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Michael Lynch: How Two Nobel Prize-Winning Economists Got Oil Wrong


My recent book details the numerous mistakes made by many experts—real and apparent—about the oil market and oil prices, and this post will point to two in particular (the latter of which did not appear in the book).  Robert Solow and Paul Krugman are both M.I.T. professors of economics (Krugman only for a time) and Nobel Prize winners in economics.  I had an undergraduate course with the former, and very minor contact with both over the years (neither of whom is likely to remember me) and consider them to be scholars and gentlemen.

Which doesn’t mean they haven’t been seriously wrong about petroleum economics in ways that are instructive to us all (in theory; in practice, I’m not so optimistic about our ability to learn). The former allowed himself to be blinded by math, the latter more by ideology, but both fall prey to what Tom Nichols (author of the excellent book The Death of Expertise) calls “stretch[ing] their expertise from one area to another.”

To the WABAC machine, Sherman. December 1973, the American Economic Association is holding its annual meeting in Boston, its members spread out across a number of hotels (and a larger number of bars).  The October/Ramadan war between Israel and Egypt and Syria (primarily) had broken out two months earlier, and OAPEC (not OPEC) declared an oil embargo (the second, not first) and cut production by 4 million barrels a day, at the same time that some of their negotiators were meeting with the operating companies in Vienna to demand higher tax payments.

Not surprisingly, given the tight oil market at that time, oil prices shot up, roughly tripling in a few months. By the time of the AEA meeting, the first Oil Crisis had begun and naturally was an object of attention. Two speakers in particular are of interest here, one a young Robert Solow, who promoted what came to be known as the Hotelling Theory, an interpretation of a 1931 article by Harold Hotelling. Briefly, it could be shown mathematically that mineral prices should rise exponentially over time. Later, other economists would argue oil prices in particular should rise at the rate of interest, roughly 3% per year above inflation.

The figure below, showing oil prices up to 1972, should immediately have thrown this into question. There is obviously no such trend as the Hotelling theory would predict. Indeed, quite a lot of work has been done to show that mineral and energy prices do not have historical trend towards rising prices. Indeed, this was the subject of a famous wager between Julian Simon and Paul Ehrlich, which Ehrlich lost badly (and foolishly, betting on rising prices after a period of rapid inflation).

Oil Price in 2015$

Author from BP data.

Oil Price in 2015$

Now, it is true that oil prices had not been governed by a free market through most of the period before 1973, which can could be a rationalization for the theory’s failure, although not as much for prices of metals, for example. What might be more troublesome is that another M.I.T. economist, M. A. Adelman (my friend and mentor) also spoke at the 1973 AEA meeting and he was a resource economist, who had the previous year published The World Petroleum Market, a data-heavy exploration of petroleum economics. He ascribed the price increase to the production cutbacks.

Which view prevailed? Neither at first, especially since the market began to weaken after 1974. However, as a chorus of voices were raised to say that oil markets would tighten again and prices renew their upward march (see chapter 2 of my book), the onset of the Iranian Revolution, when prices soared again, the consensus somehow interpreted the effect of a 6 million barrel per day supply disruption as unimportant and argued rising prices were due to resource scarcity. The Solow interpretation of Hotelling dominated the oligopoly view of Adelman.

Fast forward to the peak oil “crisis” of the 2000s and our second economist, then Princeton professor Paul Krugman, is a columnist for The New York Times and as such, presumably felt compelled to talk about the high oil prices in 2008 and the peak oil theories. And he gets both completely wrong.

In a May 12, 2008 column, Krugman pooh-poohed the idea that speculation was driving the oil price (then at $125 a barrel), saying:  “all through the period of the alleged bubble, inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn’t the result of runaway speculation; it’s the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China.”

[Compare and contrast with my May 28 column entitled “Investing for the Oil Price Collapse”]

Further, he attributed the tendency to blame speculators on conservatives in this instance, a reversal of the usual politic spectrum, and especially because of their failure to recognize that “a realistic view of what’s happened over the past few years suggests that we’re heading into an era of increasingly scarce, costly oil.”  He later doubled down on this, describing “the way ideas go from crazy stuff that only DFHs believe to stuff everyone knows, without ever going through a stage in which the holders of conventional wisdom acknowledge that they were wrong. Oh, and the people who were right are still considered DFHs; you see, they were right too soon.

It looks as if peak oil may be going that way.”  [DFH is an acronym that can’t be translated here, but consider ‘treehuggers’ as a good equivalent.]

In this case, the problems are that a) Professor Krugman is not an expert on resource economics, b) he has viewed this through political lenses, c), he has assumed temporary price trends are due to long-term changes; and d) cardinal error: he takes a bad price forecast as evidence of bad underlying theory, as when he noted, the headline of an October 2004 article in National Review, which argued that oil prices, then $50 a barrel, would soon collapse.

Ten months later, oil was selling for $70 a barrel. ‘It’s a huge bubble,’ declared Steve Forbes, who warned that the coming crash in oil prices would make the popping of the technology bubble ‘look like a picnic.’”

[Disclaimer:  I receive some (very inadequate, IMHO) compensation from Forbes for my columns, and Steve Forbes is a minority stakeholder. Neither he, nor Forbes, is responsible for any of my opinions.]

