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16 | GlobeAsia June 2016
Since its high of almost $108/
bbl in June of 2014, we
have witnessed a stunning
collapse in the price of oil. Indeed, in
February 2016, a barrel of West Texas
Intermediate (WTI) was trading at $26/
bbl, a 76 percent plunge from the June
2014 highs. It has since clawed its way
back to $49/bbl (May 24th).
What caused the price collapse
On the price of oil
of this all-important commodity, and
where is its price headed? When
looking for the causes of price change,
nothing beats a sound supply-demand
analysis. In the past few years, the
United States has played a big role
in affecting the world’s oil supply
picture. The U.S. was once the world’s
largest producer and exporter of oil,
and by 1970, its production peaked
at 9.6 million barrels per day. Then, a
long decline set in, and by 2008, U.S.
oil production had been slashed to 50
percent of its peak.
Two new technologies – hydraulic
fracturing and horizontal drilling –
turned oil and gas production in the
U.S. around dramatically in a few
short years. By the start of 2015, oil
production in the U.S. was 80 percent
June 2016 GlobeAsia | 17
higher than it had been in 2008. The
increase of 4.1 million barrels per day
exceeded the comparable increase in
every OPEC country but Saudi Arabia.
So, there was a supply surge led
by the U.S. In addition, the world was
mired in slow growth following the
financial crisis of 2008-09. The supply-
demand factors finally caught up with
the oil market in June 2014, when the
market started to roll over. By the
time of the 166th OPEC meeting in
November 2014, the price of a barrel
of WTI had fallen from $108/bbl to
$74/bbl, a 31.5 percent plunge. Then, a
historic decision was announced at the
meeting. In what became known as a
“battle for market share,” the members
of OPEC stated that they would allow
market forces to determine oil prices.
On that announcement, oil prices shed
another 8 percent in one day.
Since that historic November
2014 OPEC meeting, there has been a
great deal of shadow boxing among
producers and an endless stream
of forecasts about the future course
of oil prices. One move that merits
particular attention is that of Prince
Mohammed bin Salman of Saudi
Arabia. With Prince Mohammed’s
Vision 2030 plan, it looks like the battle
for market share will be the law of the
Steve H. Hanke
Professor of Applied Economics at the Johns Hopkins University in Baltimore. Twitter: @Steve_Hanke
50-50 chance that a belligerent will
overthrow the House of Saud within
the next 10 years.. In this case, there
would be a 6.7 percent chance of an
overthrow in any given year. This
risk to the Saudis would cause them
to compute a new real risk-adjusted
rate of discount, with the prospect of
having their oil reserves expropriated.
In this example, the relevant discount
rate would increase to 28.6 percent
from 20 percent. This discount rate
increase would cause the present value
of reserves to decrease dramatically.
For example, the present value of $1 in
10 years at 20 percent is $0.16, while
it is worth only $0.08 at 28.6 percent.
The reduction in the present value of
reserves will make increased current
production more attractive.
So, the Saudi princes are panicked
and pumping oil today – a ‘take the
money and run’ strategy – because
The Saudi princes are panicked
and pumping oil today – a ‘take
the money and run’ strategy –
because they know the oil reserves
might not be theirs tomorrow. In
short, problematic property rights
encourage rapid exploitation.
Histogram of Oil-Gold Ratios
Sources: “Historical Data-Crude Oil” Historical Data-Energy. CRB, n.d Web.26 Apr 2016. <http://
www.orbtrader.com/marketdata/energy.asp>. “Historical Data-Gold.” Historical Data-Metals and
Plastics. CRB, n.d. Web. 26 Apr. 2016. <http://www.orbtrader.com/marketdata/pro_metals.asp>.
Calculations by Prof. Steve H. Hanke, The Johns Hopkins University
0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16
Feb 2016 Oil-Gold Ratio
May 18 2016 Oil-Gold Ratio
land for the foreseeable future.
To understand the economics
behind the Saudi production increase
in their quest to maintain market
share, we must understand the forces
that might cause the Saudis to increase
their discount rates.
