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                                                                                 Stanford University • June 2006

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                                                                                 About The Author
Lower Oil Price Volatility for                                                   Frank A.Wolak received his

a Smooth Transition to a                                                         Ph.D. and S.M. from Harvard
                                                                                 University. He is a Professor
                                                                                 of Economics at Stanford

Green Energy Future                                                              University, and the Chairman
                                                                                 of the Market Surveillance
                                                                                 Committee of the California
                                                                                 Independent System Operator
By Frank A. Wolak                                                                (ISO), an independent market
                                                                                 monitoring entity for state’s
                                                                                 electricity supply industry. He has been a
    For the past two years, there       that time until the late 1980s, the      visiting scholar at University of California Energy
has been enormous public                price of oil steadily fell, and it has   Institute (UCEI), is a Research Associate of the
                                        fluctuated in the range of $10/bbl       National Bureau of Economic Research (NBER),
outcry over the level of oil and                                                 and a Senior Fellow at SIEPR. Wolak’s fields of
gasoline prices. The price of           to $20/bbl until early 2000.             specialization are industrial organization and
oil has recently risen above $70            Excluding these two periods of       econometric theory. His recent work studies
per barrel and the retail price of      rapid price increases and slower         methods for introducing competition into
                                        price decreases during the post-         formerly regulated infrastructure industries—
gasoline has persistently exceeded                                               telecommunications, electricity, water delivery
$3 per gallon. For both oil and         1973 period, the average real price      and postal delivery services—and on assessing
gasoline, these prices are more         of oil in May 2006 dollars before        the impacts of these competition policies on
than double their values from less      1973 is roughly equal to the             consumer and producer welfare.
than three years ago. However,          average real price during the post-
this percentage increase in             1973 period. The major difference        world oil market by a sometimes
nominal oil and gasoline prices is      between the pattern of prices            successful cartel of the major
not unprecedented.                      during the pre- and post-1973 time       oil producing countries—the
    Figure 1 plots the nominal          periods (even if the period from         Organization of Petroleum
price of West Texas Intermediate        October 1973 to December 1985            Exporting Countries (OPEC).
(WTI) crude oil from January 1946       is excluded from the post-1973           The eleven members of OPEC
to May 2006. It also plots these        period) is the increased volatility      are Algeria, Indonesia, Iran, Iraq,
                                        of real oil prices after 1973.
same prices adjusted to May 2006                                                 Kuwait, Libya, Nigeria, Qatar,
                                        Including the period October 1973
dollars using the consumer price                                                 Saudi Arabia, the United Arab
                                        to December 1985 only increases
index (CPI). There have been two                                                 Emirates and Venezuela.
                                        the post-1973 period real price
periods of comparable percentage                                                     Although OPEC first started
                                        volatility relative to the pre-1973
nominal price increases. The                                                     in 1960 as an association of
                                        real price volatility.
first occurred in the early 1970s                                                producing countries attempting to
when the price of oil rose from                                                  capture a greater share of world
slightly less than $4 per barrel        Determinants of Oil Price                oil market revenues, it wasn’t until
(bbl) to over $10/bbl. The second       Volatility                               the early 1970s that OPEC was
occurred in the late 1970s when             The major factor explaining          able to gain some control over
the price rose from approximately       the increase in price volatility         world oil prices. Following the
$12/bbl to over $30/bbl. Since          after 1973 is the domination of the      nationalization of many of the oil-
                                                                                 continued on inside...
SIEPR policy brief
producing assets in their member       oil is less than $20/bbl, country          The second factor that
countries during the early 1970s,      1 would prefer to produce 2            explains the current run-up in
OPEC was able to have a greater        million bbl/day instead of the 1       real oil prices is the unexpectedly
effect on world oil production and     million bbl/day output level that      rapid increase in the demand
used it to raise world oil prices.     maximizes the joint profits of the     for oil from developing
    The record high real price of      cartel. Country 1 is not unique in     countries, such as China and
oil in 1979 led to a substantial       this example. All countries would      India. According to the U. S.
reduction in the world demand for      prefer to produce more than the        Department of Energy, China
oil and an increase in exploration     cartel output amount if they were      has accounted for approximately
activity. In addition, OPEC faced      confident that the remaining
                                                                              40 percent of world oil demand
the standard problem that plagues      cartel members would produce
                                                                              growth over the past five years.
all cartels of maintaining the         their cartel output amount.
