Friday, June 20, 2008

OPEC Conversation with Steve Waldman, Part 2: Optimize Revenue, and Invest It Well

Steve's reply to my previous post is here. I answer back here:

I agree that if all they care about is maximizing their own wealth, then they will optimize current revenue as monopolists, which usually means withholding some supply.

But they would do it only to increase current revenues, not to save the oil for later because they think it's better to hold as an asset, for like 40 years, than stock or other conventional assets they could have purchased instead.

And, if they hold the oil in the ground as a form of saving it as an asset, the only possible time horizon for that would be like 40 years. What if they say, oh, I'll hold it in the ground as an investment for just 1 year, then sell it? What return would they get? In a year they should just still sell the optimal amount for a monopolist to maximize revenue, and in a year they would still have way more than enough from other oil in the ground to do that, or to sell any feasible quantity, so that unit that they held aside as an investment would just sit there.

It would do the same thing next year, and the year after, and the year after. It would only make a difference and actually be sold in about 40 years when they ran out of other oil in the ground. So it would just sit and make no money for 40 years, and then make it's selling price 40 years later.

For that selling price to make even a paltry 1% real return, the real price of oil would have to go from $130 today to $194. And the odds are great that in 40 years the price of oil will collapse due to the advance of substitute and efficiency technology. From what I've read, reliable sources, plug-in hybrids and pure electrics should become inexpensive and common in only like 20 years or less, pushing average global mileage per gallon into the hundreds, if not thousands. And for electricity there's nuclear, solar (see the Scientific American article mentioned in my previous post), coal (hopefully with carbon sequestering), etc.

Investing the $130 in keeping the barrel in the ground is a terrible idea. Yes, there is risk to stocks, but it's reasonable. The risk to keeping that barrel of oil in the ground as an investment for 40 years is much greater than the risk with stocks, and the expected return is much lower. Any conventional investment is much better than this. If I had to, I would estimate that the marginal revenue from an additional barrel of oil would have to be way below $130 for keeping it in the ground to be a good investment.

With regard to how good an investment a diversified stock portfolio is over the long run, I'd say it is the best for any single asset class, not just due to the historical performance and the arguments of Siegel (not all of which I agree with), but due to a tremendous amount of other evidence, theory, and other logic, which would take about 50 pages to really explain well even at a basic level.

I would add that If you follow a balanced money plan (see Harvard Professor Elizabeth Warrens book, "All Your Worth") or my INDV 102 course syllabus, it's not that hard to sock away a substantial amount in a well diversified stock portfolio each month. Following Dr. Warren's Plan means keeping your expenses, especially your fixed expenses, low enough that if the market swings up and down 5, 10, even 15+ percent, most people won't feel that stressed because they will know that their savings are still quite high relative to their expenses and income. And, the modern stock markets of the U.S. and Western Europe are quite different from the ones of 1950 and earlier. The odds of a communist takeover and expropriation, or anything like that, are virtually zero. The odds of something like the great depression happening are very tiny with the learning, track record, and resulting support of Keynesian-type policies.

Finally, with regard to heavy investing by OPEC pushing demand for stocks up and risk-adjusted returns down. First, note that the world stock market is vast even relative to OPEC money, but also, I have a working paper on the issue of whether a substantial increase in stock demand would push down risk-adjusted returns, or push them down much.

The main idea is that mostly due to the high prevalence of constant and increasing returns to scale in many productive processes and endeavors, the supply curve of investment opportunities may be very long and flat even for amounts of stock investment much higher than today's level. It might even curve up for a while due to increasing returns to scale.