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• • •
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May 21, 2006

Please Welcome Michael Pollak

I've read Doug Henwood's listserv lbo-talk for a long time. In fact, I blame it for this site. Seth Ackerman often posts stuff there, and it's always compelling—which is one reason why I've kept pestering him to write stuff here.

Lbo-talk also introduced me to another extremely interesting commenter, Michael Pollak. I've been after him too to chip in, and so now I'm very pleased to present the first of what hopefully will be many posts of his. As you'll see, it's in response to what Seth wrote yesterday. Both Seth and Michael are trying to answer the question: what is it the people who run America think they're DOING, for God's sake?

Be forewarned, however: Michael shares Seth's fatal flaw, which is knowing what you're talking about. This leaves both of them much less time for my specialty, which is crude insults and jeering.

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by Michael Pollak

Seth,

I don't buy the Nitzan-Bichler theory, although I clearly haven't put as much work into the book as you have. But with that qualification, I think this Kinsley anecdote is kind of perfectly timed to highlight the central problems with the Nitzan-Bichler theory.

When it comes to this oil prices, I'm a conventional thinker. I think oil companies do like price stability for all obvious reasons that have always been given. The only time they like war is when it's very short -- like Gulf War I, which has clearly just finished when Kinsley is having this conversation. At that point, oil prices had been suffering from glut since the mid-1980s (the third oil shock, the one that everyone forgets, the negative oil shock, the one that had Poppa Bush running to Saudi Arabia to get them to raise prices). And then, during GWI, just for a few months, the price spiked enormously. And then went back to its previous level. It was one of the shortest, most successful wars in history. And it was one of the steepest and shortest price spikes in history.

Well, you can see why an oil man would want to have one of those again. It was an idyllic example of the fabled windfall profit. Oil companies did nothing and money just fell in their lap.

But what you don't want as an oil company is a war that keeps oil prices high for an extended period of time. Because then you run into three problems that are all very much increasingly in evidence now -- and which have always invariably recurred since oil first became an industry in the 1860s whenever disturbances have kept prices high for an extended period:

1) Resource nationalism

Oil price contracts are between countries and country-size companies. There is no higher court. It's a purely a matter of power. Whoever has more power gets more money.

When oil prices are low, oil companies have more power. Countries are starved for income and dying for investment. They can be forced to make deals that are outrageously in the companies' interests. And so long as the oil price stays steady (or even better, goes up slowly and steadily) the oil companies keep the whip hand. The countries can't afford the losses that would be incurred by abrogating those agreements.

But double the oil prices and suddenly the producing countries are rolling in money. And then they have the whip hand. And all the advantageous contracts that were agreed to in time of scarcity are "renegotiated" -- i.e., torn up. And the oil companies have to take it. Because they do have contracts at the consumer end that they have to honor or they'll get sued.

As you rightly say, its all about percentages. Gas companies in Bolivia were a lot happier paying 18% of a low price than 82% of a high one.

2) Consumer nationalism

Oil companies are the juiciest scapegoat in the world. No one trusts them and no one likes them. And when price jump dramatically and stay up, the people cry for their heads. The longer they stay up, the more the cry for windfall profits taxes and removing incentives and renegotiating contracts -- whatever will take it out their hides.

The current US government is the exception that proves the rule. This has to be the most oil friendly administration and congress in history. And even here you can see how congressmen feel they have to at least pretend to hit the oil companies. In the past, they did hit them. It takes sole ownership of the government to make it not happen now. And once the oil companies are hit -- in consumer countries, this means an increase in taxes and decrease in subsidies and, most importantly, changes in the bookkeeping and restrictions on doing business -- that hit stays until the balance of power shifts the other way. Which in a consumer set-up happens when prices are stable for a long time. Because that's when gas prices recede into the background. And then they can write in their depletion allowances and lease terms and everybody's eyes glaze over. In consumerland, stable prices are the grail for goldilocks reasons: oil prices going down is always bad; and going up too fast means unwelcome attention; but going up slowly is just right.

3) Huge, long-term fixed investments

This of course is the main reason that oil companies like stability -- and the main reason they hate wars that keep prices high for years at a time and uncertainty of any kind.

If you're going to sink a couple billion dollars into an infrastructure project that's going to last for 30 years, you've got to have an estimate of how much oil is going to cost. And so long as prices are being artificially inflated by war, you don't know what that price is. So no one is going to build a project based on $60 a barrel oil. But if they don't, and prices stay that high, then they'll slowly get squeezed. Producers will take a larger and larger cut. And if it goes on long enough, they'll start nationalizing billion dollar infrastructure projects you've already built. This is the oil companies' idea of hell. This is when their power is at a minimum vs. the other two players in the game.