                                                                              To put this in perspective, China’s
reduced output level necessary to          This divergence between each
                                                                              growth in oil demand over the
sustain high prices. A cartel raises   country’s unilateral incentive and
                                                                              past year is equal to slightly more
prices and earns higher profits        what is in the joint interest of all
for its members by producing less      cartel members causes countries        than half of California’s annual
than each member country would         to cheat on their agreed-upon          demand for oil. Although India’s
find unilaterally profit maximizing    cartel output levels. Reduced          demand for oil is substantially
given the cartel output levels of      world demand and greater supply        less than China’s, the growth
the remaining firms.                   from non-OPEC members at               in India’s demand for oil has
    A simple example illustrates       these higher prices also increases     recently increased.
this point. Suppose that the           this incentive to defect because           The final factor allowing
cartel is composed of 10 identical     the cartel member that expands         OPEC to raise world oil prices
firms and at the cartel’s profit-      its output only slightly reduces       is that its share of world oil
maximizing level of output each        market prices.                         production is now above 40
firm produces 1 million barrels            All of these factors make it       percent for the first time since
per day (bbl/day) for a total          extremely difficult for countries to   1980, when the real price of oil
demand of 10 million bbl/day           maintain cartel output levels for a    was almost $100/bbl in March
and market price of $30/bbl.           long period of time. Consequently,     2006 dollars. Controlling a large
However, if each of the remaining      the pattern of prices after 1973 is    share of world oil output implies
nine firms produces 1 million          consistent with temporary periods      that OPEC now has a greater
bbl/day, country 1 would find it       of coordination on the cartel          ability to influence world oil
unilaterally profit maximizing to      output levels and higher prices        prices.
produce 2 million bbl/day. Then,       that trigger greater output from
                                                                                  These high real oil prices will
suppose that this higher level         non-cartel members and reduced
                                                                              trigger reductions in demand and
of supply, 11 million bbl/day as       demand. This results in cheating
                                                                              increases in supply from non-
opposed to 10 million bbl/day,         on the cartel output levels by
                                                                              OPEC producers and competing
causes the price to drop to            some or all cartel members. This
                                                                              energy sources, which are
$25/bbl.                               leads to price reductions and
    Under the cartel solution,         renewed attempts of OPEC to            likely to make it more difficult
country 1 makes $30 million per        coordinate on cartel output levels.    for OPEC to maintain real oil
day, but by producing 2 million        These movements between                prices at their current levels. The
bbl/day it earns $50 million per       varying degrees of successful and      increased incentives for OPEC
day, assuming in both cases            unsuccessful coordination on           members to cheat on their cartel
that all other firms continue to       cartel output levels have been the     production levels could trigger
produce the cartel output level        major cause of the price volatility    a percentage decline in real oil
of 1 million bbl/day. As long as       that has occurred in the world oil     prices similar to the one that
the variable cost of producing         market after 1973.                     occurred from 1980 to 1985.
Why Limit Oil Price Volatility         Moreover, the many possible             likely that these energy sources
    The unpredictability of            biomass inputs to produce               would be developed if investors
future oil prices has a number         cellulosic ethanol imply that a         were certain that real oil prices
of negative consequences. First,       substantial investment in this          would stay above $50/bbl in
there are many environmentally         technology could allow it to            May 2006 dollars. Thus, a key
friendly and financially viable        replace a significant fraction          factor in a smooth transmission
competitors to oil if the real         of U.S. gasoline consumption.           from an oil-based economy to
price of oil was known to be           Unfortunately, the capital costs        a renewable energy economy is
greater than $70/bbl into the          of a facility that would produce        oil price stability. By limiting oil
distant future. These competing        about 25 million gallons of             price volatility into the distant
technologies require substantial       ethanol per year are easily more        future, the best possible economic
                                       than $100 million.                      case for these alternative energy
up-front investments and
                                           Consequently, unless potential      sources can be made.
longtime lags between the
investment decision and actual         investors are very confident that
production of energy. These            oil prices will remain at or above      How to Limit Oil Price
facilities are unlikely to be          current levels, it is unlikely that     Volatility
built unless investors expect          they will sink this amount of               The usual way to limit short-
to earn a reasonable return on         money into a cellulosic ethanol         term price volatility is to develop
their investment. Examples of          facility. Similar logic applies         an active forward market for the
environmentally-friendly energy        to solar- and wind-powered              product. Instead of purchasing
sources that are economic if           electricity generation facilities.      gasoline in the short-term market
current real oil prices persist into   Without government subsidies            when it is needed, consumers
the distant future include solar       to invest in existing versions of       should instead purchase in
power, wind power and cellulosic       these technologies, it is unlikely      advance their expected demand
ethanol.                               that investors will construct these     for gasoline for the next year
    Virtually all ethanol currently    renewable energy facilities unless      or two. This would significantly
                                       they are confident that oil prices      limit their exposure to short-term
produced in the United States
                                       will remain at or above current         gasoline price fluctuations.
