Cal has been the agent of
Adam Smith’s famous invisible hand:



By betting on his hunch about
the future, he has contributed
to upward pressure on the price
of beans in the present,
thereby increasing the supply so that more
is available precisely when needed (by the Army).
The movie even treats us to a scene where Cal
watches the beans grow in a farmer’s field,
something real-life speculators seldom get to see.
Appendix II:
Long-term world price trend
(i) The old “structuralist school” (Prebisch-Singer):


The hypothesis of a declining commodity price trend
(ii) Hypotheses of a rising price trend



Hotelling, non-renewable resources, & the interest rate
Malthusianism & the “peak oil” hypothesis
(iv) Empirical evidence


Statistical time series studies
46
Permanent upward trend?
It looked like it in 2007.
Price of oil
47
But not in 2009.
One needs to look at the very long term
48
(i) The old “structuralist school”
Raul Prebisch
(1950)
& Hans Singer
(1950)
The hypothesis: a declining long run trend
in prices of mineral & agricultural products


relative to the prices of manufactured goods.
The theoretical reasoning:
world demand for primary products is inelastic
with respect to world income.


That is, for every 1 % increase in income,
raw materials demand rises by less than 1%.
Engel’s Law, an (older) proposition:
households spend a lower fraction of their income
on basic necessities as they get richer.
Demand
=> P oil


49
Structuralists, continued



This hypothesis, if true, would imply that
specializing in natural resources was a bad deal.
Mere “hewers of wood & drawers of water” would
remain forever poor if they did not industrialize.
The policy implication of Prebisch:



developing countries should discourage international
trade with tariffs,
to allow their domestic manufacturing sector to develop
behind protective walls,
rather than exploiting their traditional comparative
advantage in natural resources

as the classic theories of free trade would have it.
50
“Import Substitution
Industrialization” policy (ISI)

was adopted in the 1950s, 60s and 70s


in most of Latin America and much of the rest
of the developing world.
The fashion reverted in subsequent
decades, however.
51
(ii) Hypotheses of rising trends



Persuasive theoretical arguments
that we should expect oil prices to show
an upward trend in the long run.
(A) Hotelling: depletable resources;
(B) Malthus: geometric population growth.
52
Assumptions for Hotelling model

(1) Non-perishable non-renewable resources:


Deposits in the earth’s crust are fixed in total supply
and are gradually being depleted.
(2) Secure property rights:
Whoever currently has claim to the resource
can be confident that it will retain possession,

unless it sells to someone else,



who then has equally safe property rights.
This assumption excludes cases where warlords
compete over physical possession of the resource.
It also excludes cases where private oil companies fear
that their contracts might be abrogated
or their holdings nationalized.
53
If property rights are not secure,

the current owner has a strong
incentive to pump the oil quickly,


because it might never benefit if the oil is left in the ground.
That is one explanation for the sharp rise
in oil prices from 1973 to 1979:



Western oil companies in the 1960s had anticipated that
newly assertive developing countries would eventually
nationalize the reserves within their borders,
and thus had kept prices low by pumping oil more quickly
than if they been confident that their claims would remain
valid indefinitely
until they indeed lost control in 1973.
54
Price of oil, 1900-2006
Oil shocks
1 1973 Arab oil embargo
2. 1979 fall of Shah of Iran
3. 2008 spike
55
While we are on the subject
of the 1970s oil shocks…

A more common explanation for the oil price
increases of 1973-74 and 1979-80 is
simply geopolitical disruptions:



Yom Kippur War and Arab Oil Embargo
Revolution in Iran and Fall of the Shah
Less common explanations:

Excessively easy monetary policy



coming from US Fed accommodation of Vietnam deficits
“The world is running out of oil.”
We consider both later.
56
One more assumption,
to keep the Hotelling model simple:

(3) The fixed deposits are easily accessible:



the costs of exploration, development, & pumping
are small compared to the value of the oil.
Hotelling (1931) deduced from these
assumptions the theoretical principle:
the price of oil in the long run should rise
at a rate equal to the interest rate.
57


King Abdullah of Saudi Arabia,
with interest rates close to zero,
apparently believes that the rate of return
on oil reserves is higher if he doesn't pump
than if he does:
"Let them remain in the ground for our
children and grandchildren..." (April 12, 2008)
58
The Hotelling logic:

The owner chooses how much oil to pump


Whatever is pumped can be sold at today’s price
(price-taker assumption)



and how much to leave in the ground.
and the proceeds invested in bank deposits
or US Treasury bills, which earn the current interest rate.
If the value of the oil in the ground is not expected
to rise in the future, then the owner has an
incentive to extract more of it today, so
that he earns interest on the proceeds.
59
The Hotelling logic,

As oil companies worldwide react in this way,
they drive down the price of oil today,




continued:
below its perceived long-run level.
When the current price is below its long-run level,
companies will expect the price to rise in the future.
Only when the expectation of future appreciation
is sufficient to offset the interest rate will the oil
market be in equilibrium.
Only then will oil companies be close to indifferent
between pumping at a faster rate and a slower rate.
60
Hotelling,

continued:
To say the oil price is expected to increase
at the interest rate means that it should do
so on average;


it does not mean that there won’t be price
fluctuations above & below the trend.
The theory does imply that, averaging out
short-term unexpected fluctuations, oil prices in
the long term should rise at the interest rate.
61
If there are costs of extraction & storage?
-- non-negligible costs

(but assume constant)
?
then the trend in prices will be lower
than the interest rate, by that amount.
If there is a constant convenience yield
from holding inventories?
 then the trend in prices will be higher
than the interest rate, by that amount.
The arbitrage equilibrium equation:
E Δp oil = interest rate + costs – convenience yield

62


The upward trend idea is older than Hotelling.
It goes back to Thomas Malthus (1798)
and the first fears of environmental scarcity:
Demand grows with population,
 Supply does not.
 What could be clearer in economics
than the prediction that price will rise?

63

Over the two centuries since Malthus,


or the 70 years since Hotelling,
exploration & new technologies have
increased the supply of oil at a pace
that has roughly counteracted the increase
in demand from growth
in population & incomes.[1]
[1] Krautkraemer
(1998) and
Wright & Czelusta
(2003, 2004, 2006).
64
Hubbert’s Peak – U.S.


Just because supply has always increased in
the past does not necessarily mean it always
will in the future.
In 1956, M. King Hubbert, an oil engineer,
predicted that the flow supply of oil within
the US would peak in the late 1960s and then
decline permanently.
65
Hubbert’s Peak – U.S.


The prediction was based on a model
 in which the fraction of the country’s reserves
that has been discovered rises through time,
 and data on the rates of discovery versus
consumption are used to estimate the parameters
in the model.
Unlike myriad other pessimistic forecasts, this
one came true on schedule,


earning subsequent fame for its author:
U.S. oil output indeed peaked in the late 1960s. 66
Hubbert’s Peak – Global




Planet Earth is a much larger place
than the USA, but it too is finite.
Some analysts have extrapolated Hubbert’s words
& modeling approach to claim that the same pattern
will follow for extraction of the world’s oil reserves.
Some claimed the 2000-2008 run-up in oil prices
confirmed a predicted global “Hubbert’s Peak.” [1]
Are we witnessing a peak in world oil production?


forecasts of such peaks have proven erroneous in the past.
The “fracking revolution” supports the opposite view.
[1] E.g., Deffeyes (2005).
67
Hubbert’s Peak – global
HeatUSA.com blog
68
The complication: supply is not fixed.




True, at any point in time there is a certain
stock of oil reserves that have been discovered.
But the historical pattern has long been that,
as that stock is depleted, new reserves are found.
When the price goes up, it makes exploration &
development profitable for deposits farther
under the surface or underwater
or in other hard-to-reach locations.
…especially as new technologies are
developed for exploration & extraction.
69
The empirical evidence


With strong theoretical arguments on both sides,
either for an upward trend or for a downward
trend, it is an empirical question.
Terms of trade for commodity producers had





a slight up trend from 1870 to World War I,
a down trend in the inter-war period,
up in the 1970s,
down in the 1980s and 1990s,
and up in the first decade of the 21st century.
70
What is the overall statistical trend
in commodity prices in the long run?



Some authors find a slight upward trend,
some a slight downward trend. [1]
The answer seems to depend, more than anything else,
on the date of the end of the sample:



Studies written after the 1970s boom found an upward trend,
but those written after the 1980s found a downward trend,
even when both went back to the early 20th century.
[1] Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington
& Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Hadass & Williamson
(2003), Reinhart & Wickham (1994), Kellard & Wohar (2005), Balagtas &
Holt (2009) and Harvey, Kellard, Madsen & Wohar (2010).
71
What is the trend in the price of oil
in particular?
 1869-1969:
Downward
 1970-2011:
Upward
 The
long run: Unclear
?
72
Price of oil, 1869-2009
73
74