The New Gold Rush

This post was written by HEC-Montréal professor Simon van Norden

With changes to environmental review processes, I get the feeling that the Harper government is keen to speed up development of the Oilsands. That’s not particularly odd. Oil prices tripled and Canada is sitting on the second largest reserves in the world; the Canadian dollar now rises and falls with the price of oil. Development of this resource has the potential to have an important effect on Canadian GDP for many years.

And the Oilsands are not alone; resource developments are in play all over. The Québec government has put out a long-term strategy («le Plan Nord») centered on resource development (esp. Mining and Hydro) in the province’s North.  Republicans in the US relentlessly continue to promote domestic oil production. Mining exploration and development is active all over all over the globe. All this looks like a logical response to the boom in natural resource prices that started before the last recession and, with growing demands from industrializing nations in Asia and elsewhere, is expected to continue.

So let me try to argue that speeding up resource production in response could be a very bad idea. Let me try to argue that we should think hard about doing exactly the opposite, even if it lowers GDP growth, because delay may make us wealthier.

Just to be clear, I’m going to ignore any possible arguments about environmental impacts, native land claims or social issues. I’ll ignore market failures and labour shortages, transport bottlenecks, etc. for now (I’ll come back to that at the end) so I can focus narrowly on the economics of resource extraction in a simple world with perfect markets. I’ll use the Oilsands as an example, but the argument applies generally to non-renewable resources: oil, gas, mining, forestry (in Canada, we don’t farm trees – we mine them) and forget about hydro power and agriculture for today. I also want to focus on resource extraction: exploration that adds to our known stock of reserves seems like good thing, as do new technologies that make extraction more efficient.

For argument’s sake, suppose we have a pipe in the ground that spews oil and we have a valve that controls the flow rate. (If you prefer, you can suppose we have gold bars buried in our basement that we can dig up as wanted.) The more we open the valve, the more oil we produce, the more we increase real GDP.  Is opening that valve wide a good idea? Could it be a very bad idea?

I think it depends on our wealth. In this case our wealth depends on the profit stream that our well can produce. Because we’ve got a non-renewable resource, opening the valve wider means we’re producing more barrels of oil today, but fewer in future. It seems to me that we really want to be asking the question “Would we prefer to pump oil today or tomorrow?”

The advantage of producing oil now is that we can earn interest (i) on the revenue it generates. However, it also means that we get today’s price of oil for our barrel instead of tomorrow’s. If that oil price is expected to grow at rate g (g<>0), then delaying production by one period costs us roughly i-g. The higher the interest rate, the more delaying our oil revenues is costly. The higher the expected growth rate of oil prices, the better it is to wait and pump our oil in the future to get a higher price for it. So the key question should be, is i<>g?

At this point, many economists invoke Hoteling’s Rule. Harold Hoteling argued back in the 1930s that non-renewable resources should be produced at the rate where their expected price increase g equals the rate of interest i. That makes a lot of sense if you’re looking at the world market and you want to understand how the market should clear. That’s not the question I’m asking. I’m assuming that Canada is small relative to world markets; we take the market price as given. (Probably a bad assumption for natural gas, better for oil and good for gold.) For that matter, I think it’s probably a bad idea to assume that all countries face the same i and g; interest rates have not moved similarly across major economies in recent years, and expected changes in real exchange rates mean that g isn’t necessarily the same. So, as I said above, I think the key question should be, is i<>g?

I’m not sure what the answer to that question is. Consider oil: if I’m looking long-term, the govt.’s 2010 survey of long-term oil-price forecasts showed the average outlook was for just over 1% growth, with more bullish forecasts going up to 2.3% and bearish ones around -1.2% (all in real terms.) Meanwhile, the Bank of Canada tells me that the yield on long-term government real-return bonds is about 0.5%. On that basis, some could argue that we should shut the value for now. I’m not sure that’s right because I think the right interest rate should be higher than that. Our long-run forecasts of oil prices are very uncertain, so I think we need to add a risk-premium to that govt. bond yield.

And that’s where I think the debate the needs to be. How bullish are we about the long-term prospects for oil (or gold, etc.) prices? How uncertain are we? What kind of premium should we be using to adjust for that risk? The more bullish you are on oil for the long-term, the more likely that you should want to delay production. The more uncertain or risk-averse you are, the more you should want to produce immediately. That same logic applies to gold mines, forestry developments and any other non-renewable resource.

