Friday, June 20, 2008

Not the best investment strategy for the OPEC countries

In response to Steve Waldman's June 19th post, "Market power, asset allocation, and oil prices":

It is possible that OPEC countries are thinking that it's more valuable to leave some barrels of oil in the ground than to sell them for $130, and use the $130 to buy western stocks, but this appears to be a huge mistake.

First, there's a gigantic time value of money issue. I don't have time to research this, but I recall seeing estimates of how long the world oil supply will last of like 40 to 50+ years. Suppose it's 40 years, then if the Saudi's leave a barrel of oil in the ground today, instead of running out 40 years later, they will have that extra barrel in the ground and can sell it.

Let's compare the two alternatives:

A) Sell the barrel of oil now, and get $130. Then, invest that $130 for 40 years.

B) Sell it 40 years from now.

Which will make them wealthier? It depends on the rate of return, and on the price of oil in 40 years.

Without loss of generality, let's talk in terms of real dollars. Suppose they invest the money in a diversified U.S. stock portfolio (say the Wilshire 5000) and get the historic average real return of about 7%. After 40 years the $130 they got for the barrel of oil in 2008 would grow to $1,947. Do you think the real price of oil will be $1,947 in 2048, or anywhere near that.

From what I've read, it looks likely that inexpensive plug-in hybrids and pure electrics will be the norm long before then, and hooked up to electricity supplied almost exclusively from nuclear, solar, and other non-oil sources. Scientific American has a great article by a noted scientist on a solar grand plan that would "supply 69 percent of the U.S.’s electricity and 35 percent of its total energy by 2050" for "$420 billion in subsidies from 2011 to 2050". That's a fraction of the cost of the Bush tax cuts for the rich over that period, tax cuts that John McCain wants to make permanent – Yes, more and bigger yachts and mansions would be better for the economy and the globe than a vast solar network. – I'm not saying you're for that Steve; that's just a general comment about disastrous Republican policies.

Suppose the stock market did worse than its historic average. First, note that according to Wharton Financial Economist Jeremy Siegel's data set, between 1802 and 2006, stocks have never had a non-positive 20 year return period (Stocks for the Long Run, 4th edition, page 24). But suppose that the real return over the next 40 years was just 3%; still, by 2048, that $130 from selling a barrel in 2008 would grow to $424.

And stocks are a great inflation hedge because they are claims on real assets. Moreover, over a period of 40 years, I would certainly expect purchasing power parity to approximately hold, at least for tradable goods.

So, if OPEC governments are savvy, it certainly doesn’t look like they would want to pump less than the amount that maximizes revenue in the short term. Doing otherwise seems not qualitatively better than investing long term in gold instead of stocks. By the way, adjusting for inflation, a dollar invested in gold in 1802 grew to $1.95 in 2006. That same dollar invested in stocks grew to $755,163.00! (page 11 of Siegel's book)