To some extent, this is like the dispute between the psychic Uri Geller, whose abilities were confirmed by physicists and the Amazing Randi, who showed that Geller was simply performing sleight of hand.  Steve Forbes does not have a Nobel Prize in economics, but he apparently understands market behavior better than Paul Krugman.

In fact, I have taken much grief for bad (short-term) price forecasts from many who consider me a ‘denialist’ on peak oil.  The difference is that I freely acknowledge, and address, my mistakes.  My book even includes a list of bad price predictions collected by a critic, to which I add a list of research papers and long-term price predictions and the extent to which my work does, or does not, hold up.  Paul Krugman (nor my many critics) hasn’t admitted to his error from what I can see, putting him in company with apocalyptics like Paul Ehrlich and James Howard Kunstler, a disreputable place for a scholar.

And whatever happened to our first Nobel Prize winner and the Hotelling Theory? Funny you should ask.  In a 2009 review of the theory, two economists warned, “The oft-cited fact that the Hotelling model is frequently rejected by the data … must be interpreted with caution.”  What they failed to note is that a number of resource economists, including Richard Gordon and Campbell Watkins, as well as Adelman, had explained in detail the theoretical errors that make the theory invalid—and been ignored.

Ultimately, the peak oil theory and the oil price spike to 2008 should serve as a strong object lesson to those who think a little internet research can be a substitute for years of experience in a field, lest they become the object of snarky internet posts by arrogant bloggers with experience and a sense of history.


13 Comments on "Michael Lynch: How Two Nobel Prize-Winning Economists Got Oil Wrong"

  1. onlooker on Fri, 16th Jun 2017 10:16 am 

    And what is your expertise Mr Lynch?
    Other than prostituting yourself for the BAU institutions. Notice no mention of thermodynamics or ETP. Too bad cause those who study tat field are the experts that count

  2. spike on Sat, 17th Jun 2017 6:35 am 

    Gee, onlooker, you don’t suppose 40 years of work and numerous research publications qualifies me? How about my membership in the Bavarian Illuminati?

  3. Davy on Sat, 17th Jun 2017 7:28 am 

    Spike, we don’t care for self promotion by elite wannabes.

  4. spike on Mon, 19th Jun 2017 3:51 am 

    Gee, Davy, you didn’t notice that I was asked for my qualifications? but thanks for the insult, I’ll add it to my collections.

  5. Davy on Mon, 19th Jun 2017 4:41 am 

    Spike, insults are a way of life on this board if you don’t like them go to another. IOW “toughin” up. I find it is those with the qualifications today that are the most off course. When I see qualifications I see the opposite of what those qualifications stand for. We are in a turning and the turning includes wisdom. Those claiming to be wise are delusional. What are you spike? What is your goal in life? Self-promo?

  6. makati1 on Mon, 19th Jun 2017 5:01 am 

    spike, nope! I agree with onlooker, and, “Gulp!”, Davy. You don’t touch on the real important points.

    I don’t care if you have so many worthless degrees that you cannot remember them all or that you did something for 40 years. I did ‘something’ for 40 years also but I would not pretend to be an expert, just experienced.

    BTW: I equate “economists” along with used car dealers and snake oil salesmen. Few ever get it right and fewer still have actually sweated for a living for even one day of their lives. Pompous leeches mostly. About equal to lawyers.

  7. Davy on Mon, 19th Jun 2017 6:00 am 

    Say something makati. Do you have anything to back that assertion up? Could it be I slap you silly daily with points and all you can do is complain? Yeap that’s the point I think.

    At least spike is not a drop out. I guess you couldn’t handle the rigor of a university. Maybe we can look at your experience as a Mormon priestess. Your experience is continuous failure and this is why you spend your days telling us how special you are. It is your failed way of finding worth from a worthless life.

  8. makati1 on Mon, 19th Jun 2017 6:22 am 

    Davy, you are the delusional one. Slap me silly? I didn’t notice anything but rants coming out of you. More of your “exceptionalist” bullshit every day.

    You are jealous because I escaped the Police State and am enjoying life with more freedom than you will EVER have. Spike is a self promoter that likdly never actually worked a day in his life. You probably relate to that. How many hired hands are doing your dirty work these days?

  9. Sissyfuss on Mon, 19th Jun 2017 8:35 am 

    If Spike knows what’s good for him, he won’t be back. Our boys will rip him a new one and then go back to their breakfast. We have now experienced peak Spike.

  10. Davy on Mon, 19th Jun 2017 8:56 am 

    Makati, yea, you just described yourself and your fantasy farm. You sit daily in your high-rise in Manila busy internet trolling. You send a few dollars a month to the farm hands at the fantasy farm then act expert on farming. You go to the farm once every 6’months or so and claim to be a farmer. How do I know this? When you arn’t here you are at the farm. There is no internet on the farm so it is easy to monitor your lies.

  11. spike on Mon, 19th Jun 2017 2:51 pm 

    Wow, Sissyfuss, such confidence! I’ve been insulted by CEOs (well, just one, and he’s dead now). I might not come back, but because I get bored with an entire conversation that consists of nothing but insults. There are people on this site who discuss real issues, but none of them here so far.

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