Has anyone heard this debate? Me neither. I don’t think we’ve had to think seriously about this trade-off for a long time because it seemed pretty clear that i>g. But both seem to have shifted in recent years. Most have raised their estimates of g as demand pressures from industrializing BRICs made themselves felt. Just after this took place, the financial crisis caused a profound shift in real interest rates, dropping rates in favoured countries (including Canada) to new lows. The result, as I think I’m made clear, is that there can be doubt was to whether we should favour current production or prefer to “save” our resources for a better day.

Now, to make my argument simple, I’ve ignored some real-world factors that may complicate things. Perhaps most importantly, I’ve assumed that anything we don’t produce today we can produce tomorrow; the implicit trade-off is 1-for-1. If it isn’t, that skews our decision. If we think current production is less efficient than future production (due to supply bottlenecks or expected technology improvements), that makes delaying or smoothing production more attractive. If we instead expect that the resource will decay if we wait (think of trees killed by pine beetles), we may prefer to produce now. I’ve also ignored demand elasticity by assuming that g isn’t affected by our production choices. Where it is (Alberta heavy oil might be this year’s poster child for this problem), that gives an additional incentive to shift production over time to avoid glutting the market.

At this point, someone is bound to argue that a competitive and free market will take into account all these factors and guide us to the wealth-maximizing solution. I can think of three factors that might prevent that.

1. If investors are overly concerned with short-term corporate performance rather than long-term wealth creation, managers will respond with too much production in the short-term.
2. If the supply bottlenecks or demand elasticity factors I mentioned above are important, they operate at the industry level.  Perfectly competitive firms will ignore such factors as beyond their control, causing too much production in the short-term.
3. Our politicians understand that we don’t vote on the basis of wealth creation; we’re more easily swayed by GDP growth and employment growth. I think Alberta politicians who are bullish on oil long-term and would therefore advocate a “go-slow” approach to the resource sector would be buried at the polls. I think much the same would happen in pretty much any democracy I can think of.  That gives politicians a strong incentive to encourage short-term expansion rather than long-term wealth creation. Usually that’s not a big difference; non-renewable resources may be an exception. 

 

This post was written by HEC-Montréal professor Simon van Norden

Comments

[Simon van Norden]

I should say thanks to Nick, Stephen and an anonymous colleague for their helpful suggestions in writing this, but the opinions (and mistakes!) here are mine.

[Bob Smith]

Interesting post,I'm pursuaded.

But it leads to some unusual results. If one believes that environmentalists will succeed and governments will impose a carbon tax or regulate the sale of oils from oil sands (for example), which should drive down g, you should want to pump it all out now. Greenpeace should take heart, that the Conservative government wants to increase the production of oil now is evidence that Greenpeace is winning. (Maybe)

[rsj]

I think because you can substitute away from oil as an input, that the long run price change of oil will always be less than the long run growth rate of the economy.

Historically, commodities did not increase with CPI let alone with GDP.

Look, for instance, at whale oil:
http://3.bp.blogspot.com/_8UVGnCIfOVk/TUdTVLX1kaI/AAAAAAAAAho/tHUcq8MRqig/s1600/whale1.bmp

Here is a study from your Commodity Sister Australia showing a clear downward trend in commodities when deflated by the GDP deflator:

http://www.rba.gov.au/publications/bulletin/2007/apr/pdf/bu-0407-1.pdf

The problem here is really two-fold.

First, the number of commodities is virtually infinite and you can find ways of substituting away from the use of any particular commodity.

Second, commodity prices are such an important input into CPI that you are not going to have a persistent increase (in terms of CAGR) in commodity prices that is greater than the increase in CPI.

So the long run real rate of return of commodity prices as a basket is generally less than or equal to zero.

Any particular commodity can shoot up in price until replacements are found, but once replacements are found, the market demand for the obsolete commodity starts to fall quickly and you have the whale oil effect.

[Michaelargast]

As a resident of BC, I've had very similar thoughts for sometime about the potential oil held in offshore deposits. Assuming prices rise faster than inflation, and environmental technologies improve over time, it makes sense to delay significantly in order to benefit from future prices and improved technologies.

Of course, none of this factors in externalities (as you state in the third paragraph, loosely). Let me throw out an argument for short term rises in price (BRIC demand, etc) followed by long term dramatic falling in prices. Oil, as we know, has no value on its own - the value is as an embodied, dense form of energy with the rare exception of chemical processes/manufacturing etc (ie, use of oil in making of other goods like plastics). In the short term, it has network advantages over other energy sources (natural gas, etc) but in the long term, any significant rise in the price of oil creates significant competitive development in alternative energy sources (natural gas, electric car development, solar for heating/cooling, etc). In the long run, this puts significant downward pressure on demand and supposedly pricing. So while it is feasible in the short run for oil prices to outgrow inflation, it is infeasible in the long run (similar to basic micro/macroeconomic principles that state a given industry over time should have profits similar to inflation/interest rates) given that there are competitive alternatives. The network effect (distribution, gas stations, standardization) has created a short term barrier to entry but long term that is unsustainable.

