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An Economics Lesson

Don Fullerton's reaction to the peak oil scenario is one of generalized skepticism

Posted: September 1, 2005

"The bottom line is that I trust the market," says Fullerton. If an economic/energy disaster was impending, Fullerton says, the price of oil would already reflect that. To believe the severity of the crisis described by peak oil analysts, one has to believe that they have the truth and that all of the thousands of analysts working for the oil companies, government, and Wall Street traders, most of whom surely have read the books in the peak oil subgenre, do not.

Past that general skepticism, or trust in the market, that Fullerton describes, there is a rule that he teaches his economics undergraduates called the Hotelling Rule (after Harold Hotelling who discovered it in 1931). It states that the rate of price increases for a commodity is driven by the interest rate during that period.

If the interest rate is 5 percent, then there is every reason to expect that oil will rise at 5 percent (over and above inflation). This simply reflects the fact that if it was projected to rise at more than that, it would be smart business to just buy it up in large quantities, store it, and sell it in the future at a rate greater than the interest rate. For this reason, he doubts that the peak oil crowd even believes its own scenario. If they did, then they should keep the information to themselves instead of writing books and creating Web sites, and instead buy up oil for future sale.

If the price of oil were expected to be, say $100/barrel in 2008, one could back down the Hotelling curve to the present and estimate that it would be much higher than it is now. What are oil futures now? For the year 2011, delivery contracts are being written for just over $46/barrel, lower than the current price. If cheap oil is about to run out, clearly people who buy and sell it around the clock haven’t gotten the memo.

Says Fullerton, "All of the available information with all of the uncertainties and all of the available technology and information about what the reserves are and how much oil is really under the Alaska wildlife refuge ... is already in their expectations, and they’re already using those facts to buy oil futures, or buy or sell stock in oil companies. All of that is already reflected in the current market price.

"Whatever information they have, chances are everybody in the oil business has already read that stuff, and they think it’s a crock. It would be highly unlikely if these guys were right, and everybody else was wrong." Fullerton points out that the futures price is absolutely connected to the current price, and one can’t have the futures price go way up without the current price moving.

The caveat that Fullerton adds is that there are always surprises. Only trendlines in the future are smooth. Trendlines of the past are invariably jagged. There may be another war that sends oil prices up, and there may be new discoveries that send it down. The oil shocks of the 1970s, in which oil climbed 400 percent, were a reaction to a surprise. The market had not fully realized that political events in the Middle East could have such a profound effect on energy prices. Fullerton says that a stock market crash would be the first irrefutable sign that things were seriously amiss. Again, this is owing to the collective intelligence of all of the analysts and investors who study the future of commodities around the clock.

Asked if there is anything that affects the overall world economy more than the price of oil, Fullerton answers no. "That growing gap between oil supply and demand is real," says Tinker. "We’re going to have to fill it with other stuff. If we’re not very forward-looking about how we do that, price could continue to go up, and economies can get hurt, because economies depend on energy, period. I think we should all expect to pay more for energy now, and we should pay more. It’s pretty precious. We should conserve and improve our efficiencies. We just have to do that. There’s no reason to drive 15 miles-per-gallon cars."

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