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The Oil Market

Economics 331b

1. Basics of oil regulation2. The integrated world oil market

Major Themes1. Standard themes of US oil policy2. The bathtub model of the Oil Market3. Some simple econometrics of the law of

one price4. Implications for Oil Policy

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Policy Themes of the Oil Market1. We should reduce our oil dependence on hostile or

unstable regimes and limit oil imports to secure sources like Mexico.

2. Protecting oil sources is so important as to justify war.3. We can use oil sanctions to penalize unfriendly

regimes.4. We need a carbon tax to reduce oil imports.5. Reducing oil imports will have major macroeconomic

benefits.6. We have to prevent China from gaining oil concessions

in Africa.7. We need to develop oil in wilderness areas to increase

domestic oil.8. We should expand the Strategic Petroleum Reserve to

cover more days of imports.

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The world oil market

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Basic idea of bathtub model

Oil policy can only be considered in the context of world supply and demand. National policies are effective only to the extent that they contribute to total demands or total supplies.

The reason is that the “law of one price” holds for crude oil.

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The “Law of One Price”The Law of One Price (LOOP) is an economic hypothesis

stating that the common-currency price of a standardized commodity should be the same in different markets.

Conditions to hold are (1) homogeneous good, (2) perfect competition, and (2) costless transportation

LOOP is often a justification for efficiency of markets (efficient market hypothesis in finance and classical macroeconomics)

AlgebraHave two markets (1 and 2) and two prices (p1 and p2).They are linked together by arbitrage:

p1(t) = p2(t) + ε(t)Where ε(t) is small and represents generalized transportation

costs (e.g., transport, insurance, brokerage, …).

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Failure of Law of One Price: All Consumer Prices

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3.53.02.5

2.0

1.5

1.0

0.580 81 82 83 84 85 86 87 88 89 90

CPI CanadaCPI FranceCPI ItalyCPI JapanCPI UKCPI GermanyCPI US

John Baffes, “Some Further Evidence on the Law of One Price: The Law of One Price Still Holds,” American Journal of Agricultural Economics, 1991 8

Pretty good fit for wheat prices

LOOP and stock prices

0.0

0.4

0.8

1.2

1.6

2.0

2.4

86 88 90 92 94 96 98 00 02 04 06 08

Canada France ItalyJapan UK GermanyUS

LOOP and house prices US, 1987-2010

67.54 66.48 65.50 66.55 70.53 75.80 81.45 85.81 92.41 102.13 109.85 116.42 126.61 173.08 227.38 200.72 117.13 110.060.00

50.00

100.00

150.00

200.00

250.00

300.00

200150

100

504030

2015

10

51998 2000 2002 2004 2006 2008 2010

Price

($ p

er ba

rrel)

Prices of Crude Oil in 31 Regional Markets WorldwideSource: EIA primarily from Platts. 11

LOOP and the world oil market (n=18,169)

Independent variableRegression coefficient Standard error t statistic Probability

Price of Brent crude (logarithm) 0.999 0.0008 1212.8 0.0000Sulfur content (percent) -0.041 0.0006 -62.4 0.0000API gravity 0.006 0.0001 56.3 0.0000Constant -0.223 0.0051 -43.3 0.0000

Summary statisticsAdjusted R 2 0.988Standard error of the regression 0.068Mean of the dependent variable 3.426Standard deviation of the dependent variable 0.626

12Regression: ln[p1(t)] = α+β ln[pbenchmark(t)] + other things + ε(t)

Speed of adjustment test

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Sector Half life of shock (years)Oil 0.058Real exchange rate 2.269Housing 4.135Lumber 4.538Consumer prices 6.269

Speed of adjustment asks how quickly a market adjusts to disequilibrium.For example: oil v. autos v. houses v. lumber.

This shows the unusual integration of world oil market

Speed of adjustment test: persistence of disequilibrium

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0

0.2

0.4

0.6

0.8

1

1.2

0 20 40 60 80 100 120 140

Pers

isten

ce o

f sho

ck (f

racti

on re

mai

ning

)

Weeks after shock

Oil Real exchange rate

Lumber Housing (Case-Shiller)

So why are we wasting all this time on an esoteric economic theory about spatial arbitrage, blah, blah, blah?

The reason is that whether the LOOP holds for oil FUNDAMENTALLY changes your view of oil policy.

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Policy Themes of the Oil Market1. We should reduce our oil dependence on hostile or unstable

regimes and limit oil imports to secure sources like Mexico.2. Protecting oil sources is so important as to justify war.3. We can use oil sanctions to penalize unfriendly regimes.4. We need a carbon tax to reduce oil imports.5. Reducing oil imports will have major macroeconomic

benefits.6. We have to prevent China from gaining oil concessions in

Africa.7. We need to develop oil in wilderness areas to increase

domestic oil.8. We should expand the Strategic Petroleum Reserve to cover

more days of imports.

These are all wrong: The vulnerabilities are determined by the world oil market and not by our imports.

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Examples1. Secure sources2. Sanctions3. Strategic petroleum reserve4. China winning oil concessions in Sudan5. Inflation and other macro issues.

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Example of insecure sourcesLimit imports to “secure sources” in region A.Limit import from region B.But then region B exports to region C which was

previously importing from region A.Net impact: very small increase in global transportation

costs (perhaps $0.05 per barrel out of $100).

How about sanctions?Same story.

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19

100

10 200

100

USROW

Initial situation

20

100

10 200

100

USROW

Sanction

x

21

100+10

200-10

100+10

USROW

Result

Sanctions and the price of Libyan oil

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0.0

0.2

0.4

0.6

0.8

1.0

1.2

350 360 370 380 390 400 410 420 430 440 450

Libya dummy (1=sanction; 0 = no sanction)Price Libyan crude/ OPEC crude

EEconometrics of sanctions

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Dependent Variable: LOG(price Libyan crude) Method: Least Squares Sample (adjusted): 1 645 Included observations: 645 after adjustments

Variable Coefficient Std. Error t-Statistic Prob. C -9.872807 1.645015 -6.001652 0.0000

Dummy for Libya sanctions 0.001856 0.006153 0.301621 0.7630

LOG(p Saudi crude) 0.968326 0.005930 163.2838 0.0000 YEAR 0.005010 0.000827 6.060142 0.0000

R-squared 0.995664 Mean dependent var 3.485963

Adjusted R-squared 0.995644 S.D. dependent var 0.608497 S.E. of regression 0.040162 Akaike info criterion -3.585632 Sum squared resid 1.033901 Schwarz criterion -3.557915

But this doesn’t apply everywhere…1. Other energy sources (natural gas in Europe)2. To situations of war (World War II in Germany) or

stealing oil resources (Iraq seizing Kuwaiti oil field in 1990).

3. Doesn’t mean we shouldn’t be concerned with oil consumption (for many reasons to be discussed starting next week).

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Appropriate Policies for Oil in the Integrated World Market

Objectives:1. Oil policy can only be rational if externalities are

internalized (pollution, global warming, etc.)2. Given 1, oil prices should be low, stable, and sustainable.

Policies (assuming 1 is met):

3. Encourage production everywhere (no domestic subsidies)4. Discourage consumption everywhere (not just at home),

particularly with respect to subsidies.

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