The only potential alternative I can see is if we literally come close to running out of oil and it becomes a precious commodity (similar to diamonds/etc) with critical needs, but no alternatives (similar to rare earth metals today).

[Simon van Norden]

I think the relevant question for those of you who really don't want to believe in long-run commodity price increases (and I'm not going to open that can of worms today) is just how much you think should be invested in development of resources (in the form of pipelines, housing, ports, etc.) whose value you expect to fall inexorably. (Any of you remember NE BC coal?)

[rsj]

Simon,

Yes, that is the normal state of affairs. IIRC, the capital stock depreciates at about 10% per annum, and each industry has its own guidelines for dealing with things like future obsolescense or a future price collapse in the products that they sell. They take these things into account before pulling the trigger on investment.

[Frances Woolley]

Simon, good for you for writing this. One thing that I find particularly bothersome about the tar sands is that the value of the land and watersheds that are being degraded by the development will increase over time, as food resources become increasingly scarce.

Who would have thought when we were happily filling party balloons with helium back in the day that helium shortages would become a concern within our lifetimes?

[Ryan Cousineau]

I have to throw my lot in with those who think this argument pays very little attention to downward pressure on resource prices. Indeed, I'm much more confident of the existence of upside limits on the price of oil (due to substitutes ranging from CNG to batteries to car pools) than I am of limits on its down side (due to substitutes...).

As for the right rate of investment in depreciating assets, I leave that to those brave enough to invest.

The example of the helium shortage is an apt one: it turns out that most of the helium consumption was highly substitutable the moment there was price pressure. (The substitutes for a helium party balloon are left as an exercise for the reader). I realize oil consumption is less recreational (and less rapidly substitutable) than helium, but it is much more discretionary than most people assume (did I really hear the CBC claim that in the US, peak driving may have happened? I'm skeptical, but still...)

And while I am apparently tweaking our host Prof. Wooley here, I'd comfort her with the thought that as I understand it, global warming is predicted to expand the arable land in Canada. The proponents of Gaia theory may not have meant the oil sands/arable land cycle, but if it works, it works :).

[Patrick]

Frances: the land where the oil sands sit are not good for agriculture, except maybe some the Peace River area deposits. Off the cuff, my geography isn't good enough to be sure. Of course, the wildlife living on the land probably has a different take on the issue. Maybe if the developers had to fight a wolverine or bear and win the right to dig-up her den ... (though some of those oil patch guys might just win!)

I would note that there does seem to be a general misconception that all the oil sand extraction is strip mining. It's not. At least it won't be in the future. The older developments are strip mines, but most deposits are too deep underground to be strip mined. IIRC, the official claim is that something like 80% of the recoverable reserves must be recovered via in-situ methods. Anyone interested in how they do it can just Google SAGD.

That said, all the extraction processes burn huge amounts of natural gas and use huge amounts of water.

[Frances Woolley]

Patrick - "the land where the oil sands sit are not good for agriculture."

It's not the land where the oil sands sit that's the concern, it's the water. It's the impact of the tailing ponds on watersheds - toxins leaching from tailing ponds into ground water and making their way further south, the tailing ponds overflowing into the northern watersheds and destroying fisheries, pollutants being sucked out of the tailing ponds as water evaporates and coming down further north.

[Simon van Norden]

Frances - thanks for the encouragement.

On the subject of climate change, IIRC, much of southern Alberta is in Palliser's Triangle, a particularly dry area in the rain shadow of the Rockies. Global warming risks further drying/desertification of these areas. Alberta's Council on Economic Strategy Report has already identified water management as a key economic concern moving forward. Water systems are frequently damaged by all kinds of natural resource developments, not just Oilsands.

But my post is not particularly about the Oilsands or Alberta. I'm trying to understand how we should think about long-term resource development in an era of very low interest rates and high commodity prices. That's a very odd configuration historically. The only other period of such low nominal interest rates was the 1930s, when commodity prices collapsed (and economists argue that real interest rates were not low.) Some point to the 1970s as a period of low real interest rates, but others argue that expected real rates (esp. long-term) were not low at the time. In any case, the current situation seems quite different from the standard practice of the past few decades; I haven't noticed that our thinking about it has caught up yet.

[Frances Woolley]

Simon - I agree absolutely about the crucial and underexamined importance of interest rates.