comes from corn. There is
                                       levels into the distant future.             An example of how forward-
considerable debate whether more
                                           A worst-case scenario for           market purchases limit a
energy is required to produce
                                                                               consumer’s exposure to short-
corn ethanol than it contains          these technologies is if the real
                                                                               term price volatility comes from
and whether greenhouse gas             price of oil fell back to $20/bbl,
                                                                               the airline industry. A consumer
emissions are, in fact, reduced        as it did during the middle of
                                                                               always has the option to show
by producing ethanol from corn.        the 1980s. Investors would be
                                                                               up at the airport on the day he
In contrast, cellulosic ethanol is     forced to shut down their facilities
                                                                               would like to fly and purchase
produced from agricultural and         unless they were given production       the ticket at that time. If there
forestry residues, municipal solid     subsidies. At $20/bbl oil, the price    are plenty of available seats on
wastes, and even fast-growing          of gasoline would be far too low        the flight, the consumer may be
plants cultivated specifically for     for ethanol to compete with. The        able to purchase the ticket at a
this purpose.                          price of fuel oil and diesel fuel       very low price. But if the flight is
    Producing ethanol from             would be too low for solar power        over-booked, the consumer may
cellulosic biomass uses a              and wind power to compete with          be unable to get on the flight at
significantly more complex and         oil-fired electricity generation on a   any price, unless he can convince
expensive process than the             subsidy-free basis.                     another passenger to give up his
one used to produce ethanol                Therefore, a necessary              ticket. Because consumers would
from corn. However, this               condition for the development           prefer not to bear this short-
process results in dramatically        of alternative energy sources is        term price risk, they purchase
less greenhouse gas emissions          greater certainty about future          their tickets in advance of the
than ethanol made from corn.           oil prices. In fact, it seems           day they would like to fly. This
hedges them against any short-         purchases in the forward market,       customers the option to buy such
term fluctuations in the price of      oil refineries will have far more      contracts. This company, First
the flight. However, this does         certain demands for oil into the       Fuel Banks, allows customers to
not guarantee the consumer             distant future.                        purchase a pre-specified number
the lowest possible price for the          Large forward purchases of         of gallons of gasoline at a fixed
flight, as anyone who has priced       refinery output by consumers           price and then pump this gasoline
the same itinerary a few days          of these products will also            as needed. Other retailers around
after purchasing it can attest.        cause refineries to purchase the       the United States are planning to
Nevertheless, the customer has         necessary oil in the forward           offer similar products. One retailer
locked in the fare for the itinerary   market to meet these fixed-            plans to offer a product similar
and guaranteed a seat on the           price future output obligations.       to the one offered by First Fuel
flight.                                This process will stimulate the        Banks, which allows the customer
    The fact that customers hedge      development of an active forward       to lock in the price for a fixed
this price risk also benefits the      market for oil.                        quantity of gasoline. Retailers are
airline. Because the airline knows         If a substantial fraction of oil   also offering price-spike insurance
how many customers are flying          consumption is purchased in the        where a customer might pay 20
from one city to another on given      forward market far in advance          cents per gallon to cap the price
flight, it is better able to plan      of delivery, there will greater        they will pay for a fixed period
which airplanes to fly on which        opportunities for alternative          of time into the future at today’s
routes. This reduces the operating     energy sources to compete against      price of gasoline.
