AS THE ECONOMY TURNS

A TIME TO GATHER STONES TOGETHER

DR. WILLIAM SHINGLETON

FEBRUARY 20, 2006

In Ecclesiastes 3:1 we are told that for every thing there is a season, and a time to every purpose under the heaven. For the United States, this may be the season to reconsider our choices in the energy field, specifically with respect to oil. While we don’t often agree with many administration positions, Mr. Bush was quite correct when he said that America is addicted to oil. One of the reasons for the deceleration of the economy in the fourth quarter was that some players in the economy were badly stung by some pretty substantial increases in the price of oil and its related products. The hurt extended from the individual consumers who were scared by the higher price of gasoline to some major corporations, like our airlines, where the higher jet fuel prices took a good bite out of their bottom lines. Now, as we begin to think about digging out from winter, the price of gasoline has come back down a little but the prices of home heating oil and other related products are continuing to contribute to drag on the economy. The betting here is that the long-term trend for the price of oil is a rising line, although we’ll have a few dips and downdrafts along the way. On the positive side, Washington has been busy with other things lately and has never actually gotten around to doing much with any changes in our ENERGY POLICY. While they are twiddling, this week we’ll look at some of the rules that exist in the oil industry. [NOTE: The entire topic of energy policy is too broad for a simple newsletter. However, the prices of the various forms of energy are somewhat interconnected because when the price of one increases, people and companies increase their demands for the other energy sources, which act as substitutes, and those prices rise as well. So we’ll talk about oil as an energy source but you are free to substitute natural gas or electricity or coal for the oil in our story and you’ll get pretty much of the same results.]

One would think that the basic problem would be one of our old friends, OPPORTUNITY COST, which has shown us a number of times that you usually can’t have it both ways, so you have to make choices. In petroleum, while we would love to have a situation in which we could have a low price for oil and, at the same time, reduce our dependence on foreign oil, it is not realistic to expect that we would be able to have both. Even worse, we probably are not going to have either one, at least for a while. If we have a low price for oil, the LAW OF DEMAND says that we will want to buy more of it, taking advantage of the lower price to keep our homes a little warmer and to buy more comfortable and less fuel-efficient cars. That is rule NUMBER ONE: If we hold down the price of oil in the United States we will want to buy and use more oil, not less.

However, a lower domestic price for oil will reduce the PROFITABILITY of producing oil in the United States. Since even the big, bad oil companies have a limited amount of capital to work with, if the profitability of investments here in the United States goes down, they’ll use their resources to find more oil in other countries, where they can get a better rate of return on their investments. Even the oil sources that look profitable in the United States will be neglected if they are not profitable enough. The concept of NORMAL PROFIT in economics says that a firm must expect to earn a minimum profit equal to the profit it could earn in its next best alternative investment before the firm will even bother with a project. So RULE NUMBER TWO is: If we hold down the price of oil in the United States we end up producing less oil, not more.

If we combine the results of the first two rules, we see that the consequences of holding down American oil prices would be a volume of oil that we would want to buy that would be greater and a volume that would be produced by domestic sources that would be smaller. The simple math says that the gap between domestic consumption and domestic production would grow even wider than it is now. This would lead either to a SHORTAGE, and long lines at the gas pumps, or to a situation in which we would have to IMPORT more oil and become more and more dependent upon foreign sources. However, even that last solution requires a bit of an arrogant reach. That’s because the United States is not the only market in the world for oil. If we hold our prices down, or even if we just do not allow them to adjust to world-price levels, foreign suppliers will simply direct their supplies to other countries, like China or Japan, where the customers might be willing to pay more for the oil. Of course, we might hope that our American companies might come to our rescue because we know we have American oil companies in most of the important oil fields in the world. Don’t count on it. Their fiduciary responsibility is to their shareholders and their shareholders expect the highest possible profits. If the price of oil is $60.00 in the United States and $70.00 elsewhere, the oil will head for the $70.00 flag every time. Since we already import a little more than ten million barrels of oil per day, we could very quickly develop an energy shortage in which the amount that people wanted to buy would be greater than the amount that would be available for sale. Of course, whenever a shortage develops the price finds a way to rise, even if it has to be outside the legal marketplace. RULE NUMBER THREE is: Oil prices in the United States are going to rise and fall with those in the rest of the world unless we want to do something really stupid like impose our own shortages on ourselves.

If we can’t stop the price of energy from rising, can’t we at least limit the amount of oil we import from other countries? The answer there is, “Yes we can.” But, again, think about what the consequences would be. We currently import about ten million barrels per day of oil and gasoline. Without those imports, the idea of even $3.00 per gallon for gasoline would quickly become nothing but a fond and distant memory. We would be causing a shortage that would dwarf the problems caused by hurricane Katrina until the price of gasoline found its new EQUILIBRIUM at five or six dollars per gallon. [NOTE: It would be great for bicycle makers, but most of our bikes are imported from China these days.] While some of the shortfall would be replaced with increased domestic production as the price rose, most of the domestic sources in the United States have seen their better days in terms of their ability to pump more oil, regardless of the price. Our domestic supply does not have the capability to respond all that much to increases in prices, especially in the short-run, which is why we label our supply as INELASTIC. RULE NUMBER FOUR: The only way we are going to keep imports out and avoid devastating domestic shortages is if we allow the price to go right through the roof.