Suppose we figure the discount rate = the interest rate. Then low interest rates change how environmental damage factors into development decisions, as future costs are now not nearly so heavily discounted. E.g.present discounted value cost of decommissioning a nuclear power plant in 50 years time much much higher with a 1% discount rate than a 5 or 10% rate. (And what are the arguments for using a discount rate that's greater than the interest rate?)

[Simon van Norden]

Bob Smith But if the govt. is going to impose a carbon tax, wouldn't they want to maximize the revenue from it, and so encourage production delays?

rsj "Historically, commodities did not increase with CPI let alone with GDP." Does that statement sound overly general to you? Consider a couple of examples.
1) US CPI has an energy index (CPIENGSL) going back to 1957. Since its creation, the price of energy has increased by a factor of 1098% (up to the July 2012 figure) while the CPI has increased by 827%
2) As I write this, the market price of gold is $1667.40, while it traded at $35 in the 1960s, an increase of 4764%. Canada is a major gold exporter. Why specifically do you think the historical rate of return on gold is less than that of the CPI? Do you think gold mining stocks are terrifically overvalued? Have you shorted them outright, or just bought put options?

As for your statement about "the normal state of affairs", I don't follow how you square companies' wise planning for falling prices with the survey evidence I mentioned that they expect prices to rise. Perhaps you can explain this in terms that even I can understand.

[Simon van Norden]

Frances: I completely agree. An important point.

[Ryan]

If you've ever wondered how monopolies end up in bed with the government, you've just read precisely the argument that makes it happen. Reducing supply to hold marginal revenue above marginal cost is the hallmark of a monopolist. If this argument makes sense to any of you, then I never want to read anyone on this blog - author or commenter - ever condemn monopolists ever again.

[Simon van Norden]

I can't resist another note on expected resource prices. I have no intention of arguing that they must go up or must go down; I've just noted that many seem to be bullish on the prospects for further increases while many above have given some reasons for skepticism. That's fine.

However, I think arguing that the trend must always be down (or up) ignores much historical evidence. We've seen plenty of big, persistent movements.

One last note to debunk the claim that resources prices don't keep up with inflation. Above I only offered figures for narrow categories (energy and gold.) However, the Bank of Canada has a much broader commodity price index (http://www.bankofcanada.ca/rates/price-indexes/bcpi/commodity-price-index-monthly/) going back to 1972. As of July, it was up 615% since inception; the CPI about 550% over the same period.

[Louis S]

I'm not persuaded that from a sheer wealth standpoint, the free market is insufficient to handle this question.
Let's look at oil. If you are a capitalist who expects the price of oil to rise dramatically, and believe that short-term considerations by public company managers are leading to excessive extraction today, then you can either 1) buy futures contracts in the out years, sending a market signal to firms that they can sell future production for higher prices than current production 2) buy oil and store it above ground, effectively shifting current production to the future 3) buy mineral rights and sit on them, watching the value rise ahead of market interest rates.
The fields with known reserves are all in private hands. The producing companies each year set budgets that determine the amount of drilling/mining they will do, and so the amount of resource that will be extracted. In order to fund their budgets, they need to raise capital, which the market should price commensurate with the risk of fluctuation in the future value of the resource (we are leaving aside the execution risk in this stylized example, but in the real world that also gets priced in).
Faced with the need to meet their cost of capital, and cover 1) the opportunity cost of selling the mineral rights themselves, which rises as expected future prices rise 2) labor and equipment costs 3) infrastructure.
At any given time there is a marginal cost to attract incremental labor and equipment into the market. If it is really attractive to drill aggressively today, this price will rise until more resources are available, but ultimately these costs are an incentive to restrain activity today versus tomorrow.
As for infrastructure issues - no one builds infrastructure without a credible long-term customer commitment, or at least a very good understanding of the expected supply/demand dynamics for next couple of decades. If you want more infrastructure, you will have to pay for it. So production will be smoothed so as to avoid building infrastructure that is only needed for a brief peak in production.

[Colin]

Nice article. I'm surprised it hasn't generated more discussion.

It's not clear that the more uncertain things are the more you would want to produce. Consider investment being irreversible, or being even very costly to reverse, then waiting would be the right decision. Waiting allows the investor to retain the option to invest, and not force themselves into building a project and later finding out the oil price isn't as high as forecasted. This is a classic result from those early 1990s Dixit and Pindyck papers. If the government is simply using the net-present-value rule, then investing today makes sense. Perhaps this is the case.

Governor Carney's latest comments---which from I know are unprecedented in the realm of "moral suasion"; ie, firms, not only banks, get your act straight---were meant to "nudge" firms to invest their cash holdings. I'm not sure if some of the targets were oil companies, but if they were, that suggests the firms are considering the optionality of their decisions. Furthermore, if this is the case, then I guess I'm the first person to say that the market will take care of it.

