Once you have dropped it, outcomes are much more difficult to pin down. For quite a general look at these issues there is:

author = {Klemperer, Paul D. and Meyer, Margaret A},
title = {Supply Function Equilibria in Oligopoly under Uncertainty},
journal = {Econometrica},
year = {1989}

You say, “. Saudi Arabia _is_ a residual monopolist — take Saudi production out of world production, and you can’t meet demand.”

—————————————-

Hmm: By definition, take out ANY supplier and demand can’t be met – at that instant. But if the Saudis were to turn off the taps price would rise to a point where no demand were unmet.

But I imagine you knew that.

Or was I misrepresenting you?

Would you say that the UK housing market was a competitive market. And if so, do you think it required massive collusion to get to the point where future prices were expected to be higher than today’s? Did it require massive collusion to get Gladys waiting 6 months before she sold?

There are many models outside pure monopoly that would allow sustained monopoly-level pricing without perfect collusion. The models of residual monopoly that I mention are one such class.

Admittedly,most of these models require some ultimate capacity constraints – you certainly find it hard to generate them in a regime of pure contestability. I think the piece about “competitive market” that you are forgetting certainly does not apply here in a term inside 3 to 5 years is ease of entry and exit. The capacity situation changes slowly here, and this is the space that SA is playing in.

It is odd to accept the existence of bubbles here but not there, and also, with recent experience, to refuse that conditional on a bubble, the sort of behavior I describe be rational. I suppose that was the starting point for my argument – having conceded that markets, and especially markets in which financial markets play key roles, can lead to such serious mispricing (of houses, of tech stocks, of emerging market stocks) … then why the resistance to see similar effects in oil? Why did the Economist have to revert to a “fundamentals” explanation?

Equilibria in beliefs are much more numerous and less well behaved than equilibria in which some external reality is somehow tracked. This is the power of the Soros quote at the end of the piece, and generally of Keynes’ understanding of the markets over that of his more reality-tracking contemporaries.

There is the small point of data, also. As the excellent BP review of energy statistics points out, “Saudi Arabia’s output dropped by
440,000b/d, the largest decline in the world
last year” [2007]. It has also delayed bringing on-stream fields it has developed for production. I am interested in your model of a so-called competitive market in which the largest supplier and the one with spare capacity reduces output in the face of growing demand. Let me know your model that squares up those facts.

Tony

Tony

Tim adds: “The Nobel prize was not awarded to Hotelling for this observation,”

Correct, because the Nobel wasn’t awarded to him for any reason. One of them being that he was a mathematician, and given that old Alfred’s wife ran of with one of such he didn’t found a prize in it. Thus the Field’s Medal.

But your argument still depends upon the thought that the pumping of oil is not a competitive market. I’m willing to believe that it is constrained by technical issues, by the number of pumps, the pipelines, just like any other market can be constrained by capacity problems. But for your argument to work there has to be collusion amongst all the major players (and no, OPEC isn’t large enough here, let alone Saudi A) to pump less, despite no production constraints, in order for future revenues to be higher than those available currently. Large numbers of people have to be actively deciding to leave more in the ground now to get a higher price in the future.

There’s no model I know of, outside a true monopoly, where this holds for anything longer than the very short term.

1. the futures price point does not _only_ apply to a monopolist. This was the point about the housing market bubble. If you were sitting on a valuable house in 2004 and thinking of cashing in, you were tempted to wait – put your house in storage – if you believed prices would go up and up. The housing market is pretty competitive, but still fell to this logic.

So to the extent that future prices work into your expectation formation, they reduce current supply. There is no market power here – it is simply maximising expected profits in the face of rising future prices. The basic logic is that the opportunity cost of supplying your asset today is that you don’t supply it tomorrow (…or when your portfolio comes off max capacity…). In the face of prices that are expected to rise, the opportunity cost of extraction today mounts. If you want to think of it in spot supply and demand terms, your opportunity cost gets factored into your supply curve, and so shifts inwards in the face of an exogenous increase in future price expectations. This happens to everyone with an asset of this sort, regardless of any market power.

2. Saudi Arabia _is_ a residual monopolist — take Saudi production out of world production, and you can’t meet demand. (US and Russia also seem to be residual monopolists). That means that there is some number of barrels that Saudi knows only it can supply. It is a monopolist over those. The situation of residual monopoly of course complicates the straight Hotelling story no end, as does the politics of keeping OPEC together. It is precisely the market power of SA that means that future prices cannot be taken to be exogenous.

Tony

JF is one of the world’s most respected economists.

Tony

Tim adds: Erm, I’m not sure that Jeff’s statement that the largest oil inventory is the one underground quite supports your case. For your case to be true it is necessary that not only is that true, but that high (or rising) prices are leading to the owners of those inventories not pumping from them (ie, increasing future stocks). I can entirely see that a monopolist might do this: but the oil market isn’t a monopoly: it’s at the very worst a weak oligopoly. Which is why I expressed surprise at your theory. What monopolists might do iof they were indeed monopolists doesn’t work in more competitive markets.

But if your storable good, you think, will be worth more tomorrow than it is today — as happens in many bubbles, and as often happens in extractive industries — you are looking at the supply curve of tomorrow’s price against today’s quantity. It is no great mystery that this should be downward sloping.

As for the salaries point — these don’t really enter the decision, since, to a first degree of approximation, they are paid whatever you choose to produce. Your profit change from one period to the next, to a first approximation, is determined by the opportunity cost of the cash (which I argued was low in the article) and the expectation of price changes (which I argued was positive in the article).

Tony

Sure, but in the meantime there are salaries to be paid and other unavoidable expenses; this can never be more than just one of the factors in the decision of how much to produce.

Speculators often have upward sloping supply curves in the short-run, don’t they?