In a recent edition of his ‘blog’, one of the authors of Freakonomics (2005) – Stephen Levitt – made a few comments about his short stay in the United Arab Emirates (UAE) state of Dubai. As most viewers of CNN are aware, luxury is the order of the day in that lucky nation, however in mulling over the details of this condition, Professor Levitt failed to emphasize the key economic element behind Dubai’s rise from a fishing village to a middle eastern version of Monaco. The ingredient to which I am referring is systematic diversification, which in this case means that emphasis is unambiguously put on the conservation rather than the production/export of crude oil – where crude oil is oil as it is found underground, i.e. unprocessed. This approach means that less than 10% of Dubai’s GNP is now directly attributable to oil, and as trade and the provision of services increases, measures may be taken reduce the output of crude even further.

Unfortunately, I probably know less about the behaviour and intention of Dubai’s government than most of the persons who generously commented on and extended Professor Levitt’s observations, however unlike many of them I understand that in the Gulf (and perhaps elsewhere), policies derived from the laws of mainstream economics have finally superseded ad-hoc or knee-jerk response to shifts in oil supply and demand, and consequently could have a profound effect on the future (global) availability of that indispensable commodity. To get some idea of what we are dealing with, I would like to sketch the argument that I imposed on students in my course on oil and gas economics at the Asian Institute of Economics (AIT) during the spring term of 2007.

THE MAIN ARGUMENT

One of the prerequisites for successfully completing any course in energy economics that I teach is to understand perfectly the situation in the key oil exporting country, Saudi Arabia, in the early 1970s – specifically, just before and just after the nationalization of oil production facilities that were owned or controlled by foreigners.

The intention by foreign managers was to raise production (in phase with increasing demand) to a peak of about twenty million barrels per day (= 20mb/d), and to keep it at or close to that level for as long as possible. Eventually, for economic reasons, it would decline. Once it is understood that the most important variable is cost, the relevant algebra is straightforward: cost is a function of present and past production, with the latter a determinant of what is known as natural depletion(or natural decline) due to its effect on deposit pressure. As explained in my new textbook (2007), and also in Henderson and Quant (1995), what we are dealing with is inter-temporal profit maximization in the presence of a constraint. The constraint is the (estimated) total amount of reserves to be exploited, with these being parcelled out over a certain number of periods (e.g. years) on the basis of expected future prices and costs. The costs are of course opportunity costs, one component of which involves comparing the profit from exporting crude oil to the profit from exporting oil products and petrochemicals.

The thing that made (or should have made) this exercise exceptional is that oil is an exhaustible resource: oil that is removed from a deposit in the present period is unavailable later. The major producers (e.g. ‘Seven Sisters’) recognized this, but initially they believed that when oil began showing signs of exhaustion in one locality, it should be possible to begin or expand operations elsewhere. For this and other reasons, until recently, several influential researchers found some of my lectures highly objectionable, since they preferred to assume that the global output of oil in a given year would always be a trivial or uninteresting fraction of the total in the earth’s crust. The way they sometimes put it was that we were running into rather than running out of oil! But the appearance of an oil price above $90/b concentrated many prestigious minds, and so now it takes a brave scholar to disregard the misfortunes that depletion might eventually bring to those of us on the buy side of the market.

Conceptually, things were not so easy for the new owners of oil in places like Saudi Arabia. Their aim was to maximize ‘welfare’. Expressing welfare in a serviceable mathematical form would probably overtax the ingenuity of Albert Einstein, but it definitely means more than profits and ‘transfers’. Probably the best description is sustainable prosperity in the widest possible sense – i.e. not just for the oil sector. The rigors of maximizing welfare have undoubtedly been brought to the attention of Major Chavez, and I gained a small insight into these matters when I was attempting to teach development economics in Dakar (Senegal) as an offshoot of my course in mathematical economics; however, as I surmised for many years, the oil states in the Gulf possess the wherewithal to ultimately provide a commendable example. A display of this capacity is sometimes labelled ‘resource nationalism’, and as Edward Morse pointed out (2005), it could entail “much lower oil supplies than would otherwise be available.”

FURTHER ADO ABOUT SOMETHING

In the termination of a not so friendly discussion, I was presumptuously informed by a well-known academic that Saudi Arabia now has 4 large deposits in the initial phase of exploitation. If that were true, which it isn’t, then the present discussion would be uncalled-for. Saudi Arabia is still regarded as the primary exporter of oil to the main oil importing countries, and my contention both here and elsewhere is that a demonstrable willingness on their part to steadily increase output over the foreseeable future is perhaps the most bizarre fantasy ever put into circulation by the International Energy Agency (IEA). Arguably, the most provocative writer on this topic is Matthew Simmons, an investment banker and former advisor to President Bush, whose work implies that the forecasts of the IEA cannot possibly be taken seriously. He maintains that Saudi Arabia (and probably other Gulf states) are either incapable or unwilling to produce and export an amount of oil that could turn the pipe-dreams of the IEA into reality. Best to think of a sustainable output in the vicinity of 9-10 mb/d for that country.