[ZBP]

Excellent post.

One important caveat: while the experience of forest management in parts of some jurisdictions in recent years (e.g. Quebec) has been akin to "mining" I think the characterization "in Canada, we don’t farm trees – we mine them" is inaccurate. The first half of the statement "we don't farm trees" is undoubtedly true. The majority of forest management (by area) in, say, Northern Europe, or private US lands, could be accurately described as "farming" (for good and ill). On the other hand, forest management over the vast majority of Canada, where those forestry operations are practiced on Crown Land (over 95% of the total), is practiced on a sustainable harvest basis that has repeatedly been recognized by a variety of non-industry international bodies as a global leader, and truly "sustainable". To describe this as "mining" is, as I say, inaccurate. It is fair to debate whether or not every value held on the forested landscape is being managed on an equally sustainable (if such a phrase has meaning) basis, and whether or not every stakeholder's interests are being equally represented, but "mining" is unfair.

Nonetheless, a relatively minor quibble on an otherwise excellent post.

[Patrick]

Frances: the watersheds all 'drain' north, so you don't have to worry about the toxins coming south. At least not directly. North of the development area, the people of Fort Chipewyan (downstream of MacMurray) already seem to suffer severe affects from the water pollution.

IMO the water pollution is really an engineering problem. There are solutions (or solutions are within reach), it's just that nobody wants to pay for them. The GHG emissions from the gigantic amounts of natural gas burned to extract the bitumen are a much tougher problem. There's no plausible alternative (well, except maybe nuclear which is way worse in other ways), and no plausible way to 'clean-up' after the fact.

Anyway ... I'll shut-up now. Don't want to hijack the thread.

[jt]

From a wealth POV, the better strategy is to continue current oil sands expansion until Keystone XL is completed, then reduce output!
Seriously, I don't think setting a strategy for the oilsands is really possible at the moment. We are one of the highest marginal cost producers and are subject to the whims of the producers with the lowest marginal costs. The private sector will invest accordingly. The strategy might be different for Quebec Hydro or other commodities (esp. agricultural). When you are the marginal cost leader, you form OPEC, and then yes, it's better to wait.

[Simon van Norden]

Ryan: I can't speak for the other bloggers here, but personally, I'm a consumer, I dislike monopolists. When I'm a shareholder, however, my view may differ.

Note also that monopolists (by definition) face a downward-sloping demand curve; I've assumed a flat curve (there's a fixed world price.) If that's the case, keeping resources for when they are most valuable will be pareto-optimal (in an otherwise competitive market.) You can't say that for a monopoly.

[Joel W]

Simon,

Very interesting article. Reminds me vaguely of option value and quasi-option value from graduate resource economics.

Anyway, as to forecasting "g", Ron Alquist at the Bank of Canada has a couple recent papers showing that the best predictor of the future oil price may be a "no change" forecast, i.e., g = 0. But with current low interest rates, your argument can still hold due to risk aversion, as you mentioned.

[Simon van Norden]

ZBP: I wondered whether someone would object to that! You seem to know the facts of forestry better than I do....tell me, what fraction of Canada's annual harvest these days comes from forests that were grown on a managed basis? I don't know what this answer is, but a figure upwards of 50% could really change my perception of the forest industry hereabouts.

[Joel W]

"someone is bound to argue that a competitive and free market will take into account all these factors and guide us to the wealth-maximizing solution"

That someone should be me; however, since most oil in Canada is based on a lease system where lease holders either "use it or lose it", the pace of development is heavily influenced by the government.

[Simon van Norden]

Colin: I didn't think I was making the "option-value" argument for investment. However, when I teach the option-value approach to investment, for years I've used the govt.'s investment in oilsands in the late 80s and through the 90s as my example.

[Simon van Norden]

Joel W. Thanks for the tips!

"Use it or lose it" would seem to destroy free-market incentives to delay production (as some other commentators have argued should exist.) Is that just oil and gas leases, or is that common in mining and forestry as well?

In addition to the Alquist paper you mentioned, I think Christine Baumeister and Lutz Kilian have a new paper on oil price forecasting that claims to beat the no-change forecast. Although I think they only look at short-horizon (1-4Q) forecasts, they claiming success ratios of 60% or more in some cases and improvements in MSPE sometimes exceeding 15%.

[Ryan]

Simon, you said: I'm a consumer, I dislike monopolists. When I'm a shareholder, however, my view may differ.

Seriously?

