April Freeman Banner 2014


Politicians Eye the Oil Market

Politicians' Fixes for High Gas Prices Are Based on Faulty Economics


With oil prices setting records every week and gas prices topping $4 per gallon, voters are getting increasingly angry. This naturally makes the politicians nervous, so they do what they can to divert blame from themselves at all costs. Two easy targets are “Big Oil” and speculators. In this article we’ll see that the politicians’ accusations against these scapegoats are nonsensical, while the corresponding policy recommendations will only push oil prices higher.

Before exploring the errors of the political charges, we should first understand exactly what’s happening in the oil market. The simple explanation for high prices is: supply and demand. Global oil output has been roughly flat since 2005, while demand in developing economies such as China and India has been growing quickly. In a market the only way to reconcile these facts is for the price to rise; if China is consuming more barrels per day while producers aren’t churning out more product, that means other countries have to cut back their daily consumption. Rising prices do just that, without anyone consciously orchestrating the worldwide coordination involved.

To add nuance to the explanation, we should note that the sinking U.S. dollar has played a role. From June 2007 to June 2008, the price of oil—measured in dollars—more than doubled. Yet 15 percent of this rise can be attributed entirely to the sinking dollar, which fell 15.6 percent against the euro during the same interval. Because oil is a fungible commodity traded on a world market, changes in foreign-exchange rates translate immediately into changes in the price of oil (quoted in dollars).

If politicians want to “do something” about record oil prices, the answer is simple: Enact policies that boost supply and/or reduce demand—and this prescription indirectly includes policies that strengthen the dollar. For example, opening up the Arctic National Wildlife Refuge (ANWR) and the outer continental shelf (OCS) to drilling would boost (expected future) supplies of oil, causing producers with excess capacity today to ramp up current production. The feds could also start unloading the Strategic Petroleum Reserve, which currently has some 700 million barrels stockpiled. As the early Reagan experience showed, large marginal tax-rate reductions would boost the dollar on the foreign exchanges. And as far as reducing demand, foreign governments could stop subsidizing gasoline prices for their populations.

All these policies made sense even five years ago when oil was trading around $30 per barrel. Now that oil is flirting with $150 per barrel (as of this writing), such policies are imperative. Unfortunately, as we’ll now discuss, the suggested remedies coming from Washington will have the exact opposite impact.

Likely driven more by politics than sound economics, Republicans have increasingly endorsed expanded drilling on domestic land and in sea areas controlled by the federal government. For various reasons the standard Democratic response has been to dismiss these proposals as gimmicks that won’t solve America’s long-term “addiction” to fossil fuels. In this context the rhetorical lengths to which some politicians have gone are simply astounding.

The best (or worst) example concerns statistics on federal land-leasing that have served as talking points during the presidential campaign. The congressional Committee on Natural Resources prepared a report (http://resourcescommittee.house.gov/images/stories/Documents/truth_about_americas_energy.pdf) intended to derail the enthusiasm for more drilling by “Big Oil.” According to the report:

Even if increased domestic drilling activity could affect the price of gasoline, there is yet no justification to open additional federal lands. . . . Combined, oil and gas companies hold leases to nearly 68 million acres of federal land and waters that they are not producing oil and gas [from]. . . . Oil and gas companies would not buy leases to this land without believing oil and gas can be produced there, yet these same companies are not producing oil or gas from these areas already under their control.

If we extrapolate from today’s production rates on federal land and waters, we can estimate that the 68 million acres of leased but currently inactive federal land and waters could produce an additional 4.8 million barrels of oil and 44.7 billion cubic feet of natural gas each day.

Now this is truly astounding. It’s hard to know what would be worse: Do the authors of this report—and the politicians who repeat the accusations—actually think this is how the oil industry works, or are they consciously throwing out ridiculous “facts” just to win votes?

If we are to believe the figures in the quotation above, oil companies have the ability to produce an extra 1.75 billion barrels of oil per year (4.8 million x 365), which at $140 a barrel would yield around $245 billion in extra annual revenues. It’s true, they would have to pay a lot more in wages and equipment costs, and the price of oil would certainly drop with that much additional production. Even so, it is ludicrous to think the oil companies are staring at that much money on the ground (or in the ground) and ignoring it.

