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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
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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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