The Tyranny of the Immediate

One of the great challenges that has to be faced in any attempt to make sense of history while it’s happening is the misleading impact of short-term trends. While the late housing bubble was still inflating, for example, soaring real estate values made it easy for most people to fool themselves into believing that it made sense to sink their net worth, and then some, into houses priced at even the most delusional levels. They had seen prices march steadily upwards, month after month and year after year, and that experience made it seem likely that the same steady march would continue for the foreseeable future.

The same mistake on an even more grandiose financial scale underlies the implosion of much of the world’s banking system in recent months. The first generation of derivatives, credit default swaps, and equally exotic financial livestock netted huge profits for their original breeders; so did the next generation, and the next, and before long these dubious securities – valued with an optimism usefully summed up in the phrase “mark to make-believe” – accounted for a very large proportion of the paper assets held by banks, hedge funds, and the like. Because the financial community’s recent experience with such things had been so positive, all too few investors glanced further back and saw what happened every time in the past that financial paper unlinked to sources of real wealth had been allowed to breed beyond the carrying capacity of the market.

The difficulty, as I’ve suggested in previous posts, is that historical change happens at a pace much more leisurely than textbook summaries suggest. Most people who didn’t live through the opening years of the last Great Depression leave school with the notion that when the stock market crashed in the fall of 1929, the economy reached a full stop by the time investors stopped plummeting from Wall Street windows. In reality, it took more than three years for the economy to finish contracting, and scenery en route included a dramatic stock market rally in 1930 and some of the best days of rising prices, in percentage terms, that Wall Street has ever seen. At every point along the course of contraction, furthermore, financial pundits drew false conclusions from short-term changes. The resulting headlines have more than a little similarity to the ones that clutter the financial press today.

This habit of reading too much into short-term conditions has shown itself more than once in the recent economic convulsions, and guesses about the future price of oil – a subject of interest to many peak oil researchers – have been particularly affected. Earlier this year, as the price of oil soared to $143 a barrel, a great many people argued that it would keep on climbing to $200 or $250 a barrel in the near future. Now that the price of oil has slumped below $70 a barrel, the tide of opinion has turned, and some pundits are now predicting a continued slump to $50 or even $35 a barrel. These predictions seem quite plausible at the moment they’re uttered, but then so did the idea that shares in dot-com startups would keep on climbing in value all through 2000.

The problem with linear projections of oil prices is that several factors unrelated to ordinary issues of supply and demand dominate the price of petroleum just now. One of the most important comes out of the crucial but rarely remembered fact that, while oil is priced in US dollars, most of the oil in the world these days is produced and used in countries where the US dollar is not the local currency. Since the value of the US dollar has been anything but stable of late, the price of these transactions in dollars has changed dramatically, while the price in any other terms has remained much more stable.

A barrel of oil for which a Japanese refinery pays 7500 yen, say, would cost US$75 if the dollar buys 100 yen and a bit over US$65 a few months later if the dollar rose to 115 yen. Has oil dropped in price? Only on paper, since the refinery’s bank account changes by the same amount each time. Check out exchange rates, and you’ll find that the period when oil spiked to $143 a barrel was also a period when the value of the US dollar dropped steeply against other currencies, while the plunge in the price of oil since then has paralleled a steady rise in the relative value of the dollar.

Even more dramatic, though, has been the effect of commodity speculation on the price of oil. Those economists who still insist that a completely free market will manage production and price with perfect rationality have apparently done their best to ignore the multiple monkey wrenches speculation throws into the market’s machinery. The crucial point to realize is that the results of speculation, unlike most other economic phenomena, are radically asymmetric over time. It’s worth taking a moment to understand how this works.

Consider a poker game in a tavern back room. Like speculation, poker is not a productive economic activity; instead, it is a means of exchange by which money passes from one person to another on the basis of differences in skill and luck. The results of a poker game, however, are symmetric – that is, in each game, the winnings of the winners are equal to the losses of the losers. You’ll never see a poker game in which all the players win and nobody loses, or vice versa.

Yet this is more or less what takes place in the successive phases of a speculative bubble. While the bubble is inflating, nearly everyone wins; the difference between one tulip bulb, internet stock, or condominium and another during the first phase of their respective bubbles was simply how much money you would make from it, not whether you would gain or luse. Once the bubble bursts, by contrast, nearly everyone loses; if you bought tulip bulbs at the peak of the Dutch tulip mania, internet stocks in 2000, or real estate last year, the question a year or two later was not whether you lost money or not, but simply how much of your wealth was gone.

