Friday, August 26, 2005

Why you don't need to know anything about oil itself to take Tierney's side in the bet against $200-a-barrel oil.

NY Times columnist John Tierney has made a real-money wager against energy industry investment banker Matthew Simmons and the latter's claim that oil will cost $200 a barrel (in today's money, inflation adjusted) in 2010.

Simmons says empirical analysis shows oil resources are depleting and supplies are about to fall -- especially in Saudi Arabia -- in a way that must drive price starkly upward, something the players in the oil market haven't yet recognized.

Tierney invokes Julian Simon's case that the price of such natural resources always declines in the long run (his bet openly echoes Simon's famous 1980 winning wager on future commodity prices against famed eco-doomster Paul Ehrlich).

But those two positions apart, there's a simple yet powerful argument on Tierney's side of the bet that Tierney himself doesn't make. That is: if you know something will be worth $200 five years from now, and you are a greedy sort of fellow, you don't give it away for $65 today.

Oil companies are greedy. They have a big financial incentive to know more than anybody else about the state of the world's oil reserves. And clearly they don't believe those reserves will be worth anything like $200 a barrel in 2010, or they wouldn't be giving away as much as possible at $65, and be ramping up fast to sell even more. They'd instead be buying and holding oil and reserves and thus be pushing the price towards $200 today, making an automatic profit on anything they bought for less.*

Simmons answers that the oil companies don't know about the coming fall of Saudi production. He says the Saudis keep the status of their oil fields secret, but that he has made an investigative study of their status that gives him better information than the industry as a whole is using -- so he knows better.

Now the logic of this is questionable on its face. The oil companies have a huge financial incentive to understand the status of the Saudi oil fields, so why wouldn't they make the same kinds of investigative studies that Simmons has? If they have, why are they less competent at doing so than he is?

But put those questions aside ... all we need recognize is this: the Saudis certainly know the status of the Saudi oil fields better than Simmons does. And do the Saudis have a reputation for being major donors of commercial charity?

If the Saudis believed their oil was going to be worth $200 in 2010, would they be pumping flat out to sell as much as they can at only $65 today, and be in the process of ramping up production by 20% in the immediate future to sell more?

Unless they've taken to literally giving money -- and their nation's sole source of future wealth -- away, and in a very big way, it seems unlikely.

Thus we can conclude from their actions that the Saudis don't believe their production is about to falter, or they'd be nurturing their shrinking but appreciating-in-value resources -- rather than be selling them off at an accelerating rate at a 65% discount.

So the Saudis are on Tierney's side of the bet regarding Saudi production -- and that's good enough for me.**

UPDATE: The Simmons side of the bet gets new published support.

* This is why the current market price of an item generally is the best first guess of its future price on the basis of currently available knowledge. For if it is clear to even a minority of market participants that the price of the item will be much higher or lower in the future than now, they can make a small (or large) fortune for themselves by bidding it to that price right now.

Buy low now to sell high later. Buy fast, before competitors beat you to the opportunity. And buy as much as you can to maximize your profit. The buying drives the price up now, rather than later. (Or, conversely, sell high now to avoid taking a loss... )

This doesn't mean that the current price is an accurate prediction of future price, of course, because the unexpected happens every day. Economies unexpectedly surge and prices rise ... falter and prices fall (remember that oil was under $10 only seven years ago) ... politicians act ... new technologies develop ... industries reorganize ... and all kinds of other things happen, all in ways not seen five years previously. So prices always change.

The test of current price as generally being the best first guess of future price is not that it is correct, but that the error in it is equally likely to be high or low.

** There is some controversy in progress on the excellent Econbrowser site as to whether this bet is just a publicity ploy by Tierney and/or Simmons, since neither is putting up "real money" in light of what he could afford.

Well, of course it is a publicity ploy, by both of them. So what? The original Julian Simon bet was a publicity ploy too (only $1,000) and it worked. A good 25 years later people still remember it -- and are imitating it. And it's conveyed his ideas to far more people than a dozen serious academic papers would have.