1. 1 The Oil Market Economics 331b 1. Basics of oil regulation 2. The integrated world oil market

2. Major Themes 1.Standard themes of US oil policy 2.The bathtub model of the Oil Market 3.Some simple econometrics of the law of one price 4.Implications for Oil Policy 2

3. Policy Themes of the Oil Market 1.We should reduce our oil dependence on hostile or unstable regimes and limit oil imports to secure sources like Mexico. 2.Protecting oil sources is so important as to justify war. 3.We can use oil sanctions to penalize unfriendly regimes. 4.We need a carbon tax to reduce oil imports. 5.Reducing oil imports will have major macroeconomic benefits. 6.We have to prevent China from gaining oil concessions in Africa. 7.We need to develop oil in wilderness areas to increase domestic oil. 8.We should expand the Strategic Petroleum Reserve to cover more days of imports. 3

4. The world oil market 4

5. Basic idea of bathtub model Oil policy can only be considered in the context of world supply and demand. National policies are effective only to the extent that they contribute to total demands or total supplies. The reason is that the “law of one price” holds for crude oil. 5

6. The “Law of One Price” The Law of One Price (LOOP) is an economic hypothesis stating that the common-currency price of a standardized commodity should be the same in different markets. Conditions to hold are (1) homogeneous good, (2) perfect competition, and (2) costless transportation LOOP is often a justification for efficiency of markets (efficient market hypothesis in finance and classical macroeconomics) Algebra Have two markets (1 and 2) and two prices (p 1 and p 2 ). They are linked together by arbitrage: p 1 (t) = p 2 (t) + ε(t) Where ε(t) is small and represents generalized transportation costs (e.g., transport, insurance, brokerage, …). 6

7. Failure of Law of One Price: All Consumer Prices 7

8. John Baffes, “Some Further Evidence on the Law of One Price: The Law of One Price Still Holds,” American Journal of Agricultural Economics, 1991 8 Pretty good fit for wheat prices

9. LOOP and stock prices

10. LOOP and house prices US, 1987-2010

11. Prices of Crude Oil in 31 Regional Markets Worldwide Source: EIA primarily from Platts. 11

12. LOOP and the world oil market (n=18,169) 12 Regression: ln[p 1 (t)] = α+β ln[p benchmark (t)] + other things + ε(t)

13. Speed of adjustment test 13 Speed of adjustment asks how quickly a market adjusts to disequilibrium. For example: oil v. autos v. houses v. lumber. This shows the unusual integration of world oil market

14. Speed of adjustment test: persistence of disequilibrium 14

15. So why are we wasting all this time on an esoteric economic theory about spatial arbitrage, blah, blah, blah? The reason is that whether the LOOP holds for oil FUNDAMENTALLY changes your view of oil policy. 15

16. Policy Themes of the Oil Market 1.We should reduce our oil dependence on hostile or unstable regimes and limit oil imports to secure sources like Mexico. 2.Protecting oil sources is so important as to justify war. 3.We can use oil sanctions to penalize unfriendly regimes. 4.We need a carbon tax to reduce oil imports. 5.Reducing oil imports will have major macroeconomic benefits. 6.We have to prevent China from gaining oil concessions in Africa. 7.We need to develop oil in wilderness areas to increase domestic oil. 8.We should expand the Strategic Petroleum Reserve to cover more days of imports. These are all wrong: The vulnerabilities are determined by the world oil market and not by our imports. 16

17. Examples 1.Secure sources 2.Sanctions 3.Strategic petroleum reserve 4.China winning oil concessions in Sudan 5.Inflation and other macro issues. 17

18. Example of insecure sources Limit imports to “secure sources” in region A. Limit import from region B. But then region B exports to region C which was previously importing from region A. Net impact: very small increase in global transportation costs (perhaps $0.05 per barrel out of $100). How about sanctions? Same story. 18

19. 19 100 10200 100 USROW Initial situation

20. 20 100 10200 100 USROW Sanction x

21. 21 100+10 200-10 100+10 USROW Result

22. Sanctions and the price of Libyan oil 22

23. EEconometrics of sanctions 23

24. But this doesn’t apply everywhere… 1.Other energy sources (natural gas in Europe) 2.To situations of war (World War II in Germany) or stealing oil resources (Iraq seizing Kuwaiti oil field in 1990). 3.Doesn’t mean we shouldn’t be concerned with oil consumption (for many reasons to be discussed starting next week). 24

25. Appropriate Policies for Oil in the Integrated World Market Objectives: 1.Oil policy can only be rational if externalities are internalized (pollution, global warming, etc.) 2.Given 1, oil prices should be low, stable, and sustainable. Policies (assuming 1 is met): 3.Encourage production everywhere (no domestic subsidies) 4.Discourage consumption everywhere (not just at home), particularly with respect to subsidies. 25