This is what makes unrestrained speculation so serious a threat to the functioning of market societies: it amplifies the extremes of the business cycle out of all proportion. On the way up, it boosts the funds available for investment as well as speculation, and encourages overinvestment in productive capital by fostering unsustainable levels of consumption; on the way down, it slashes the availability of investment funds, helping to drive the vicious circle of contraction and disinvestment that feeds a recession and can turn it into a depression. Still, damaging as these effects are, they are temporary; sooner or later, every boom turns into a bust; sooner or later, every bust bottoms out and yields to the first stirrings of recovery.

This is exactly the dynamic traced by the price of petroleum over the last two years or so. The price spike to $143 a barrel was driven by many factors, including the first stirrings of a decline in the world’s production of conventional petroleum, but speculation played a massive role. For well over a year beforehand, financial pundits had been touting petroleum and other commodities as surefire investment vehicles, and those who got in early often made a great deal of money as oil prices climbed through 2007. This laid the foundations for a dramatic speculative bubble in the first half of 2008. Not that many years before, the idea that oil might break $100 a barrel was unthinkable to most people, and those who argued for it couched the idea in terms of a “superspike” driven by some international crisis like a US assault on Iran; what happened instead was a classic speculative bubble that zoomed far beyond anything the facts would justify, and then inevitably crashed.

That crash brought the price of a barrel of oil down more than 50% from its all-time high. It’s crucial to remember, though, that the bust phase of the speculative boom-and-bust cycle is just as exaggerated as the boom. Generally speaking, speculative busts in the past have tended to drop proportionally as far below the long-term trend line as the preceding boom rose above it, and then revert to the mean. If, as seems likely right now, petroleum is nearing a bottom somewhere around $60 a barrel, the proportional mean between peak and trough – and thus the rough current location of the mean toward which oil prices will tend to revert – is a little above $90 a barrel. Under normal circumstances, this would be the price toward which oil prices would tend to return over the months to come.

The problem, of course, is that these are not normal circumstances. While the US dollar gains in value against other currencies, as mentioned above, the price of oil will dip accordingly; if the dollar begins sliding again, on the other hand, we can expect price increases. Furthermore, not all oil fields are created equal; some of the production brought on line over the last two years or so pays for itself only when oil is well above current prices, and the likelihood that some of these will be shut down or abandoned – to say nothing of the likely impact of the unfolding credit crunch on drilling and production – make a mockery of any attempt at exact prediction.

The governmental response to the credit crunch and the near-implosion of the speculative end of the economy has its own implications, and these also push the situation away from normal. In a truly free market, the bust would have erased most of the capital that had been available for speculation, and destroyed so many businesses that the survivors would be likely to flee the more exotic realms of finance for a generation to come; this is exactly what happened in the 1930s, for instance. In the present case, though, governments around the world have propped up investment banks and speculative markets with huge inflows of cash, preventing the wave of bankruptcies that would normally end a speculative boom as wild as the one just finished. One very likely possibility is that the investment banks will attempt to launch another round of speculative excess in order to improve their balance sheets before the political consensus that supports them comes unglued; if this happens, commodities are a likely target, and could soar upwards again.

Looming over all these factors is the arrival of peak oil. Since 2005, world production of petroleum has been locked into a narrow plateau that not even a 300% increase in prices could breach, and the most believable estimates suggest that by 2010, that plateau will turn into a slow and irrevocable decline. Many of the official figures for oil production lump biofuels and tar sand extractives in with conventional petroleum; since these latter are produced using large amounts of oil and other fossil fuels, there’s a real sense in which some of today’s petroleum production is being counted twice, hiding any early signs of the approaching contraction. The credit crunch and the low price of oil, furthermore have placed additional challenges in the way of the already difficult struggle to replace the world’s rapidly depleting oil fields.

The obvious implication of peak oil is that the mean price of oil is likely to trend upward over time. The less obvious implication is that changes in the mean price may well be hard to extract from the chaotic data provided by an economy in disarray. Thus when peak oil advocates came to believe that the price of oil would soar upwards from $143 a barrel, they were running ahead of the date; when, as now, some of them are predicting a continuing decline in the price of oil for years to come, they are very likely doing the same thing. The tyranny of the immediate makes these short-term phenomena seem much more significant than they are.

My guess, based on historical examples, is that the price of petroleum and other commodities will find a bottom within the next month or two, stay there for a while, and then begin a ragged upward movement as renewed speculation cuts in sometime in the first half of 2009. Radical changes in the relative value of the US dollar could change that forecast, though the trends I’ve outlined might well still be visible if the price of oil is tracked in other currencies; a concerted attempt to reflate the economy by engineering a new commodities boom, that would have an even more dramatic effect, though the impact of rising commodities prices on a crippled economy could be dire enough that the boom might collapse of its own weight in short order. Over the long run, though, investments in energy conservation and less energy-extravagant infrastructure are likely to pay off in a big way – and the long term is what most needs to be kept in mind just now.