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

Consumption

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.

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.

Forbes



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

  1. Outcast_Searcher on Sat, 4th May 2019 11:58 pm 

    Bravo. Far too few people who claim expertise are willing to admit their mistakes, and we all certainly make them.

    Paul Krugman might well be better able to get people to listen to his ideas if he were less arrogant, and if he were willing to admit to his MANY mistakes more often.

  2. Anonymous on Sun, 5th May 2019 12:55 am 

    Then there’s James Hamilton. He’s gone radio silent now that he was so wrong.

    What always got me was how poor his microeconomic instincts were. Just very different from James Griffin or Ron Braeutigam. Those guys get supply and demand and oligopolies. Hamilton was almost more of a scholastic in trying to throw footnotes at things versus thinking.

    And then in addition, he was too willing to listen to the nuttier analysts like Berman and Hughes. And his comments about companies showed a lack of NPV intuitions.

  3. makati1 on Sun, 5th May 2019 1:32 am 

    Economist: A degreed person who still guesses and uses the past when prognosticating the future. Reading chicken guts would be as accurate. A lot of fancy words and names for guesses.

    Tell me ONE of them that predicted the last crash (2008) accurately AND the following 10+ years of stagnation/regression? Who predicted zero interest for 8+ years? Who can tell me accurately what the price of oil will be at Christmas? Answer: NO ONE!

    I still maintain that the Fed is deliberately setting the US up for a huge fall. When? Soon.

  4. Davy on Sun, 5th May 2019 3:49 am 

    “Paul Krugman might well be better able to get people to listen to his ideas if he were less arrogant, and if he were willing to admit to his MANY mistakes more often.”

    Yea, right, LOL…that money grows on trees and government is the true generator of growth? Blind lying liberal and somethin-for-nothin socialist love to hear those ideas and BTW these types are arrogant and stuck up to boot.

  5. Davy on Sun, 5th May 2019 3:56 am 

    “Economist: A degreed person who still guesses and uses the past when prognosticating the future. Reading chicken guts would be as accurate. A lot of fancy words and names for guesses.”
    BS, makato, economist provide a very important service to complicated economies. The fact that some are frauds does not mean the field or the activity is not important and respectable. You don’t understand economics is your problem. You look for propaganda material for your agenda and honest mathematical economics messes up your fantasy.

    “Tell me ONE of them that predicted the last crash (2008) accurately AND the following 10+ years of stagnation/regression? Who predicted zero interest for 8+ years? Who can tell me accurately what the price of oil will be at Christmas? Answer: NO ONE!”
    Like we all know their names by heart, stupid?? There were plenty who saw the problems coming pre 08.

    “I still maintain that the Fed is deliberately setting the US up for a huge fall. When? Soon.”
    What a dumbass conspiracy theory loon. You and cloggo have something in common you project your agenda in to conspiracies. Cloggo’s favorite is that Trump is secretly breaking up the US as his primary goal. LOL. Two fruit cake old men board and lonely speculating with fantasy.

  6. Davy on Sun, 5th May 2019 4:17 am 

    “Then there’s James Hamilton. He’s gone radio silent now that he was so wrong.”

    I salute you Nony for proving us peakers wrong. I was an early peaker but came around once the numbers told the real picture. You are lucky central banks intervened making lots of cheap money available to the energy sector. You took lots of abuse and came out a victor, Nony, so you deserve to gloat a little. Yet, shale is still a retirement party…then what? Not much will be left in the ground to mess with post shale.

  7. Cloggie on Sun, 5th May 2019 4:34 am 

    OK, so mr Robert Solow and Paul Krugman got oil wrong?

    Well, we have to cut these two illustrious representatives of The Tribe some slack here, as they have bigger fish to fry then dutifully spending their lives anticipating the development of the oil market. The organizing of the demise of white America comes to mind.

    Krugman:

    https://documents1940.wordpress.com/2017/09/27/paul-krugman-white-americans-are-losing-their-country/

    Solow:

    He is the guy who sought to create a scientific underpinning for the idea that “immigration is good for the economy”.

    https://democracyjournal.org/magazine/42/the-case-for-more-immigration/

    The real aim of both gentlemen is purely political and self-serving tribal and aimed at increasing the power of The Tribe by weakening European-America.

    Both Krugman and Solow are prominent members of George Carlin’s “Big Club of which you ain’t in it!”. They couldn’t care less about oil.

    https://www.youtube.com/watch?v=cKUaqFzZLxU

  8. makati1 on Sun, 5th May 2019 7:57 am 

    Cloggie. we seem to agree on your assertion that TPTB are taking down the US deliberately and scamming as much money from it as they can before it pops. Most have their wealth locked away in real things, not paper I’O’U’s. Especially not dollars.

    The more I read, the more I find that many have their real wealth outside the US. In that sense, they are smart. when the SHTF you want to be mobile if you are still in the US. Owning big chunks of land will mean nothing. Ditto for big houses.

    All you need is shelter. No one will want, or be able, to buy those mac-mansions many are planning to use as their retirement nest egg. Maybe they can become boarding houses, if there is anyone able to rent the rooms?

  9. Cloggie on Sun, 5th May 2019 9:44 am 

    Cloggie. we seem to agree on your assertion that TPTB are taking down the US deliberately and scamming as much money from it as they can before it pops.

    No, “they” are not deliberately taking down America. For decades they have been taking down European-America, a subtle difference.

    The 100 year old idea and grand strategy was to use America as a template for a future world without borders and mixed races and religions, and once achieved to gradually phase out religions and replace it with a secular holocaust religion.

    Between 1990 and 2000 (((they))) had America, Europe and Russia under control.

    “Peak Jew”: 1999

    And then Hitler-2.0 appeared on the scene: Vladimir the Great.

    Russians now very well understand the motives of the Austrian:

    https://russia-insider.com/en/history/adolf-hitlers-spot-1936-speech-evil-soviet-bolshevism-transcript/ri26932

    Since 1999, a few unexpected things things happened along the route towards that kosher nirvana and global Zion:

    – meteoric rise China, immune for kosher influence
    – consolidation post-communist Russia, kicked out oligarchs
    – European populism
    – Brexit
    – American white nationalism + Trump

    All huge negatives for the NWO.

    Instead they are now with the back against the wall and attempting to at least keep the US and UK under control.

    They have meanwhile given up on the world and even on the West:

    https://documents1940.wordpress.com/2019/01/07/the-good-news-zog-is-dying/

    I have never been more upbeat, geopolitically speaking, in my entire life.

  10. Sissyfuss on Mon, 6th May 2019 8:43 am 

    We are currently in the process of developing an economic system that will succeed in a Limits to Growth burgeoning reality. To say we are struggling to implement such a non-growth based fiscal apparition is quite the understatement. The Fed knows that one false move could bring down the debt levee that encircles us and their mission of salvage is made all the more difficult by Herr Drumphs lack of reasoned thought. Capitalism has changed its basic form forever and will keep changing with alacrity to try and stem the tide of collapse while we descend into further overshoot and an ever tightening bottleneck.

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