When it comes to the political
instability in the Middle East, the
popular view is that increased
tensions in the region will reduce
oil production. However, economic
analysis suggests that political
instability and tensions (read: less
certain property rights) will work to
increase discount rates, which will
increase oil production.
Let’s suppose that the real risk-
adjusted rate of discount for the
Saudis, without any prospect of
property expropriation, is 20 percent.
Now, consider what would happen
to the discount rate if there were a
18 | GlobeAsia June 2016
they know the oil reserves might
not be theirs tomorrow. In short,
problematic property rights encourage
This sets the stage for what is the
big question on everyone’s mind:
where is the price of oil going from
here? To answer that question,
we have to have a model – a way
of thinking about the problem. In this
case, a starting point is Roy W.
Jastram’s classic study, The Golden
Constant: The English and American
Experience 1560-2007. In that work,
Jastram finds that gold maintains its
purchasing power over long periods
of time, with the prices of other
commodities adapting to the price
of gold. Taking the broad lead from
Jastram, my colleague, David Ranson,
produced a study in April 2015 in
which he used the price of gold as a
long-term benchmark for the price of
oil. The idea being that, if the price of
oil changes dramatically, the oil-gold
price ratio will change and move
away from its long-term value. Forces
will then be set in motion to move
supply and demand so that the price
of oil changes and the long-term oil-
gold price ratio is reestablished. This
is nothing more than a reversion to
We begin our analysis of the
current situation by calculating the
oil-gold price ratios for each month.
For example, as of May 24th, oil was
trading at $49.24/bbl and gold was
at $1231.10/oz. So, the oil-gold price
ratio was 0.040. In June 2014, oil
was at $107.26/bbl and gold was at
$1314.82/oz, yielding an oil-gold price
ratio of 0.082. The ratios for two
separate periods are represented in
the accompanying histogram – one
starting in 1946 and another in 1973
(the post-Bretton Woods period).
Two things stand out in the
histogram: the recent oil price collapse
was extreme – the February 2016 oil-
gold price ratio is way to the left of the
distribution, with less than one percent
of the distribution to its left. The
second observation is that the ratio is
slowly reverting to the mean, with a
May 2016 ratio approaching 0.04.
But, how long will it take for the
ratio to mean revert? My calculations
(based on post-1973 data) are that a
50 percent reversion of the ratio will
occur in 13.7 months. This translates
into a price per barrel of WTI of $60 by
March 2017. It is worth nothing that,
like Jastram, I find that oil prices have
reverted to the long-run price of gold,
rather than the price of gold reverting
to that of oil. So, the oil-gold price ratio
reverts to its mean via changes in the
price of oil.
The accompanying chart shows the
price projection based on the oil-gold
price ratio model. It also shows the
What caused the price collapse of this all-important
commodity, and where is its price headed? When looking for
the causes of price change, nothing beats a sound supply-
historical course of prices. They are
doing just what the golden constant
predicts: oil prices are moving up.
The report that motivated this
line of inquiry is: R. David Ranson.
“Tactical Asset Selection: Implications
of Cheap Crude Oil for Its Future Price
Trajectory,” Cambria, California: HCWE
Worldwide Economics, April 17, 2015.
I would also like to acknowledge
excellent research by the following
research assistants at The Johns
Hopkins Institute for Applied
Economics, Global Health, and the
Study of Business Enterprise: Stephen
Johannesson, Pranay Orugunta, Anshul
Subramanya, and Jennifer Zheng.
Oil Price (WTI) Projections
Sources: “Crude Oil Futures-CME Group.”Crude Oil Futures Quotes. N.p., n.d. Web. 26 Apr. 2016.
“Crude Oil Prices: West Texas Intermediate (WTI) - Cushing, Oklahoma.” -FRED.N.p., n.d. Web 26 Apr. 2016.
Calculations by Prof. Steve H. Hanke, The Johns Hopkins University.
Historical WTI Price Forecasted WTI Price