Note also that monopolists (by definition) face a downward-sloping demand curve; I've assumed a flat curve (there's a fixed world price.) If that's the case, keeping resources for when they are most valuable will be pareto-optimal (in an otherwise competitive market.) You can't say that for a monopoly.

You're actually assuming much more than that.

For one thing, you are assuming that your predictions of the future are perfectly accurate. Worse than that, you're assuming that absolutely everything that could be produced from the marginal unit of oil is not worth as much to society as the higher future price.

I don't think it's reasonable to construct a model for which, by assumption, (1) your dissenters know less about the future than you do, and (2) any and all opportunity costs are lower than your preferred outcome. It becomes a tautology: Assume I am correct; therefore, I am correct.

[Simon van Norden]

Ryan

1) Yes, seriously. I'm an economist. I'm trying to figure out what is in the best interest of different agents. If my agent is resource-owning Canadian, the "best" course of action might not be to the advantage of a Japanese or Dutch resource-consumer.

2) I wasn't aware that I was assuming perfect foresight. Why do you think I am?

3) I'm valuing oil (or whatever the resource is) at its spot price and allowing for the spot price to move. Now, if you want to use some some non-market or shadow price, I think you'll find that the same logic applies once you redefine g to be the expected rate of change your chosen price concept.

[Ryan]

You know, upon further reflection, I realize that my criticism was off-base. My problem with your argument is not the technicalities of it, but rather the various blurred lines: between consumers and producers, between benefits and costs, between macroeconomics and microeconomics.

Each statement you make in isolation is true. It's just that when you pose the entire argument as a whole, it argues for much more than any statement in isolation. It's more than the sum of its parts. Like if I were to say, "(1) The bank was robbed at noon; and (2) We made a fast getaway." Technically, I never said I robbed the bank, it's just that when you put those two sentences back to back, it creates a narrative not expressed by either statement alone.

Similarly, you begin your argument with a series of statements about public policy and political initiatives, which are social and political matters in which all citizens of a country have a stake. Then, you switch gears and make an argument for a go/no-go decision faced by a microeconomic oil extraction company. Both sets of statements in isolation are purely academic and true; set them back to back, and they make a clear case of something which you have deftly managed not to state outright.

So, you're right. There is no stand-alone statment above that anyone could reasonably object to.

[JP Koning]

"How bullish are we about the long-term prospects for oil (or gold, etc.) prices?"

Why not just get g by looking at the futures price strip? This shows you how much you can earn by holding onto your respective commodity into the future rather than selling it now. You say that: It seems to me that we really want to be asking the question “Would we prefer to pump oil today or tomorrow?”. But mine managers and well managers all over the world ask themselves that question every day, and futures markets provide the answer.

[Stephen Gordon]

And the answer is "We don't know, either." Futures prices are almost always the roughly same as the current spot price. If you believed that prices are a random walk, that'd be your best forecast.

[Simon van Norden]

Stephen and JPK

1) Futures prices are set by arbitrage with spot rates and the cost of carry. Stephen is right that they will give you approximately a random walk.

2) CME trades a Western Canadian contract, but the maximum maturity is 2 years, which is much shorter than the horizons we're concerned with. Even at those horizons, trading gets pretty thin so the prices may be less than efficient

3) Mine and well managers don't ask themselves that question; head office does. And they ask consultants to give them an answer. Like the consultants in the survey I linked to. ;-)
Of course, if you prefer technicians to industry experts, you can check out Baumeister and Kilian's paper as I mentioned in the comments above.

[Nick Rowe]

Suppose I didn't have any priors about the future price of oil. I know I am uninformed.

Suppose I know that all the other oil producers are well-informed, so that market prices will reflect Hotelling's Rule conditional on information that is better than I have. Then I am indifferent about when I pump my oil, because my expected wealth, conditional on my information, is the same regardless of when I pump. (It's like picking stocks at random). Or maybe I would diversify my portfolio by pumping a constant value over time. (It's like buying the market portfolio to diversify and minimise risk).

Or maybe I believe my Marginal Cost of pumping will fall faster than other producers. Then, unless I believe I am better informed than the market, I will wait before pumping my oil. (Might that be true for Alberta??)

Or, maybe I believe that all the other governments pumping oil are short-sighted and want immediate returns. Then I will wait before pumping.

[rsj]

Simon,

I still don't understand the argument of this blog at all.

Agreed that once firms purchase leases or make capital investments, they might as well exploit their lease rights or infrastructure otherwise it just sits there, depreciating. Nevertheless they take expectations of future prices into account prior to purchasing leases or make capital investments.