But so long as the faux inflation lasts there's nothing they can do. If no oil investments are made based on an oil price above $30, and the market price stays $60, supplies will get steadily tighter and their power position will get rapidly weaker. But if they make a long term investment in oil that wouldn't normally be profitable -- let's say at $40 a barrel -- and then, 5 years from now, oil comes back down to $30, then they're fucked. They'll have to keep pumping the oil because of the financing and the contracts with the country. But if they dump it at a loss, the market will go into a death spiral. This is *exactly* what happened after the second oil shock in 1979, which was purely a matter of disturbance in the middle east -- there was no real underlying shortage, just leapfrog buying as distributors and consumers tried to secure supplies. And when all the investment made at that level came on line in mid-decade, oil prices cratered for the next decade and more.

Oil companies would have no trouble investing based on $40 a barrel or $50 a barrel so long as they're sure that's the underlying price based on supply and demand. But that's just it: you can't be sure that's true when prices are artificially inflated. And you doubly can't be sure when they've jumped suddenly and then plateaued at double their normal level. Because then you have a second problem. Not only do you not know what the true long term price is, but there is a 100% margin for using new technologies that have never been used before -- the results of which are by definition incalculable. It might turn out that with that much incentive someone really will come up with a way to make oil shale into a marketable product at $45 a barrel. And that when that opens up whole new huge reserves we'll be back in the land of glut. In which case every multi-billion dollar project based on $50 oil would be a ticket to bankruptcy.

And oil companies do go bankrupt -- all the time. (Although a lot of the time it's called mergers.) Despite their unfathomable amounts of power and money, oil investing is still a hugely risky business. And the reason it will always stay risky is because so much money is at stake, and because the time lines are so long. Keynes defined radical uncertainty as trying to guess the price of commodity in 20 years. Anyone want to bet 3 billion dollars on it? Without even worrying about being nationalized or renegotiated against your will? Or the problems inherent in running through extreme geographical and political environments -- which is the case with almost every new investment from here on out?

So that's why oil companies like stability: it maximizes their power and it maximizes their return over the long term. And the guys who really run the oil companies -- not the drones who fly retail who were ironically joking with Kinsley -- always think in the long term. It's the nature of their business.

One last footnote: the one thing the oil companies have most wanted in the middle east for the last 20 years -- and the thing they still most want in the middle east -- is the ability to invest in Saudi Arabia again on ownership terms. And in the mid 90s they were closer than they'd ever been before. It's conceivable that if they'd had just 5 more years of collapsed oil prices, they probably could have pulled it off -- they were this close to getting the gas contracts that would have led to the oil. Saudi Arabia was famously strapped and suffering badly for it. And now, poof, that's all gone for the foreseeable future. This was not the middle east future the majors wanted.

IMHO, of course.

Posted at May 21, 2006 12:33 PM | TrackBack
Comments

...it maximizes their return over the long term

It's not at all obvious to me that most of them care about the long term. Apres moi le deluge; long term we're all dead.

Posted by: abb1 at May 21, 2006 01:30 PM

i think that this is why there's so much pressure to do something about Hugo Chavez*, too. if he is diverting money that could go to make people like lee raymond into putting cuban doctors into neighbourhoods where no one has had good medical coverage before, how can they be sure some sheikh in the future won't go all bolivar(or god forbid, socialist) on their asses?

*i'm not saying that everythign he's doing is great, but the trend seems to be that the poor venezuelans are now doing a lot better than they used to, and the middle-to-upper class ones are not really worse off in any way.

Posted by: almostinfamous at May 21, 2006 01:46 PM

This (very good explanation) is compatible with the "they want to make 'more money than the other guy'" part of N-B's theory. After the basic needs and luxury desires are taken care of, it's all about power.

Posted by: J. Alva Scruggs at May 21, 2006 03:36 PM

I'm sorry. I thought you meant Michael Pollard, the actor from the seventies. It wasn't about him at all.

Posted by: Bob In Pacifica at May 21, 2006 10:18 PM

I do not buy into some of what Kinsley stated in his Washington Post-hole column.

"But until I see hard evidence, I am not going to believe that American business executives would induce the government to start a war, even if they had the power to do so."

Even if they have the power to do so? Bush comes from an oil family, Cheney, well everyone knows Cheney is oil and Rice has an oil tanker named after her. The oil companies are the government from the look of things.

"These days even President Bush is dissing the oil companies. He doesn't accuse them of starting the Iraq war, of course, but he does now favor looking into other possible misdeeds, such as antitrust violations."

Bush is desperate and would say anything to keep the democrats out of power because he does not want to be investigated. And when Kinsley says Bush does not accuse the oil companies of starting the war I have to wonder if Kinsley has scrambled eggs for brains and fried eggs for eyes. Bush started the war, he pushed and pushed and lied to get his war he does not have to accuse anyone but himself so just what is the point of Kinsley's statement? Bush says a lot of things and of course much of it is posturing does Kinsley actually believe Bush cares about misdeeds? Was Kinsley born yesterday?

Kinsley goes to some length to analyze the oil situation however he seemingly selectively forgets to leave out the problems with oil production in South America and Africa which has added to a shortage of oil, oversimplification indeed.

"The oil companies, like other big corporations, are mostly owned by ordinary citizens..."