In reality the situation is far less sinister. The oil and gas companies pay the federal government to lease some of the land where it is currently legal to do so, areas they believe are the best prospects for finding oil and gas deposits. Obviously they don’t know beforehand exactly where the best sites will be; they have to lease the land and explore. After doing so, they begin drilling in the areas with the most promise. With record-high oil prices, the companies are naturally going to cast a wide net (insofar as the feds give them legal permission to do so), and so the proportion of leased land that actually ends up being classified as “producing” will be much lower than 100 percent.

Ironically, the higher the fraction of leased land that is producing oil, the more suspicious we should be that the oil companies are purposely holding back. After all, assuming they found oil, why would they pay the government to lease lands on which they didn’t plan to drill?


Contradictions from Big Oil’s Critics

Here we run into yet another nonsensical aspect of the official story from Big Oil’s critics. Let’s suppose for the sake of argument that the accusations are correct and that opening up ANWR and other federal lands wouldn’t lead to more drilling. Then what in the world is stopping the politicians from accepting the oil companies’ money? In these hard times, why not take billions from ExxonMobil and all the rest? If they don’t end up drilling—as the harshest critics allege—then people in Alaska, Florida, and California don’t need to worry about their coastlines being soaked in crude spills, now do they?

Things get worse. It’s not merely that the conspiracy-charging politicians deny companies access to federal lands that have the potential of major oil and gas discoveries. They want to swing the pendulum in the other direction with so-called “Use It or Lose It” legislation, which would penalize energy companies that lease federal land if they don’t begin producing within a specified time.

Putting aside the arrogance of politicians telling oil-industry experts how to run their businesses, such legislation would merely present an additional risk to domestic exploration efforts. As it is, an oil company runs the risk of paying to lease a certain area and finding nothing. The proposed legislation would increase the hazards, causing companies to become more conservative in where they explore.

This sorry episode underscores the flaws with government ownership of land. There are legitimate concerns over environmental quality, just as there are obvious concerns over high gasoline prices. But the political process is a terrible way to settle disputes. If the federal government auctioned off its massive landholdings to the private sector, oil companies and conservation groups alike could make bids and channel resources into appropriate ends, guided by the price system.

As it is, we have the worst of both worlds, where valuable oil and natural-gas deposits are arbitrarily placed off-limits and where oil companies are given rights to develop in certain areas without local owners exercising oversight to ensure that the mineral extraction occurs with the appropriate level of attention to long-run resource and environmental value. The “use it or lose it” mentality already prevails when politicians sell access rights to the vast lands they temporarily control—though economists know that this mentality is conducive to economically inefficient exploitation, rather than the wise husbandry that would develop under truly private ownership.

Besides large oil companies, the other popular villains are financial-market speculators. According to the official story, oil prices are as much as $70 higher per barrel than the “fundamentals” justify. Hedge funds, pensions, and other institutional investors have flooded the futures markets, looking for a piece of the action. These investors have gambled on rising oil prices by increasing their holdings of oil futures contracts. The result (we are told) is a self-fulfilling prophecy, where institutional purchases push up futures prices, which in turn drive up spot prices. The speculators get richer while the average motorist pays at the pump for their fat profits.

There is so much wrong with this story that it’s hard to know where to begin. As always, when people accuse market participants of making profits through “manipulation” we can ask: What took them so long? Why was oil $30 back in 2003? Were investors back then more altruistic than they are today?

To unpeel the issues in oil speculation, we need to first review the mechanics of the futures market. Futures contracts allow producers and consumers to hedge against the risk of price movements. Oil producers can sell futures contracts—which are promises to deliver physical barrels of oil at a future date, for a pre-specified amount of money—while major consumers, such as airlines, can buy futures contracts to lock in a guaranteed price for the massive quantities of oil they will need for operations in the coming years. Futures markets thus promote efficiency, as producers and consumers can concentrate on their core businesses and make investments that would be far too risky if they were completely exposed to volatile spot prices.


The True Effects of Speculation

Contrary to popular belief, futures markets do their job much better in the presence of savvy speculators. When successful, speculators speed price adjustments, and actually make prices less volatile than they otherwise would be. After all, the speculator buys low and sells high (or shorts high and buys back low). These very actions are countercyclical, and keep prices within a narrower band than if the speculators had stayed on the sidelines.

