Wednesday, June 02, 2004

Economy Theory: Risk Premium Revisited

Earlier I suggested that the current price in oil with its reflected risk premium does not have the complete risk discounted by the market price. In order to establish I appealed to the logical and absolute concept of what a risk premium is and then explained why the invested or beholden nature of the market participants suggested that the difference between these two meant that the risk premium was "too low".

To understand this, let us ask a question first. Why does if the oil supply have an increased risk of disruption increase the market price at all?

Think of it with regards to supply and demand. The buyers need the oil. So if the price of oil is being raised, this means that supply must be either decreased or demand increased. Since supply is growing with OPEC and co. increasing production (Reuters via NYT),

BEIRUT (Reuters) - OPEC made a renewed bid on Wednesday to wrestle world oil prices lower by boosting export flows, even before an expected cartel decision to raise formal output limits. The United Arab Emirates said it was immediately releasing an additional 400,000 barrels daily this month, complementing 700,000 bpd already on the way from Saudi Arabia.BEIRUT (Reuters) - OPEC made a renewed bid on Wednesday to wrestle world oil prices lower by boosting export flows, even before an expected cartel decision to raise formal output limits. The United Arab Emirates said it was immediately releasing an additional 400,000 barrels daily this month, complementing 700,000 bpd already on the way from Saudi Arabia.

The extra crude is being pumped regardless of the details agreed in any official new deal among the Organization of the Petroleum Exporting Countries at a Thursday meeting in Beirut.

Leading exporter Saudi Arabia appears to have backing from most in OPEC to lift supply quotas at the top of the range under discussion -- 2.5 million barrels daily, or 11 percent, to 26 million bpd.

Then it must be that people want to buy more oil. Why do they want to buy more oil? To hedge for any supply disruptions. That way if supply is disrupted then they will have enough to keep on going. That is why the price is rising. Of course it isn't all people wanting to buy oil for their own use, people may be speculating on the price of oil to buy commitments to sell later when they anticipate the price rising even more. However this speculative buying is still dependent upon the concept of a later adjustment in pricing due to a supply disruption and the unfilled demand from invested or beholden users of oil.

FREE AGENT THEORY

So the question is how much the price should rise? How much of a price rise would fully discount the risk in continuing the engage in using oil? That amount would be determined by how much of an oil reserve would be necessary to continue safely using oil even if there were a later supply disruption. How much of an oil reserve is required? At least enough in order to keep them going long enough to switch to another viable alternative energy source.

At this point we introduce the concept of a free agent. If someone not already invested in petrochemical and fossil fuel energy were to approach the situation this would be our free agent. Suppose the free agent has to decide between their country deciding the use oil with the possibility of a supply disruption and another form of energy. In a perfectly rational market as a buyer with perfect information, they would refuse to buy fossil fuel energy systems unless they could assure themselves that a sufficient supply reserve existed in order to maintain continuity in the face of any disruption. Or at least sufficient a supply so that they could reasonably continue long enough to switch to another form in the event of such a disruption.

Put it this way. A car company is trying to sell you a hydrogen car. Would you buy it unless you knew that hydrogen fueling stations were around and that your car would be serviced? Probably not.

So what is the risk premium? The risk premium is the price charged because somebody would have to buy enough hydrogen and invest in enough hydrogen car trained technicians for you to be assured that you would be "safe" in investing your transportation dollars in a hydrogen car. However the act of stockpiling enough hydrogen and buying enough technicians would result in an increase in demand for these things. If supply was static this would create a price rise in hydrogen. So ironically, ensuring a supply and service continuity creates for a free agent a rise in the price that they would pay.

If we apply this free agent theory to the market pricing of oil, we can then guestimate what the 'free agent risk premium' would be - the price rise necessary to reflect a sufficient supply to safeguard against disruption. Well what is the actual risk entailed? The risk is of having to switch to a different energy source. The nearest competitive energy source - fossil fuel extraction from coal, solar, wind, hydrogen - all roughly start becoming competitive when oil starts getting around around $50-$60 pb.

With a "fundamental" price of roughly $30 according to many market watchers, this means a 'free agent risk premium' of about $20-$30 dollars.

Remember the 'free agent' is not interested in the cheapest energy source, but the most secure one. Hence why the risk premium is an attempt to price security and continuity of energy supply. If oil was about $50-$60 pb then the free agent would be assured of having a supply reserve sufficiently large and then even if oil were completely taken off the market later to switch to another form of energy without any disruption.

You see the important thing is maintaing energy supply in this scenario, and not getting the cheapest price. This is the result of a demand led inflation in price.

Why Isn't The Price of Oil That High?

Because the market participants aren't free agents. They are already invested in oil. They have to buy it and use it. There is no point therefore in stockpiling enough so that they can switch to another form of energy. So the market price is about $40 pb. They don't have the luxury of switching to hydrogen as long as the supply is available.

Suppose that there is a supply side shock however because the pumping of oil is disrupted on a wide scale. The supply shock when it reached the point of lowering available inventories sufficiently to raise prices to $50-$60 dollars would then cause people to start switching to other forms of energy. This would be a supply led inflation in prices. This wouldn't end the use of oil, but would be the next stability point in prices. If less people used oil, this would lower demand and stabilize prices even though supply had decreased.

But everyone knows that they may be forced to deal with a very unfriendly rise in oil prices. How much of a rise? Up to $50-$60 dollars pb. This is not my speculation. Market watchers are already calling for this number in the event of a crisis this year or next. So people are naturally anxious. This leads on a mass scale to various problems.

The Shit Rolls Downhill

The point of this exercise is to contrast the psychologically perceived risk ($50-$60 pb) with the actual risk. It has been shown that it is generally not the actual level of any stressor that determines anxiety. Anxiety is determined by how openly one can deal and communicate regarding the stressor in order to alleviate it. If the market price is $40 pb but people can't make any changes until $50-$60 pb then in the meantime there is a unresolved stress factor. It's the feeling of being helpless that is the most psychologically dehibilitating. People have an intrinsic need for what psychologists call "control" or "mastery". They need to feel in charge of their destinies.

This is why the PEW polls show that people around the world are in such despair about the way America is using its power. The results have not been all bad, but they feel like this is being shoved down their throats. So they would like to change. They would like to be free agents and opt of the system. But they can't until oil hits $50-$60 pb. So even though economically it doesn't make any sense, until they are able to switch and start feeling some control they will blame the United States of America. It's not about getting the cheapest option. It's about having options.

On the local level this will mean more fights, more tension, more family disruptions. People will be unhappy if they're forced to live in a world of uncertainty without being able to do anything about it. In return they will blame the scapegoat - which in this case is America. America is the current person of infamy bearing the blame for the world's woes regarding terrorism, etc. Hence people will take it out on Americans.

On a mass scale how much will they take it out on America? To the tune of relieving their personal stress. As anyone knows the number one thing married couples fight about is money. Similarly, if people are seeing the possibility of being forced to choose but unable to choose they will start to blame someone else for their "being stuck".

That's just the way it goes. So they will transfer their economic ire to the United States. Now this reasoning may seem odd. I do not claim that it is logical. The difficulty in dealing with people is that they are not rational. I do not claim that my reasoning is logical. I only claim that it reflects the underlying sentiments and group psychological processes of humanity.

The GDP drag factor of the world's hate therefore is likely to be 1%-2% and combined with the 1% GDP drag of the increased oil prices presently, they will combine to be the 2-3% that I suggested earlier.

2 Comments:

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