The real cause of high oil prices: an interview with James Hamilton

James Stafford: Oil prices have shot up in the last month. What range do you see oil prices trading in over the next 12 months?

James Hamilton: Oil prices have always been very volatile. If you look at 12-month logarithmic changes in WTI going back to 1947, you come up with a standard deviation of 0.27. In other words, 25% moves up or down within a year are fairly common, and 50% moves or greater have also been seen on a number of occasions.

If you look at options prices at the moment, they imply the same level of uncertainty looking forward. For example, somebody today is willing to pay $2.90/barrel for a NYMEX option to buy oil in September 2013 at $120/barrel, consistent with a standard deviation of annual log changes of 0.26. The market is saying that prices that high or higher are not that remote a possibility.

And if you look at current fundamentals, it's not hard to imagine big moves in either direction coming fairly quickly. The price of oil would surely collapse if we saw a significant economic downturn in China (something nobody can rule out) or if Iraq succeeds in producing even half of its ambitious production targets (though I personally consider the latter unlikely). On the other hand, a military confrontation with Iran could produce a pretty spectacular price spike. If the Strait of Hormuz were to close, for example, it would represent a shock to world production that in percentage terms would be 3 times as big as the 1973-74 OPEC embargo.

Because the demand for oil is so insensitive to the price over the short run, and because there is little excess capacity in the world at the moment, even small disruptions or additions could produce big price changes. For this reason, I do not have a lot of confidence in anybody's near-term oil-price forecasts.

On the other hand, I think we understand pretty clearly the main factors behind the overall increase in oil prices since 2005. Demand for oil, particularly from the emerging economies, has grown significantly, and we have had a hard time increasing global production. The single most likely outcome is that both conditions will continue to be with us. The most likely scenario is that the next decade will look something like the last, with oil prices volatile but exhibiting an upward trend.

James Stafford: For the past century or so, economies have generally been built upon energy. The economies with access to plentiful, cheap energy have developed the most. With the stagnation of oil production growth, how do you suggest economies could continue to grow from here? Should we stop expecting to see constant economic growth as the norm?

James Hamilton: I think this has put a significant burden on the oil-consuming countries. These economic problems have been compounded by the fact that some of the key manufacturing that once came out of countries like the United States and Japan has now been taken over by the emerging Asian economies.

But there is still a strategy for trying to take advantage of the resources we do have. The United States has had astonishing success in producing natural gas. This could be the basis for a renewed manufacturing advantage, a new source of U.S. exports, or an alternative transportation fuel. We should be looking for regulatory reform and infrastructure investment to encourage consumers and entrepreneurs to adopt alternatives to conventional gasoline-powered vehicles.

James Stafford: Apart from the Iran and Syria situations - are there any other geopolitical risks that could lead to increased volatility in the energy markets?

James Hamilton: The list of oil-producing countries is almost a Who's Who of world trouble spots. There is ongoing unrest in Sudan and Nigeria, and it wouldn't take much to see a major turn of events in Venezuela and Kazakhstan. Iraq, a key hope for future increases in production, has been a place of conflict for most of the last three decades. The same forces that disrupted production in Egypt and Libya last year could easily return. And the key worry about Syria and Iran is the possibility that instability there could spill over into other nations of the region.

James Stafford: Even though many Asian nations have found a way to continue trading with Iran, its economy is still suffering from high inflation and high unemployment. Do you believe that the US Sanctions are having enough of an impact on the Gulf state's economy to force them into a deal over their nuclear program?

James Hamilton: I was surprised that the sanctions were as effective as they were in preventing Iran from selling all the oil it wanted. But the other key element of that diplomatic strategy is the assumption that Iran will respond to economic pressure by acceding to U.S. demands. The other possibility is that, if significantly wounded, the regime would lash out more desperately. This looks to me like a scary situation.