Similarly, in both my lectures and written work, I have claimed that important exporters like Saudi Arabia and Russia will do everything possible to reduce their export of unprocessed oil. In line with the teachings of orthodox development economics, ‘value will be added’ by using much of the crude they lift as inputs for refinery products, and thus petrochemicals. In addition, with continued economic growth in exporting countries, additional oil will be required for domestic consumption activities. A good example is Tartarstan, which is in the Russian Federation. Their output of oil will be held constant, but much of it is destined for a new petrochemical installation. Simple arithmetic then suggests that exports (of crude) from this district will decline.

Here it is interesting to cite an important contribution of Professor Morris Adelman and his colleague Martin B Zimmerman, who more than 30 years ago perceived the handwriting on the wall. They wrote: “…. in the production of petrochemicals, most LDCs are at a severe and permanent disadvantage for lack of know-how, and the high opportunity cost of capital and feedstocks. Other countries, particularly OPEC members, who do not face these obstacles are expanding their petrochemical capacities. This too will drive prices down, lower the profitability of all plants built today, and force losses on many investors. Few can compete with those that get their feedstocks at a fraction of world prices, and are willing to earn low or negative rates of return.”

Facing “low or negative rates of return” is not (and probably never was) an outcome that the new OPEC petrochemical giants anticipate experiencing: they not only will obtain their feedstocks at a low price, but their new plants are state-of-the-art in regard to cost and flexibility. It can also be appreciated that what is said above or elsewhere about petrochemicals applies to refining. Returning to Saudi Arabia, one of the indicators of their confidence is not just a rapid expansion in oil products and petrochemicals investment, but other enterprises specifically designed to provide employment for an expanding population. These plans include four new ‘economic’ cities, power stations, smelters and facilities for exporting large amounts of various of industrial products. Furthermore, as Neil King of the Wall Street Journal pointed out (December 12, 2007), the Saudi industrial “drive” will strain their oil export role.

FINAL STATEMENT

I never tire of reminding my students how Professor Milton Friedman predicted the downfall of OPEC, and the collapse of the oil price. He convinced a number of his fans that he knew what he was talking about, but as things stand at the present time, we will be extremely lucky not to confront a sustainable oil price in the vicinity of $100/b before the end of 2008, which could mean a magnifying of the macroeconomic and share market discomforts that many are already experiencing. Think about it: an oil price of $100/b or perhaps more! This is the kind of phenomenon that starts people talking about the end of the world.

I also suspect that it might be wise to correct those persons who insist that things are different from the way they are described in this presentation because the real value of the dollar has greatly decreased due to inflation and exchange rate changes. For instance, although a declining dollar is annoying for oil exporters in general, their situation is actually not so unfavourable as often alleged. As clarified in my forthcoming paper ‘Economic Theory and the Price of Oil’ (2008), the present (and future) physical transformation of the Gulf states alluded to above would be impossible if the dollar decline was as malicious for oil exporters as often maintained in academia and the business press. The reason is simple: comparing the oil price in l980 with the oil price today – as the pompous Josh in The West Wing attempted to do – is as scientifically meaningless as comparing a rap standard to a Beatles rendition of ‘Hail to the Chief’. The base year for calculating the real price of oil should probably be in the early l990s instead of about the (journalistically convenient) time of the first ‘oil price shock’. Students of the oil market should never doubt that the real price has definitely increased, although supplying an analytical proof might take a little effort.

Last but not least, a short mention of PEAK OIL seems in order. (And here, an important analysis is provided by Mamdouh Salameh (2007).) Peak oil is not about the future – it’s about the past!. It’s about the (generally unspoken) intention – formulated many years ago by the most important countries in OPEC – to reduce the ‘RATE’ at which their oil (and probably also gas) is produced when they get the opportunity. The present high oil price has given them the opportunity. It’s about more money rather than less – that is to say common-garden profit maximization; and for students of financial economics, increasing the value of an option whose underlying is the asset called oil, by extending the exercise date. As might be shown by your favourite teacher of Economics 101, it’s about controlling the left hand side of the global supply curve, which could also mean control of the entire curve. Basically, it’s not about geology but about economics.

REFERENCES

Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory Textbook. London, New York and Singapore: World Scientific.

_____. (1980) The Political Economy of Oil. Lexington and Toronto: D.C. Heath. Henderson, James M. and Richard Quandt (1995). Microeconomic Theory: A Mathematical Approach. New York: McGraw-Hill.

Levitt, Stephen D. and Stephen T. Dubner (2005). Freakonomics. London: Penguin Books.

Morse, Edward L. (2005) ‘Oil prices and new resource nationalism’. Geopolitics of Energy’. (April).

Salameh, Mamdouh G. (2007) ‘Peak Oil: myth or reality’. Dialogue (November).

Copyright © 2002-2006, CyberTech, Inc. - All rights reserved.