The Nassau Institute: Let the Market Manage the Oil Crisis

Let the Market Manage the Oil Crisis

20 June 2008

William F. Shughart II

Reprinted with the kind permission of The Independent Institute.

As the prices of food, fuel and other basic commodities continue to skyrocket, the tiny voice warning that the sky is falling becomes louder and more insistent. There are looming shortages of oil, of wheat, of copper.... Humankind’s insatiable demand for material goods has finally and permanently outstripped the resources necessary for producing them. A bleak future of ever-rising prices and stagnant growth is the inevitable consequence.

Newsweek might well get away with rerunning its cover story of November 19, 1973, headlined “Are We Running Out of Everything?”

Predictions of doomsday have been around since at least 1798, when Thomas Robert Malthus wrote that mankind was condemned to live at the margin of starvation. He reasoned that if wages ever rose above the minimum level necessary to sustain life, it would enable people to feed and raise more children. But because agricultural production could not possibly keep pace with population growth, famine and premature death would force a return to bare subsistence.

Parson Malthus was wrong, of course. He failed to appreciate the incentives for farmers to expand output as food prices rise, thereby pushing prices back down. Nor did he anticipate the technological advances that greatly increased agricultural productivity and allowed farmers to profit from feeding more mouths. He also did not know, as we do today thanks to Nobel Laureate Gary Becker, that as standards of living rise, people tend to have fewer children.

The same mistakes are made repeatedly. In 1972, the Club of Rome warned that, “if the present growth trends in world population, industrialization, pollution, food production, and resource depletion continue unchanged, the limits to growth on this planet will be reached sometime within the next 100 years.” The Limits to Growth gained instant credibility when, following the Arab-Israeli War of 1973, OPEC embargoed oil exports and the world price of crude jumped in three months by nearly 300%—from $3.01 to $11.65 a barrel—and gas prices hit $1 a gallon!

Now that rising energy demands in China, India, and other developing nations have oil flirting with $135 a barrel, and tight U.S. refining capacity has gasoline on its way to $4 a gallon, today’s Cassandras are in full cry. But they have forgotten their history:

• The transition from the Bronze Age to the Iron Age, precipitated by a scarcity of tin
• The shortage of whale oil used for illumination overcome in the mid 1800s by the development of processes for refining kerosene, later perfected by the Standard Oil Company
• The turn-of-the-20th-century timber “crisis”, which nearly bankrupted the railroads until they adapted by substituting coal for wood to power their engines
• The great British-Dutch natural rubber conspiracy of 1922–1925 that tripled prices and was broken by the invention of synthetic fibers

There are many more such examples.

The lesson is that markets work. Shortages cannot persist in a free marketplace because higher prices prompt consumers to economize on their purchases and producers both to expand existing supplies and to search for cheaper substitutes. Oil consumption in 2008 is already below that of last year and, for the first time since the 1970s, a major expansion is underway on the Gulf Coast that will eventually bring the world’s largest refinery online.

Other than refraining from interfering, no public policy is needed to ensure that the private sector responds to price spikes. As a matter of fact, government has been part of the problem. Aggressive promotion of ethanol and other alternative energy sources is partly to blame for the recent run-up in food prices. Other regulations keep crude prices high by prohibiting recovery of the vast oil and gas reserves known to exist on the Outer Continental Shelf and on federal lands in the Rocky Mountain West—and by diverting 70,000 barrels a day from one hole in the ground to another known as the Strategic Petroleum Reserve.

Doomsday can be averted this time around, as it always has been in the past, but not by looking to Washington for relief. If the profit motive is allowed to animate entrepreneurial creativity, this too shall pass.

William F. Shughart II is a Senior Fellow at The Independent Institute, Frederick A. P. Barnard Distinguished Professor of Economics at the University of Mississippi, and editor of the Independent Institute book, Taxing Choice: The Predatory Politics of Fiscal Discrimination.

Comments

Joan - 21 June 2008 13:56

oil price and speculators

Understanding "speculators" Thomas E Woods Jr. in Mises.org explains:

" The speculator helps society adjust to changing circumstances by buying in anticipation of resale in the future when scarcity is expected to be greater and prices higher. In that way, he ensures additional supplies will be available in the future, diverting them from present use to their more urgently demanded uses in the future, and thus helps to smooth out disruptions caused by decreases in supply".

Speculators in, - government out.

Rick - 21 June 2008 13:53

Let the Market Manage the Oil Crisis

Thanks again Mr. Wirth.
My solution is market oriented yes.
There is speculation in every day life. We all want our stocks to increase in value. We all want the value of our house to increase, yet we do not expect to pay more for products, so I do not deny that speculation exists. That's human nature.
With regard to retooling, that's not as simple as it sounds either. The question is what the consumer wants. Mr. Ford started selling cars with colour because not all of his clients wanted a black car.
As you know, I work in the auto industry, and we already sell the Honda Fit, that has been rated at 45 MPG in the US, but sales are very limited. Consumers want the bigger cars. Some consumers must have a bigger car because they have large families.
There is no one size fits all in this case.
Also, most clients say, if that's the price I have to pay, I have no alternative at this time.
Changes are happening though.
With the introduction of fuel cell (hydrogen) and electric cars these are exciting times, based on consumer demand though, not some governmental decree.
What's your solution? Examine who is speculating?