So are you saying that

A) There is a market failure in which private actors predictably over-estimate future prices of oil relative to lease/capital investment costs
B) There is a market failure in which private actors predictably under-estimate future prices
C) The government should change it's lease policy in order to make it a shorter term commitment, thereby reducing risk?
D) The government should do something else?

Can you specify what you believe and then make the case for it?

I am not one to cheerlead the free market and am open to predictions of statistical bias somehow, I just don't understand what type of market/government failure you are trying to address.

[Simon van Norden]

rsj:

I've pointed out three possible market failures, which I helpfully numbered 1, 2 and 3. Joel W. has pointed out another important one in his comments.

In light of these potential market failures, I think it makes sense to check that the conditions for intertemporal efficiency are satisfied.

Clear?

[Simon van Norden]

Nick:

Thanks, that makes your earlier point clearer to me. I think what you're saying is logical if we are uninformed and we think others are better informed.

I also think that Canadian real interest rates are low compared to those of most resources producers. I suspect that where we stand with respect to marginal costs and profitability varies across commodities.

[whitfit]

Patrick: "The GHG emissions from the gigantic amounts of natural gas burned to extract the bitumen are a much tougher problem. There's no plausible alternative (well, except maybe nuclear which is way worse in other ways)"

I think that the "other" risks of nuclear are manageable (accidents, radiation, storage of used fuel), but the two biggest problems in my mind are cost and GHG emissions. There aren't any emissions while operating, but there is a lot of concrete and steel in a nuclear plant, and operations require a lot of equipment that runs on fuel (generators etc...). Also, there is a lot of carbon fuel used in the mining of nuclear fuels, not to mention the long term storage. The cost of nuclear is also enormous and is not a problem that is easily solved.

[Jacques René Giguère]

Loius S: "As for infrastructure issues - no one builds infrastructure without a credible long-term customer commitment, or at least a very good understanding of the expected supply/demand dynamics for next couple of decades."
On the Québec North Shore 40 years ago. ITT Rayonier built a huge plant. The main reason was Harold Geneen fixation on the size of the forest concession: "the size of Tennessee" he constantly crowed. Yes but here were no roads and trees were renewing themselves only every 125 years instead of the 10-15 for Georgia loblobby pines.And the plant would make rayon. The reason ITT had bought Rayonnier on the cheap was that rayon was a dying product. But Geneen wore rayon ties. Why would a billionnaire buy rayon instead a silk one was beyond anyone's understanding but that's how he made that decision.
That plant is still in Port-Cartier, producing at barely 20% capacity with the wood they free from Hydro-Québec dam-basin clearings...

http://books.google.ca/books?id=aZJ12fKaHvEC&pg=PA28&lpg=PA28&dq=itt+rayonier+port-cartier&source=bl&ots=ym0D5NzMl1&sig=T1YNYt6-OP3IaoaoPqI6RAzg8J4&hl=fr#v=onepage&q=itt%20rayonier%20port-cartier&f=false

The whole decision process at ITT was on the same level

http://books.google.ca/books?id=gw-nLbBRh8oC&pg=PA151&lpg=PA151&dq=itt+rayonier+port-cartier&source=bl&ots=YgfseFULgj&sig=M-lQwLFkjrfGptVhyMl_4xZFV9I&hl=fr#v=onepage&q=itt%20rayonier%20port-cartier&f=false

An excellent article in Fortune magazine in 1979 or 1980 is available in paper form in some archives but not electronically.

[Nick Rowe]

Simon: yep. Sorry I didn't make my point more clearly before. It wasn't very clear in my own mind. (It's still not fully clear, but it's clearer than it was.)

[Louis S]

Jacques - interesting anecdote. it is easy to underestimate human folly sometimes.
Still, I stand by my point - generally energy infrastructure companies like Transcanada or Enbridge are reluctant to invest billions of dollars of money to build pipelines out of Alberta, unless they get multiyear commitments from companies like Cenovus to subscribe that capacity. Cenovus (and its peers) want to underwrite as little capacity as possible, and want to make sure that they have enough capacity to meet all their production at every step of the way. So this is a factor encouraging producers not to hit production peaks quickly and still pay for that peak day capacity as production declines - they want to slowly hit ever higher plateaus and have the infrastructure built in stages.

[Louis S]

I'll add (somewhat optimistically) that the capital markets have gotten more skeptical of managers' plans, and more willing to impose discipline on companies that do not meet their cost of capital.

