Posted by: bmeverett | March 7, 2011

What’s the right price for gasoline?

The recent spike in crude oil prices following unrest in the Middle East has elicited the following standard political logic in Washington: (1) crude oil prices drive up gasoline prices, (2) voters don’t like high gasoline prices, so (3) government has to DO SOMETHING! Cutting the gasoline tax, releasing oil from the Strategic Petroleum Reserve, even (heaven forbid) price controls are all supposedly under consideration by the White House.

Before our elected officials react with their usual hip shot, let’s take a deep breath and remember a few economic basics. Prices tell individuals how much of any particular good or service they can buy. For any particular person, lower prices are always better. Not so for the society as a whole. Prices tell the economy consumers’ relative preferences for goods and services, so the economy can move its productive capabilities where they will do the most good for consumers. On the margin, do we want to produce more TVs or more vegetables? Prices give us the answer.

A modern industrial economy like ours has billions of prices changing second by second in response to consumer decisions. When a woman buys a green sweater instead of a red sweater at Macy’s, the decision is recorded instantly and influences Macy’s future purchasing choices. There have been many errors in government economic policy over the years, but the number-one monster error (which by the way is a basic tenet of our political left) is that “experts” in Washington can make better decisions for the society than the market does. If you agree with this argument, please note the history and ultimate fate of the Soviet Union.

There are two reasons that centrally planned economies can’t work. The first is that no individual, committee, ministry or computer can gather and process the billions of real-time bits of data necessary to make decisions. The second reason is that, although there are lots of smart people in Washington, ultimate decisions are made by politicians more concerned with appearance than with substance. Overriding the market is normal practice in Washington, but doing so reduces our standard of living.

Let’s take a specific look at oil prices. I have been working in the energy field for nearly 40 years, and I am astounded at the common belief that the oil market doesn’t function well. The primary reasons cited are OPEC and speculators. OPEC is often seen as a sinister cartel manipulating oil prices to the detriment of American consumers. On the surface, OPEC looks like a pretty formidable organization with 12 member countries accounting for about 40% of world oil production. A cartel, however, is a group of producers colluding to limit their production in order to achieve an effective monopoly. OPEC tries do limit production by assigning each member a quota. It fails miserably, however, in enforcing these quotas. Of OPEC’s 12 members, nine (Algeria, Angola, Ecuador, Iran, Iraq, Libya, Nigeria, Qatar and Venezuela) continuously ignore their quotas and produce all the oil they can every day. Two other countries (Kuwait and the United Arab Emirates) have huge oil reserves, but low financial requirements and so have made limited investments in producing capacity. In the short term, neither country can produce much more oil than it does now. That leaves Saudi Arabia as the only country large enough to serve as “swing producer.” The Saudis talk a good game about the importance of stable prices, their deep commitment to the health of the global economy, yadda, yadda, yadda, but they don’t really do much. In the late 1970s and early 1980s, the Saudi’s reduced production, often drastically, to maintain desired price levels. By 1986, however, the Saudis recognized that none of their brother OPEC members was willing to help them in any way. As a result, Saudi oil production short back up to the 9-11 million barrel per day level (10-15% of global oil supply) where it has remained for the last 25 years.

Speculators are another easy target for politicians. Congressional hearings are full of conspiratorial mutterings from both the left and the right about manipulation of oil prices. These suspicions are not new. Ebenezer Scrooge in Dickens’ “A Christmas Carol” made his money speculating in corn, holding supplies off the market to drive the price up and starving poor people in the process. There have been cases in the past in which speculators have “cornered” markets by buying up a significant share of available supply. The famous silver corner by the Hunt brothers in 1980 was one example. In the case of silver, however, the total world supply is quite small. The entire global inventory of silver today would fill a bedroom. A handful of well-financed people can get their hands on a significant share of this tiny inventory. It’s also worth noting that the silver corner bankrupted the Hunt brothers when prices ultimately fell.

Oil speculation operates through futures markets in which traders make paper bets on the future price of oil, generally one to six months ahead. They do not take physical delivery of oil or keep it off the market. In fact, it would be prohibitively expensive to try to keep any significant amount of oil off the market, and there is no evidence that any one is trying to do so. Modern futures markets trade risk, not oil. At the end of the day, their impact on oil prices is very small. Actual oil buyers and sellers use the futures markets for what economists call “price discovery”, a way to guess at next month’s price for a particular transaction. The futures markets are not infallible, but they are generally pretty good at making these guesses. If the futures markets routinely over-predicted prices, oil buyers and sellers would stop using these markets for price discovery. Oil markets can fail to reflect real supply-demand balances, but rarely and only for very short periods of time.

In fact, the global oil market functions pretty well. If the federal government takes steps, any steps to suppress oil prices, the result will simply be that we will consume more than we should and produce less than we should. In severe circumstances, like price controls, a chronic over-demand situation may arise in which consumers pay a bit less for gasoline, but wait in long lines to get it. People over the age of 50 remember gasoline lines from the 1973-74 and 1979-1980 and dread the possibility of a return. Younger consumers, however, may be forgetting that miserable experience. (It’s worth noting that President Obama was in his teens during the last period of price controls.)

So what’s the bottom line for government policy? Government plays to perception rather than economic reality. It’s interesting to note that government policy has determined over the last 80 years or so that food and housing prices should be kept artificially high while medical service prices should be kept artificially low. The current view in the White House seems to be that energy prices should be kept artificially low to support consumer spending and economic recovery but also artificially high to encourage conservation and alternative energy development. The real answer for government is: Don’t just do something, stand there. Let the market work this out. Anything else will make the situation worse.


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