cost of the airline and, if there is   oil. For example, if a cellulosic          If consumers of refinery
sufficient competition between         ethanol supplier can sell a            products purchase a substantial
airlines on the route, a portion       forward contract for ethanol to        amount of their expected
of these cost savings should be        final consumers for several years      consumption far in advance of
passed on to consumers in the          into the future, this can provide      when they need it, this will limit
form of lower fares.                   the needed revenue certainty to        their exposure to short-term price
    These forward sales to final       finance the investment needed          variability. If little oil is purchased
consumers provide a strong             to construct a new production          on the short-term market, OPEC
incentive for the airlines to hedge    facility.                              will have less incentive to raise
their input price risk. All airlines       It is unlikely that consumers      short-term prices, because less of
are active participants in the         will sign long-term supply             its output will be sold at short-
forward market for jet fuel. The       agreements for a long enough           term prices. To understand this
profitability of U.S. airlines in      time into the future to provide        incentive, suppose a large supplier
recent years is highly correlated      the revenue to fund the full           expects to sell 100 million barrels
with how well they hedged their        construction cost of the cellulosic    of oil next year. If this supplier
short-term jet fuel price risk.        ethanol facility or solar- or wind-    has already sold 90 million barrels
    Applying this logic to the         powered electricity generation         in a fixed-price forward contract,
case of gasoline implies that          facility. However, forward             then it has little incentive to take
consumers should purchase their        contracts of even one to two           actions to raise short-term prices
gasoline demand in advance             years will increase revenue            because it is a net buyer of oil
of the date that they plan to          certainty, which will increase the     until it meets its forward market
consume it. For example, each          likelihood that these facilities are   obligations of 90 million barrels.
year a consumer could purchase         constructed.                           If this supplier eventually sells
a large portion of his expected                                               100 million barrels, it will earn
annual consumption at a fixed          Fuel Banks for Gasoline                the short-term price on only 10
price. This limits his exposure            Forward contracts for gasoline     million barrels. Any change in the
to short-term price volatility. If     may sound far-fetched, but they        short-term price that this supplier
the customers for other refinery       already exist in parts of the          is able to implement will only
products, such as jet fuel and         United States. A small chain of gas    apply to 10 million barrels, rather
fuel oil, also make substantial        stations in St. Cloud, Minn., offers   than 100 million barrels. Forward
                                                                                             Stanford University • June 2006

sales of 90 million barrels implies     purchases in the forward market                         are not technological. The
that this supplier receives one-        will be at lower prices than the                        Internet represents the ideal mode
tenth (=10/100) the pay-off from        short-term price on the delivery                        for selling and administering
increasing short-term prices            dates of the contracts. However,                        this market. One can very
relative to the case that it sold all   the longer the duration of these                        easily imagine going online
100 million barrels at the short-       fixed-price forward contracts,                          to purchase and sell forward
term price.                             the greater the reduction in                            contracts for gasoline and other
    Evidence that forward-market        the volatility of the revenues to                       refinery products with very low
obligations limit the incentive of      oil producers and suppliers of                          transactions costs.
suppliers to take actions to raise      alternative energy sources. Longer                          U.S. consumers and politicians
short-term prices comes from            duration contracts yield a revenue                      can limit the ability of OPEC
wholesale electricity markets,          stream that is more conducive to                        to control world oil prices.
where suppliers typically sign          financing investments in more                           Purchase energy far in advance of
fixed-price long-term contracts         environmentally friendly energy                         delivery. Federal, state and local
with electricity retailers for a        sources. In addition, larger market                     governments and large private
virtually all of their final demand.    shares for these alternative energy                     organizations can also help by
These forward contracts limit the       sources reduce the ability of                           purchasing their expected energy
exposure of electricity retailers       OPEC to move market prices                              needs at least one year into the
to short-term wholesale price           through its output decisions.                           future in the forward market.
fluctuations. They also provide             Although the development                            These actions will give clean
strong incentives for the suppliers     of an active forward market                             energy sources their best chance
to meet their fixed-price forward-      for gasoline and other refinery                         to compete and will limit the
market obligations in a least-cost      products will take some time, the                       ability and incentive of OPEC to
manner, because they are net            barriers to developing this market                      raise short-term oil prices.
buyers of electricity from the
short-term market until they
produce and/or purchase their
forward-market obligations from         Price in Dollars
the short-term market.                     per Barrel
    If a substantial amount of
refinery product purchases are                              Nominal Prices
made under long-term contractual            90
arrangements, this will provide                             Prices in May 2006 Dollars
two sources of benefits to final            80
consumers. The first benefit will
come from greater opportunities
for suppliers of alternative fuel           60
sources to compete with fossil fuel
suppliers to serve final consumers.         50
A more certain future revenue
stream will increase the likelihood         40
that the alternative energy                 30
suppliers construct new facilities
to compete against existing fossil          20
fuel sources to provide electricity
and transportation fuels. A second          10
benefit will come from the reduced
incentive of OPEC to take actions
                                            JAN 1940       JAN 1950      JAN 1960        JAN 1970   JAN 1980   JAN 1990   JAN 2000   JAN 2010
to raise short-term oil prices.
    It is important to emphasize
that there is no guarantee that         Figure 1: Nominal and Constant Dollar (May 2006) Price of Oil
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