[ZBP]

Simon:

Tee hee. Never poke a carefully anonymous expert. It depends on what you mean by "grown". Approximately 65% of Canada's forested landbase (around 260 million ha of our 400 million ha of forests) is "managed". Which is to say, it currently held under a private or Crown licensed management plan. In any given year a fairly small percentage of "managed" forests are harvested. For instance in 2010 it was just under 700 thousand ha. The peak year (1997) was 1.1 million ha (both under 1% of the managed area). So according to generally accepted definitions upwards of 99% of Canada's harvest was on managed lands.

However, if by "grown" you mean lands that were intentionally planted for the purpose of growing trees for harvest (i.e. not old growth) - it's a harder question. Most of Canada's managed forests (ie Interior BC and the boreal) have fairly short-cycle disturbance regimes. That is, fire, insects result in near complete stand replacement every 60-150 years. As a result, for the vast majority of the managed forest, "old growth" as exists in the popular consciousness doesn't really exist. This is decidedly not the case for certain forests (e.g. Coastal BC, Great Lakes St. Lawrence Lowlands), but these aren't representative. A useful tool is the National Forestry Database (http://nfdp.ccfm.org/dynamic_report/dynamic_report_ui_e.php) - a lot of high-level forest management questions can be answered there.

[Neil King]

As an economics student that makes a living as a tree planter, I was struck by your comment that we mine trees, as opposed to farm them. I wonder if you point me to a good post about that.

[PaftParLfum]

http://onlineambienn.com/ - how to buy ambien cr - ambien overdose

[The Keysonte Garter]

I dopn't know if you are ignoring the truth or not, but the truth is: rich and powerful idiots get off by being even more wealthy and pwoerful. While taxes are at the WCI preferred cut rate, they (the rich) get off.

I was annoyed after slogging through 3 papers, none of the solar power schemes are ready yet and trade secrets prevent knowing how close, for example, dye cells are. But pleasantly surprised University of Irvine discovered polyethylene and polycarbonate can easily be "roughened" in a way that is anti-bacterial. Baceria slide right off the surface. This is 25-50% the future pandemic fight. There is scale here in making all global hospital surfaces slightly tilted and plastic. Copper (another commodity) can probably kill viruses too though...

The reason you can't ignore the AGW stuff is oilsands consumption evolves co-dependantly with the knowledge of people. The reason you are wrong about hydro is found in all green company annual reports: they blatently state ignoring GHG emissions results in risk to the company. For example, Brookfield Renewable would have 2x the market cap if Duffy wasn't going to hell. I'm tired of idiots getting all the loot. This country is a cuckoo clock. I could stand the evil, but I can't make friends with humans from the middle ages.

[The Keysonte Garter]

Boliva and the Province of BC aren't democracies? Or you only know the rich idiot democracies?

[The Keysonte Garter]

...basically, Fundie Christians are unable to learn science that conflicts with the Bible. If you believe the world is 7000 years old, you should be rewarded with pussy and income. Welcome to Canada.

[The Keystone Garter]

...actually, there are a lot of juridisctions that go slow. Going fast is an innovation of USA neocons. For example, thermoplastics, I'm about to read a Chinese paper (could've been U of A) that tells me more; right now 85% of wind turbine parts are metal. Thermoplastics have a melt temperature below degradation temp (180C vs 220C). They can't be cycled forever, but for 4 or 5 cycles they are easily reusable/recyclable. So you could make everything out of thermoplastics now, and later pay the processing losses penalty to turn them into gasoline or whatever. I never understood crack spreads on the exchanges until realized the products of a refinery are fungible. A fluidized bed (something something) reactor gets you 2/3-80% of your ethane into ethylene, and lots of other equipments gets you biger molecules cracked into bigger plastics and eventually ethane. Here, short term profit margins of exporting gasoline and diesel or raw bitumen/NG/oil are sacrificed for a sustainable econmy and permanent, not gold rush, jobs. AB, at least the non Wild Rose ridings, has farmland and freshwater, can grow to 5M (which would enable more than one RW party). A Separatist Party in a minority gov is funny.
Thermoplastics make this qualified thread, pointless. Unless you have Niedermayer's Cup Rings in your ears.

[The Keystone Garter]

...valuing short-term profits behind market share isn't too unusual, but valuing long-term future market share ahead of short-term profits might take some getting used to.
In the thread formula, maximzing the # of renewable products from non-renewables would be a better solution. Thermoplastics might get a 5x-6x credit in a peak oil tax shift. Coal might be too hydrogen-weak to be useful. Not too many papers yet but is fast growing field.

[The Keyastone Garter]

"Farm the Hudson's Bay Lowlands" combined with a big oil CEO's "we'll adapt" prescription to AGW, basically has ended my contributions to this "We are all Albertans blog". Canada has won over AB and lost reality and the future. I like my coffee like my next president: Black.