In this environment, large institutional investors provide liquidity to the physical hedgers. It is ironic that while the government takes steps to prop up Fannie Mae and Freddie Mac—whose investors certainly don’t plan on living in the houses they finance—politicians and commentators wail about the evil investors who buy oil futures even though they don’t ever plan on taking delivery of physical barrels. With large investors willing to pick up the slack, as it were, the traditional hedgers in the oil futures markets can use these contracts more liberally, because they can unload them in a more liquid market.


Markets and Speculation

Up till now we have seen the benefits of speculation. It is true that if speculators are wrong, they can distort markets—the housing bubble is a prime example. (There were government policies that encouraged speculation in real estate, but that is another story.) But the market has a handy way of enforcing discipline on speculation. If speculators guess prices will rise, but instead they fall, then the speculators lose money in exact proportion to how wrong their forecasts were. There is no need for government to tack on additional penalties, so long as contracts are enforced and the losers are made to bear the full brunt of their mistakes. The irony is that there is no hard evidence that speculators have been driving up oil prices. Thus we have been defending speculators for a “crime” that they don’t seem to have even committed.

If it were really the case that the “sustainable” market price of oil that balanced the fundamentals of supply and demand was $80, while speculators had driven the price up to a bubbly $150, we would see a large surplus. Even though supply and demand in the oil market are notoriously inelastic, surely the growth in quantity supplied, and the drop in quantity demanded, from a $70 price hike—especially one that was years in the making—would show up in a sizable excess of crude hitting the market.

This would make perfect economic sense, incidentally. For example, if certain speculators became convinced that an attack on Iran would drive oil to $400 per barrel in the coming months, they would rush to buy futures contracts. This would push up the futures price such that refiners and others with the requisite know-how would find it profitable to sell futures contracts (at the sky-high prices) and buy oil on the spot market. They would literally warehouse the oil for a few months, then unload it when the futures contracts matured.


The Stockpiling Story

Although those stockpiling oil would be doing so for personal gain, the Invisible Hand would ensure that everyone else benefited. Their purchases of spot oil would drive up spot prices, leading to conservation in the present. And of course, when war with Iran interrupted imports, the stockpiled oil would be a blessing.

However, this story doesn’t seem to be playing out when we look at the data. The “yield curve” on oil has been in backwardation—where spot prices exceed futures prices—for large portions of oil’s record price run-up, making it difficult to see how investors in futures contracts are pulling up spot prices. Moreover, official inventory data don’t show any stockpiling occurring in the last few years.

Now there are ever more convoluted stories that certain economists are spinning to explain away this lack of evidence. For example, it’s possible that investors pushed up futures prices, which in turn led Saudi Arabia to scale back its output. This drop in supply then led to rises in spot prices, which explains the lack of massive contango (where spot prices are below futures prices) during the last year. Further, we see no stockpiling in inventory data, because the Saudis are stockpiling the oil under the sand by not pumping.

Even here, the data do not really fit such a story, though admittedly OPEC figures are not as trustworthy as those issued by privately held companies. The Energy Information Administration estimates that OPEC output did drop from 2005 through the first quarter of 2007. But since then it has been steadily rising, reaching all-time highs in the first quarter of 2008. If we’re trying to explain the doubling of crude prices over the last year, a complicated story involving speculators and OPEC restrictions gets ever harder to square with the facts.

In any event, whether or not speculators are responsible for rising oil prices, we can confidently state that proposed regulations to restrict pension and other institutional investors from participating in the oil futures market would do nothing but harm the average American. If millionaires want to bet on rising oil prices, they will still be able to do so, either through hedge funds or in foreign markets. But schoolteachers and assembly-line workers typically do not have the money or savvy for such strategies. Instead, the only way they can hedge themselves against skyrocketing gasoline prices is for their pension- or mutual-fund managers to gain exposure to oil prices. Yet this is precisely what some members of Congress want to crack down on.

Americans are understandably becoming furious over record oil and gasoline prices. In response, the politicians have pointed fingers and proposed fixes that are based on faulty economics. If these odious measures pass, the result will be higher and more volatile oil prices and more exposed consumers. The truly sad thing is that even if this all comes to pass, most voters won’t understand what happened, and will believe the politicians when they blame $200 oil on anybody but themselves.

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October 2008

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