If we can’t keep the price down and we probably don’t want to keep the imports out, what can we do? Let’s start with the facts, and they are inconvenient. As Americans, we are committed to driving our cars wherever and whenever we want. Because we are so dependent on our cars we add to the DEMAND for oil, and that drives up the price, not only here in the United States, but around the world. In addition, we should expect that the future demand for oil in the United States will be even greater than it is today because oil and gasoline are classified as NORMAL GOODS, goods which demonstrate an increase in demand as income and wealth grow. Increases in demand, unless they are counterbalanced by increases in supply, will cause prices to move higher and higher. Increases in American demand, when coupled with increases in demand coming from China, India, Brazil, and a number of other emerging markets is a recipe for disaster. Be thankful for our erstwhile European allies like the Germans and the French. If their economies were growing anything like ours, demand would already be higher and the price pressure would be building. On the positive side, they do illustrate one way out of our energy mess. All we need to do is to mismanage our economy like they have mismanaged theirs and the demand for oil would dry up and the prices would fall. We doubt anyone would want to seriously consider this as an alternative.

If we know that most of the major economies of the world are going to grow over the long run then we also know there is a growing upward pressure on the demand for oil. There are only a small number of possibilities for help on the demand side but some of them are quite powerful. The first is EFFICIENCY, getting more output out of each unit of energy. As energy prices rise, it becomes more and more profitable to squeeze more output out of less energy, to become more energy efficient. It’s something most American firms have been working on for thirty years and we have had some success at it. The good news is that our economy now uses a good deal less energy to produce just about everything compared to thirty years ago. The bad news is that Japan and South Korea, and even the Europeans, are ahead of us in energy efficiency, although we are ahead of China [SOURCE: WALL STREET JOURNAL, “Japan’s Energy Advantage, “October 7, 2005] The reason for the gap is simple, in spite of what we like to think, energy is relatively cheap in the United States compared to most of the other developed countries of the world, particularly when it comes to gasoline. The federal tax on gasoline is only 18.4 cents and, the last time I checked, the average state tax was only about 25 cents. As a result, the American consumer probably pays less than half as much for gasoline compared to most of the consumers in the other developed countries. [NOTE: In addition, just about everyone else prices their gasoline by the liter, which confuses the Americans to no end.]

The key to the story is the role of the taxes. A tax is a wedge that the government drives between the price that buyers pay and the price that the sellers receive. Since the world market for oil is so deep, any tax gets added onto the world price to determine the retail price in the taxing country. (For the United States, it might not be that simple, but we’ll come back to that in a minute.) With higher retail prices, people make different decisions, again according to the law of demand. After all, except for the fact that we just mentioned it, you probably never let the 18.4 cent federal tax or the 25 cent state tax enter into your decisions; you just drive by, see the price of $2.29 per gallon, and make your entire decision based on the $2.29, ignoring the fact that the oil chain only gets $1.86. Although you are certainly correct to worry about putting more money into the government’s pockets, the truth is RULE NUMBER FIVE: Higher taxes on oil will reduce the amount that is used.

Because oil has so many international buyers and so many international suppliers, a tax in any one country has almost no effect on the world price, for any one country the supply is PERFECTLY ELASTIC. This means that most countries can fool around with oil taxes as much as they want and very few people will even notice because the world price will hardly budge. That’s not true for the United States. We are so large, and we are such a major buyer on the world market, that a meaningful tax by the United States would act as a reduction in demand in a normal market, actually reducing the world price, although by a good deal less than the amount of the tax. Still, there would be some (non-economic) comfort in knowing that an American tax would reduce the incomes of the head-cases that run Iran and Venezuela. However, the effect of a tax on domestic American production would be the same as a price reduction. With American consumers buying less and domestic producers producing less, it is not clear what would happen to our dependence on foreign oil.

Taxes can be used for a number of purposes, including as a means to tilt RELATIVE PRICES, the price of one good compared to the price of another. In the case of oil, a tax on oil from traditional sources opens new opportunities because there are some non-traditional sources that would be profitable at the higher prices being paid by consumers and the profit would attract the investment without the government spending a dime. Here, we are thinking of the Athabasca region, in Alberta, may have almost as much oil in its sands as the Saudis have under their sands, and the oil shale deposits of Colorado, Utah and Wyoming, may have about one third that much. If we impose a tax on traditional oil sources but we allow oil from oil-sands or oil-shale to be exempt, these deposits would be profitable, even as the tax encourages us to cut back on total use, so our energy dependence would be trimmed from both sides. The International Energy Agency reports that the critical price is about $40.00 per barrel for the oil sands and about $70.00 per barrel for the oil-shale. If the oil companies had the incentive (read PROFIT) to go after these new sources with the energy that they drill in the Gulf of Mexico or the wilds of Nigeria, we would expect that, over time, their costs would drop and their output would rise. If we were making policy we would say: RULE NUMBER SIX: Don’t bother with the few drops of oil off the coast of Florida or in the untouched wilderness of Alaska, go for the big stuff. Institute a policy that would make it profitable to get the non-traditional oil sources as soon as possible. Most of us trust the Canadians much more than the Saudis. Just start gathering the stones together while we still have a choice.

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