Ordinary citizens own the oil companies? Oh yeah all the ordinary folk who make up the ten percent of the wealthiest people in the country, they jes be down home folk, po folk jes like you jes like me.

Kinsley seems to be mixing fact with fantasy, first he says something that sounds quite reasonable then he fills it in with malarkey in an effort to make the malarkey sound reasonable, something Rush Limbaugh does all the time. And of course we all know how accurate Limbaugh is in his drug induced ramblings.

How hard is this? Look at the huge profits the oil companies are wallowing and to top off the profits we the taxpayers are footing the bill for Bush's 8 and a half billion dollar gift to the oil companies, talk about burning your oil wells at both ends.


Posted by: rob payne at May 22, 2006 01:02 AM

"Maybe once technology really gets going and opens up whole new huge reserves, or makes heavy oil or oil sands marketable at $45 a barrel, we could be back in the land of glut."

Maybe, just maybe, "technology" cannot summon oil into existence. The preponderance of evidence suggests there are no "new huge reserves" to be discovered. Or do you believe that we need even higher prices to provide the incentive to look?

As for "heavy oil or oil sands marketable at $45 a barrel" - hello? It's profitable at less than that. Most oil sands production costs on the order of $20 per barrel. For example

http://sustainability.syncrude.ca/sustainability2004/finance_economy/operating_costs.shtml

Posted by: JustZisGuy at May 22, 2006 08:53 AM

The longer [oil prices] they stay up, the more the cry for windfall profits taxes and removing incentives and renegotiating contracts -- whatever will take it out their hides. The current US government is the exception that proves the rule.


Since this is the administration we're talking about, that is an important exception, no?

BTW, you could make the same argument about electricity producers and distributors: "None of the companies in California would want to steal all of California's money because then the gov't would step in and turn the money spigot off."

And yet this is precisely what happened, after far too much dithering by the Bush administration. If the companies had stolen just a little bit less, they'd be far more profitable long term.

Posted by: Cal at May 22, 2006 01:10 PM

[oil prices] going up slowly is just right

This is the source of the immense power that Saudi Arabia has held over U.S. policymakers for so long. With the world's largest reserve of easily extractable oil, they've been able to fiddle with the spigot to keep oil prices right where the companies want them. (Or where the U.S. government wants them, whichever's offering a better deal at the moment; under Reagan, there did get to be a glut because of RR's demand for U.S.-economy-boosting low prices, paid for in massive military supplies and in our looking the other way while they exported their restless Salafist youth).

Posted by: Nell at May 22, 2006 02:58 PM

[Technology cannot summon oil reserves into existence.]

No, actually it can:

http://www.geophysics.rice.edu/department/faculty/talwani/articles/talwani_nyt.html

That's not to say it will. But it's not an unreasonable thing to worry about when you're making a 30 year investment. Syncrude Canada now produces 350,000 barrels/year at a production cost of $20/barrel. If they became certain it was going to be profitable going forward to produce oil at $40/barrel, then obviously they could tap reserves they currently aren't harvesting because it's not worth it. How much would that expand their reserves, and how much more could they produce per day? That's a very good question and the answer is uncertain with a wide band. And that's why oil men hate huge price leaps: they introduce discontinuity and uncertainty. If prices raise gradually, reserves rise gradually, and you have trendlines. If prices raise discontinuously then you could have a qualitative leap. This is the kind of possibility that doesn't bother consumers but does bother men putting down billions for 30 years. Which is why they prefer if at all possible to have the smoke clear first.

And oil sands and shale are simply bloggily dramatic examples of a universal process. Technology is always expanding reserves by allowing us into more extreme environments and by more efficiently processing the reserves we already know about. Raise the price discontinuously and reserves will increase discontinuously. That you know for sure -- you just don't know how much. It's not a problem on the time scale of filling your tank, and it's not a problem on the time scale of the peak oil theory. But it is a problem on the timescale of amortizing a multibillion dollar infrastructure investment, which is the timescale that counts for oil men. Which is why they hate price discontinuity.

While we're on the subject, there is a second, much more obvious way of hugely changing the supply and demand dynamics on the demand side. The demand for petroleum products is famously inelastic. But that goes both ways. If you double the gas price for a few years, you barely make a dent in the SUV market. But if you keep it up there for a decade, you will eventually reach a tipping point where people will massively replace them with Hondas, just like they did with the Cadillacs and Oldsmobiles of the 1970s. And if that happens (along with analogous developments in the way we fuel power plants, insulate houses and choose our next jobs in terms of their commute), US per person consumption could easily halve -- which would be like finding a huge reserve in reverse. This was the other side of the great negative oil shock of the mid 1980s. And what happens at this point is that inelasticity goes the other way: when the price of gas halves, demand doesn't increase much because take years before people forgot -- and years more before they slowly wear out their cars and get new houses and jobs. So if your plant, based on a higher production price, just comes online then (thanks to its long lead time) well you're pretty screwed.

All of which is to say: there's a reason why these guys move slowly -- and why they wish prices would as well.

Posted by: Michael Pollak at May 23, 2006 09:29 AM