No, speculation does not explain oil prices

Michael Giberson

Sebastian Mallaby provides a clear exposition of what might be considered the mainstream economics story of why “speculation” is not to blame for the current high level of oil prices.

[A] speculator can buy paper oil only if someone else sells to him. For every trader who bets on a price rise, there must be another who bets the opposite. So an increase in the number of speculative players does not show whether prices will move up or down….

What matters is who those players are: Will they aggressively push the ball up the field, or will they retreat? Sometimes the bulls are more eager than the bears, and prices spiral upward. But this is not some autonomous force that comes out of nowhere. If the bulls have the upper hand, it’s generally because supply and demand favor higher prices. The fundamentals of physical oil drive the psychology around paper oil more than vice versa.

… The uncertain connection between speculation and price trends is clear in recent history. The Commodity Futures Trading Commission reports how much paper oil is bought and sold by commercial users — oil companies, refiners — and how much is bought and sold by speculators. During the first seven months of 2007, speculators as a group tripled the amount of paper oil they owned, buying it from commercial players. But since last August, speculators as a group have not added to their positions — yet this was when oil prices went skyward.

It would be too much to claim that futures prices don’t influence players in the physical market. But to the limited extent that speculators’ influence is real, this is probably a good thing. If speculators see that oil suppliers are headed for trouble and that oil demand is trending up, they express their expectation of a higher price via the futures market. This can deliver a valuable message: Governments and consumers had better adjust before shortages get even nastier.

Tyler Cowen at Marginal Revolution has also been addressing oil prices, most recently seeking to reconcile current high oil prices with a belief in the overall correctness of the Julian Simon view that resource prices would continue to fall in the long run. I don’t find my position listed among Tyler’s list of possibilities – I’m closer to Alex Tabarrok’s view expressed last week: “Finally, on oil – who really cares what the price is? The issue is energy, not oil. I am confident that the long run price of energy will fall.”

Well, many of us care about the price of oil in the short to medium term, after all we have assets (i.e. automobiles, pipelines, refineries, oil rigs, factories) with usefulness tied to the price of oil. But in the long run, as Alex says, it is energy, not oil.

Pigou and the “bad things”

Michael Giberson

Greg Mankiw called it “the Pigou Club in a Nutshell“, quoting the following from Tim Kane:

we should aim to tax the bad things (noise, gasoline, trash, violent crime, evil foreign dictators) and untax the good things (homegrown profits, employment, innovation).

But take another look at that list of “bad things”: noise, gasoline, trash, violent crime, evil foreign dictators. As they used to sing on Sesame Street (and maybe they still do), “one of these things is not like the others.”

Can you tell which one is not like the others?

If you guessed this thing is not like the others, then you’re absolutely…right!

Responding to higher energy costs, the home building version

Michael Giberson

An article in the Washington Post discusses what you can do when building a new home to help keep energy costs low. Here Michael McKechnie of Mountain View Builders in Berkeley Springs, WV, provides a summary:

McKechnie outlined the major steps to building a house with the lowest possible energy costs and perhaps an eye to going off the grid at some point: “Design your house so it uses the sun’s passive energy to its fullest potential, make sure the envelope around your house is tight, invest in renewable energy systems that use the sun and the wind to make free energy, and buy heating and cooling systems that use energy more efficiently.”

Just like it is complicated and less effective to retrofit a ten-year old SUV to be more efficient, it is complicated and less effective to retrofit old homes. (Which doesn’t mean some steps are not cost effective, of course.) The Post article provides a survey.

And what about that ten-year old SUV? Have you considered taking a rickshaw?

Wind power and real-time pricing: Mutual benefits

Michael Giberson

The marginal cost of generation from a wind power generator is essentially zero, which means once the generation is installed you pretty much want to use every bit of wind power generated. A problem, of course, is that wind-based generation is not particularly dispatchable. You don’t tell it when to run, you just try to use as much of it as you can while it is available.

A further wrinkle is that, at least for some wind power locations, the winds are strongest overnight and early morning when the demand for power is lowest. And, when wind power is generated far from the consumers who’d like access to cheap power, it requires adequate transmission capability to move the power to the people. If the transmission system is limited in its ability to move all of the power available, then some of the wind generation capacity will be wasted.

Ramteen Sioshansi and Walter Short observed that there may be mutual benefits available for a power system with a large share of wind generating capacity from also implementing real-time pricing for ultimate consumers. In a paper they describe simulations they ran using data from Texas to examine the potential benefits of real-time pricing for use of wind power resources.

They find useful synergies:

  • Real-time pricing tends to smooth out the normal ups and downs in consumption, because consumers tend to decrease consumption in high cost hours (which are the high demand hours), and to increase consumption in low cost hours. Smoothing out consumption means that the transmission system is less likely to be congested and therefore it is less likely that distant wind generation will be shut in by transmission limits.
  • In addition, because wind power comes at a low marginal cost, whenever it is plentiful it will drive down electric prices. That effect encourages consumers to adapt their consumption to the patterns of wind power availability.