G.WIRTH - 21 June 2008 13:23

Free Markets manage The Oil crisis

Mr.Lowe your response is too simplistic - to develop alternative fuels or means of power.

Every alternative has its pluses and most times its negatives.... take wind as simple as that is wind generation does not work when the wind is above a certain mph, you have to stop the propellor,re-angle the properlor and the equipment stops generating power. Submarine generation is very interesting, clean and reliable but is there the cost efficiencys ?

Blindly refusing to admit or credit emminent Economists and Financial Experts who have said, very much more often to-day than before that the market is being influenced by unnatural speculation not by the OilCompanys but by others but ofcourse themarket is driven higher everyone is enjoying the higher profits. As said consumption has to be reduced substantially and effectively that would drive down the price and Government subsidys.

Yes the market will bless the global economys or kill them... your choice I presume.

The consequencys if some price reduction does not occur even a blind person will see thatUS Car factorys can be re-tooled and cars made European sized and trucks and tractor heads made smaller with less pwoer which will further aggrieve the movement of commerce and further and higher prices will occur.

Do the Markets have a conscience ? We see bank after bank with massive losses in the billions on billions and no one seems to see what is actually occuring.

Yes it would be wonderland if we can find an acceptable solution which can be effective say by the end of July 2008 - that is a dream infact there is no solution in that scope for 8-10 years forward.The sole solution is to examine the Market and see what is confirmed there is speculation said again NOT BY THE OIL COS.

Rick - 21 June 2008 11:40

Let the Market Manage the Oil Crisis

Thank you Mr. Wirth.
As I have stated on several occasions, Three Cheers to Higher Gas Prices.
That means we will find alternatives sooner, rather than later.
Mountains are being made of this mole hill in my view.
Humans are ingenious enough to invent oil burning engines. They will invent something else that will be just as viable in the years to come.
I'm willing to bet on it.
I agree with the conclusion of this piece by Mr. Shughart: "Doomsday can be averted this time around, as it always has been in the past, but not by looking to Washington (in our case, The Bahamas Parliament) for relief. If the profit motive is allowed to animate entrepreneurial creativity, this too shall pass.

G.Wirth - 21 June 2008 06:08

OIL - Free Markets and Speculating Markets

The cost of drawing Oil out of the ground has not changed over the years - exploration costs have increased as exploration goes into deeper waters however with the market costs against return have balanced out.
Consumption and demand is the driving force of current high irrational pricing. The Arabs are experiencing the same inflationary forces on their Cost of Living + the weakening dollar which ironically assist the US Economy for Exports.
Subsidies are not positive and both China and India subsidise Oil at a consumer pricing level so their markets are artificial and consumer sees no requirement to reduce use as the retail price is artificial.China is putting over 1,00 new vehicles on their roads per day!
There is no doubt that there are speculators in the market - simply selling forward paper and contracts at heavy profits. The market is fical something happens on a rig in Nigeria and the price goes up 50 cents or more when in reality that event will not effect the supply market possibly for a year as futures are sold for the majority of Oil production. The US has reduced consumption but China -India has increased their consumption by a higher amount creating further demand which is market forces so prices stay up or further increase.
If the US was to release 30% of the US Strategic Oil Reserve on a Friday after 3.00pm, Markets closed, that would do the right thing to cause the market to adjust as the market would have over-supply. Unfortunately it is Election year so they will not or do any drastic measures .Future drilling to production is at least 7-9 years away so that will not have an effect period. Detroit and the Motor industry must develop vehicles to get higher mph.... jo public must cut back use of fossil fuels thru less use of electricity or the better more efficient use - improve design of buildings etc.. Globally it has to be accepted to remove State subsidys.The Biofuel mess which everyone should have seen would increase costs of food is a perfect example where speculators pushed that market to achieve financial gains without realising by taking grain from food there would obviously be a scacity of grain for food so food prices will increase. Ironically the global harvest last years was over all estimates but certain coutnrys have embargoed exports so again you have an interuption of the market up goes the prices.

Local : diesel pays 25 cents per gallon + 27.5% Dty + 7% so retail is selling at $6.13 per gallon, Govt. is going to have a windfall of additional Tax revenue of more than $50-60+ million if this cost increases - as the fuel of commerce this will have a negative effect on wholesale-retail and all service activity as this is over 50% higher than 12-months ago and no one sees it. BEC in the Family Islands only uses Diesel, Blue Hills is diesel but ofcourse BEC will not pay Dtys for 24-months however remember BEC and Govt. trade-off the electricity costs of Govt. against BEC liability to Dty so is there going to be any lowering or advantage to the consumer?

Here my bet will be that consumption will not decrease except for the seasonal levels but the pass-on to cost of living is going to have a major effect in the prices of grcoery,services and products. My real fear is in Aviation - if the scheduled airlines cut The Bahamas out owing to the lack of an acceptable passenger load percentage against cost of flying the negative effects on Tourism etc., will be catastrophic. American Eagle in Puerto Rico has already cut flights out of Puerto Rico hub. Eagle in PR is owned by the same people in Miami who serve us, 26+ flights a day!Side note: Central Bank report for debt of B$ Credit cards 2007 is now at $257m up $35+m from the previous year - property foreclosures are increasing at a very rapid rate - don't fool yourself the bull and political talk is not going to hide what regretably looks as inevitable.

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