Robert Kaufmann Explains Petroleum Pricing

Earlier this week I was invited to listen in on a phone conference given by academic economist Robert Kaufmann on the price oil. I've certainly provided my own take on the subject in this publication, but I'm scarcely infallible, and, in any case, my real focus is alternative fuels not conventional crude. So I was eager to listen to someone who not only has impressive professional credentials but who has made something of a career of studying oil prices, with publications in this area extending back into the early nineties.

Kaufmann is Professor, Department of Geography and the Center for Energy and Environmental Studies at Boston University. His academic specialty is econometrics.

Kaufmann spoke for ninety minutes, and his discussion ranged over many related topics—so many that it's a little hard to summarize his opinions. I can, however, enumerate his most important points.

Kaufmann produced a wealth of historical data, and described three models for petroleum pricing, each of which was dominant for a certain period of time. Each successive model had long term effects upon price levels and price volatility, and set expectations among petroleum consumers and buyers as to what constituted normalcy in the market.

According to Kaufmann, world petroleum markets through the nineteen twenties were essentially laissez faire with much price volatility. Particularly in the United States, oil producers wanted more stable pricing given the risk and expense of developing oil fields and were dissatisfied with a completely unregulated market. They wanted change, and they largely achieved their objective through Federal legislation that allowed the individual states to set production quotas which were enforceable under the law. The Texas Railroad Commission, which set prices in the Lone Star State, was particularly prominent during this era due to the disproportionate amount of oil pumped in Texas.

State regulated pricing continued for as long as the U.S. retained dominance in production, that is, until OPEC began to assert itself in the early seventies. With the rise of OPEC, cartel pricing migrated from U.S. to the Middle East and the states lacked the power to move the market subsequently.

According to Kaufmann, the world oil markets have once again become highly competitive with the eclipse of OPEC and its inability to enforce rigid market discipline. Consequently, wild price fluctuations have again become the norm. Nevertheless, Kaufmann does not see the resurgence of boom and bust business cycles as boding well for the consumer. While he believes that current pricing is inflated relative to the supply and demand balance, he does not foresee a radical collapse in oil prices such as occurred in the middle eighties.

"The biggest factor in eighties pricing was the move on the part of electrical utilities away from oil and toward coal, natural gas, and nuclear. They were using a lot of oil previously. When they abandoned oil for energy security reasons, the demand was suddenly reduced."

Kaufmann does not see any similar factor that would drive demand collapse today, in fact, he sees demand ramping steadily upward. He does not, unfortunately, see commensurate increases in production.

Before I consider Kaufmann's position on future oil production, I should mention his views on the effects of rampant speculation in oil futures, which many are blaming for the record prices we're seeing currently. Kaufmann has created an economic model for price increases based upon a multitude of inputs, and which assumes a relatively open market with little effective price control by suppliers, an assumption he seemed to discount at another point in his lecture. Kaufmann asserts that oil prices have followed the model almost perfectly throughout this decade up until 2007. At that point, just as speculative activity began to increase markedly, so did prices. According to his model, speculation is the factor that would appear best to explain the sudden very steep upward trend over the past eighteen months or so.

Of course, oil prices have been increasing fairly rapidly throughout most of the decade, a fact which Kaufmann acknowledges, and he avowed that the relentless upward trend would have manifested itself without any increase in futures orders. He believes that speculative hedging probably accounts for about thirty dollars per barrel of current pricing. Which still leaves us with record high prices. Incidentally, CIBC World Market, Inc., a consultancy connected with a major investment bank, also estimates a speculation tariff in the $30 range.

Kaufmann thinks that the oil bulls will inevitably be followed by bears, and that prices will eventually drop considerably, but he doesn't see a decline below $70 per barrel as at all likely. And he doesn't see the decline having any permanence.

Why not? Supply, Kaufmann suggested.

Kaufmann went on to explain why offshore drilling and opening ANWR were likely to have almost no effect on pricing. "The U.S. oil resource base is really depleted. The oil companies squandered enormous amounts of money in an attempt to restart the American oil industry during the seventies and eighties, and they couldn't arrest the decline in production regardless of what they did. Investment in new developments has been going steadily down for a long time. The oil companies have made their decisions as to the prospects for future production here."

Kaufmann further stated that even very large oil finds on American soil would make little difference so far as consumers were concerned because oil companies would sell at world prices. "They're not going to give American consumers a break," Kaufmann predicted. "Why should they?"

Tangentially, this brings up another issue, one having nothing to do with U.S. oil supplies but with remaining supplies in the Middle East. The U.S. currently controls the country having the second largest proven reserves, namely Iraq. If the U.S. can topple the government of Iran and move in there as well it will also command the third largest reserves—a very happy and serendipitous consequence for a policy initiative aimed solely at spreading democracy throughout the Middle East. At the very least, the command of these vast underdeveloped resources, could restore some swing capacity, assuming that U.S. could secure production facilities, something it has not been able to do thus far in Iraq. But if U.S. oil firms were able to obtain very favorable production sharing agreements from the governments of those countries under whatever conditions of duress the U.S. might impose, would then the independent oil firms be willing to provide special favored nations pricing for American motorists? But then perhaps one shouldn't even entertain such thoughts. Down that path lies madness. In any case, Kaufmann wisely forbore from exploring such dangerous topics.

So what about OPEC, and, in particular, Saudi Arabia? No dice, Kaufmann indicated. Increasing production to meet demand would result in a net loss of revenue for OPEC because prices would fall quickly, and the increased sales at lower prices would not be sufficient to maintain current revenue flows.

Kaufmann went on to consider the issue of future declines in production, the peak oil controversy, and acknowledged that eventually a peak must be reached, though without predicting a date. As readers of this journal know, some authorities believe the peak of production has already occurred or is imminent, but Kaufmann only presented those projections which had the event taking place years or decades in the future—in other words, the more optimistic scenarios. He did, however, briefly visit one worst case scenario. "If Saudi Arabia has no significant excess capacity now, we're in a terrible situation I would say."

But that is exactly the position of Matthew Simmonds, the Houston investment banker and oil futures expert who wrote "Twilight in the Desert". Simmonds believes that the Saudis have exaggerated their reserves and cannot pump much more oil than they're already producing. He's saying that the worst case scenario is precisely what we're facing.

Kaufmann did not consider unconventional resources such as ultra-deep oil, shale oil, and coal-to-liquids except to say that development would be a lengthy process if it is undertaken. He had even less to say about biofuels. He concluded by observing that U.S. and the world are probably facing knotty economic problems.

Here I cannot refrain from mentioning that I was making similar dire forecasts back in 2002. The usual response of my listeners, who were mostly executives in the energy publishing business, was that I was demented. It's kind of odd because I don't feel much if any vindication today. To tell the truth, I wish I'd been wrong.