It is true that the effects can be small, but even with some conservative assumptions in the simulations, the authors found that usage of wind power could be increased by more than 80 percent. Don’t get hung up on that number, which very much relies upon the assumptions going into the simulation. Take away the idea that a series of small marginal adjustments in consumption, responding only to price signals, can have significant effects on the use of low marginal cost renewable (or any other form of) power generation.

The authors also note that many political analysts object to the idea of exposing consumers to highly variable real-time power prices. They re-ran the simulations limiting the real-time pricing regime solely to commercial and industrial consumers. Commercial and industrial consumers represented a little over 60 percent of the demand in their historical data, and the new runs of the simulation showed that just about 60 percent of the benefits were retained with the more limited application of real-time prices.

(Like the Hogan talk mentioned yesterday, the Sioshansi and Short paper was presented at “The Economics of Energy Markets” conference at IDEI.)

Electricity market pricing and how to think about it

Michael Giberson

Recently, William Hogan gave a presentation at IDEI and the Toulouse School of Economics titled Electricity Market Design: Coordination, Pricing and Incentives, or, as he more colloquially puts it early in the talk, “Electricity market pricing, and how to think about it.”

The 42 minute video is available from the EU Energy Policy Blog. Slides from the talk are also available.

Hogan’s presentation was part of a conference on “The Economics of Energy Markets“, the 2008 version of the annual Conference on Energy at IDEI. Papers from the conference are also available.

Cheaper solar power?

Michael Giberson

That is the goal. Few numbers show up in the Christian Science Monitor article to support that claim, but the people discussed are launching a business with the goal of improving the design further and then go to production. The key innovations appear to be in the cheaper process to produce the appropriately shaped mirrors and build the supporting structure.

Whether they ultimately succeed or not, the article comes with a video showing a board bursting into flames, so at least the designers are having fun:

Out on a lawn at the Massachusetts Institute of Technology with joggers and traffic passing nearby, Spencer Ahrens is demonstrating what looks like either the future of solar power – or perhaps a death ray.

Thrusting a 12-foot board up into the air in front of a large mirror-covered satellite-type dish, Mr. Ahrens, an MIT graduate student, waves the board, looking for an elusive sweet spot where reflected sun rays converge.

With three student teammates looking on, he steadies the board once its tip begins to glow. Shining white in the reflected solar rays, the wood suddenly bursts into flames. Students laugh as smoke billows in the breeze.

This burning-board trick may seem like a YouTube stunt, but it’s actually a visceral demonstration of a device with a serious purpose: to make super-cheap solar heat.

KP vacation: biking the Lewis & Clark Trail

Lynne Kiesling

I’m outta here for a couple of weeks of bicycling! Sunday night we will arrive in Pierre, South Dakota, from whence we bike east along the Missouri River to St. Charles, Missouri. We are biking the first one-third of the Lewis & Clark Trail in reverse, accompanied by their journals and other history-relevant readings. Should be fun!

If you would like to keep up with our journey, I’ve created a blog, L&C Bike Tour, as our online journal. We will post as often as Internet access permits.

I am also using this trip as an opportunity to raise awareness and funding for the Melanoma International Foundation. The Melanoma International Foundation funds patient assistance programs, providing reassurance and understanding on the journey of having the disease as well as providing free screening and awareness events. They provide education through their professionally moderated forum and helpline. Melanoma can be fatal, especially if not caught early. But there’s also a lot of low-hanging fruit in melanoma prevention — broad-brimmed hats, protective clothing, staying indoors or in the shade during the most intense midday hours.

I am using this bike ride to request pledges and donations to support the excellent and important work of the Melanoma International Foundation. In particular, your pledges here will support the Leroy Coolbreeze Fund at the Melanoma International Foundation.

The Leroy Coolbreeze Fund honors the memory of Ian Copeland, a legendary music agent and bon vivant who brought great joy to many people throughout his too-short life. Along with his brothers Stewart (best known as the drummer in The Police) and Miles (who, among other things, managed The Police and founded IRS Records), Ian brought music into being that changed my life and thrilled me starting in the late 1970s. Their work continues to thrill and excite me to this day. Ian died from melanoma in 2006. My request for your support is a testimony to the value the Copeland family has brought to my life, and the joy I experience daily through listening to and playing the music that they have created.

As my friends and I ride along the Lewis & Clark Trail, please give to this worthy cause. If you can specify the “Leroy Coolbreeze Fund” and “Lynne” in your donation, then the great MIF folks will take it from there, and will know that our Lewis & Clark Trail bike tour is raising your awareness of the importance of melanoma outreach and research, and enabling them to do even more of this important work.

$4 gas is changing consumer behavior

Lynne Kiesling

The New York Times has an article today that supports the anecdotal evidence I reported last month: consumers are substituting out of low fuel economy cars and into high fuel economy cars.

With gasoline prices topping $4 a gallon, consumers are overwhelming dealerships with demand for the littlest vehicles in the showroom.

Mr. Libby said that the tiny Honda Fit is on a dealer’s lot an average of 11 days before it is sold, half the time of traditional quick sellers like the Cadillac CTS and Mercedes-Benz C300 luxury sedans.

“These are amazingly low numbers for a car of this type,” he said. “If gas prices stay where they are, I think we’ll see this for quite a while.”

Hybrids are even more difficult to buy. Four of the 10 fastest-selling vehicles are hybrids, led by the Toyota Prius, which sells within four days of arriving at the dealer, according to J. D. Power. The average time to sale for the industry in June, by comparison, is 57 days.

But while inventories are low, manufacturers cannot move quickly enough to increase production of popular small cars like the Toyota Corolla, Honda Civic and Ford Focus.

On the morality of raising prices in an emergency

Michael Giberson

Arnold Kling has some interesting insights on what is sometimes pejoratively referred to as price gouging:

One of the issues that [Russ Robert's didactic novel, The Price of Everything] raises–the very first one, in fact–is the morality of raising prices when something becomes scarce, such as flashlights after a weather disaster. Russ makes the standard case for allowing the price to ration the scarce resource, but I don’t think he will necessarily overcome people’s moral intuition, and I think it is very important to understand why.

The basic moral intuition is, “Don’t take advantage of somebody when they are in distress,” and I think it has broad implications. It explains usury laws. It also may explain the way we approach health insurance….

Kling’s conjectural history of the morality of usury seems to get it more or less right:

Back in Biblical times, when somebody came to you to borrow, it was not to build a steel mill or start a social networking site on the Web. Chances are, if somebody needed to borrow it was because of an illness, a famine, or other disaster. Since people in that situation were in distress, moral codes developed that prohibited charging interest for loans. Charging interest would have meant taking advantage of people in distress.

Jews and Christians overcame their aversion to usury when they saw money being lent to businesses and governments, rather than to people in distress. Even today, however, if a destitute person is sick or hungry, religious authorities would frown on your charging interest on a loan to that person. In that sense, the moral opposition to taking advantage of a person in distress persists.

So notice that while the moral intuition and the case of usury were initially bound together, in Kling’s telling, some cultures developed distinctions between the concepts. We might view achieving this distinction as a kind of moral progress. Kling doesn’t mention, perhaps because he sees the idea as too obvious to remark upon, that the business of borrowing and lending money has been an overwhelmingly positive development for humankind.

Kling continues:

I suspect that the moral opposition to raising the price of flashlights after a storm reflects that same intuition. It’s one thing to charge what the market will bear in the normal course of business. It’s quite another to profit from distress.

What changes in our moral concepts regarding price gouging would represent moral progress?

Many economists are of the view that “price gouging” is, as Lynne once put it, “a non-concept.” Or, perhaps more exactly, a concept that actively makes people in distress worse off by interfering with the most efficient means of rationing limited supplies and motivating increased supplies of useful goods.

Kling advises economists “to justify confronting people in distress with market prices.” Economists can do that, he says, but:

We have to persuade our fellow human beings … that people in distress should receive support from charity or government, not from suppliers of loans or flashlights or medical care; and that there are reliable mechanisms to ensure that people in distress will receive support from those alternative sources, so that placing the burden on suppliers is as wrong-headed as we always allege it to be.

I once observed, “Few things drive economists crazy faster than a politician talking about price gouging.”

Why? Because to economists, the economic lessons here are clear, commonsensical, and well settled, and politicians almost always advocate policies that appear to use the power of the state to make people worse off. In that post I also noted that while the fundamental economics appeared well settled, the policy debate remains as unsettled as ever. I suggested that economists needed new arguments.

Kling is on the right track.

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Current and future state of regional wholesale electricity markets

Michael Giberson

What is the current and future state of regional wholesale electricity markets?

FERC wants to know, and so it has assembled a panel of experts to appear at a July 1, 2008, technical conference to be held at the Commission. All interested persons are invited to attend, and there is no registration required.

The conference also will be webcast – the official notices says it will be available for a fee, but the event page on the Commission’s web calendar says the webcast is free. I don’t know which version is correct, but maybe someone from FERC will clear up the confusion.

The agenda (as included in the second notice):

Review of Wholesale Electricity Markets

9:30 Opening Remarks

9:45 ISO New England, Inc.

Gordon Van Welie, President and Chief Executive Officer
Hung-po Chao, Director, Market Monitoring

New York Independent System Operator
Karen Antion, Interim Chief Executive Officer
David Patton, President, Potomac Economics

PJM Independent System Operator, Inc.
W. Terry Boston, President and Chief Executive Officer
Joseph Bowring, Manager, Market Monitoring Unit

12:00 Break

1:00 California Independent System Operator

Yakout Mansour, President and Chief Executive Officer
Keith Casey, Director, Department of Market Monitoring
Frank Wolak, Chairman, Market Surveillance Committee

1:45 Midwest Independent Transmission System Operator

T. Graham Edwards, President and Chief Executive Officer
David Patton, President, Potomac Economics

Southwest Power Pool, Inc.
Nick Brown, President and Chief Executive Officer
Richard Dillon, Director, Market Development and Analysis

3:15 South and West Regions

Charles Whitmore, Senior Market Advisor
Division of Energy Market Oversight, Office of Enforcement

4:00 Adjourn

For those of you interested in looking this stuff up on the FERC website, the official docket number is AD08-9-000.