Wednesday, November 14, 2007

Hoping for the Government to Save Us

Today’s Investor’s Business Daily includes two articles about the current high price of oil. The articles are promoted as being from opposing left and right perspectives, but if you were to read each article without this preconditioning (and without knowing anything about the authors); you’d be hard pressed to see where they disagree.

Indeed, Robert Samuelson (on the left) and Victor Davis Hanson (on the right) both agree that we are entering “a new geopolitical era,” as Samuelson puts it. In fact, reading the articles, I’m not sure the two authors substantially disagree about anything. They each highlight different perspectives about the oil economy, but their views seem quite compatible with each other.

Both writers note the substantial increase in demand for oil from China, India, and developing nations. Samuelson notes that, despite plentiful reserves, the capacity to exploit those reserves began to be outstripped by demand in 2004 for the first time in two generations. He discusses how higher prices make negotiations with suppliers more difficult. Hanson mentions our alliances with “creepy suppliers” and rips on domestic oil firms for charging the international rate for oil that is produced domestically at about the same cost as it was being produced 20 years ago. Both writers are upset about long-term inaction on dealing with a problem that was readily foreseeable.

Hanson’s solution leaves me a little flat. He writes, “It is past time to demand from our presidential candidates, as well as the current government, exactly when and how they plan to slay this many-headed oil monster.” Samuelson suggests that we “Raise fuel economy standards for new cars and trucks; gradually increase the gas tax (possibly offset with tax cuts) to induce people to buy those vehicles; expand oil and natural gas production in Alaska, the Gulf of Mexico and off the Atlantic and Pacific coasts.”

In other words, both of these guys are calling upon the great savior of the almighty federal government to come down and rescue us from ourselves. Samuelson, at least, acknowledges how politically unlikely it is that his suggestions will gain any traction. Hanson’s solution would surely produce a lot of hot wind, but little else.

I think both of these distinguished gentlemen are barking up the wrong tree. And while each is well educated on economic issues, they both seem to have forgotten some of the basic rules of economics. Although Samuelson notes that “higher prices will [eventually] dampen demand,” neither he nor Hanson seems to have any inkling that higher prices will eventually spur market-based solutions — provided that the government doesn’t thwart them.

Government should get out of the way. It should quit oil subsidies and other oil-friendly policies that raise barriers to entry into the energy market. Likewise, it should scrap subsidies and policies that support specific types of alternative fuels. For all the cash poured into these policies over the years, we have very little to show for it. And some of the results are actually harmful.

When the market actually demands solutions, the market will supply those solutions. History shows us that the form these solutions may take simply cannot be predicted very far in advance. Government tends to work counter to real innovation. Even if the government doesn’t get out of the way, innovation will still come. It will just take longer and be more expensive. The tide cannot be held back forever.


NonArab-Arab said...

While I find many government intervention schemes hare-brained (especially in regards to energy), I find this odd, mystical, almost religious belief in the invisible hand of the market to be equally so. The colonialists of the Victorian era had a similar belief in the mystical power of free trade that led them to justify no end of evils as well. But if we stick to domestic consequences, speaking as someone who works in the oil markets daily and has done a lot of work on long term supply-demand balances as well, I can tell you that while the free market may sort things out in energy, the odds are it will do so in an excruciatingly painful way. Oil price swings in the early days of oil were almost unfathomably wild, swinging by thousands of percent within months sometimes (or less). The economy was less oil dependent 100 years ago and managed to squeak by, but if you were to have swings like that today (and with the supply-demand balances what they are, those swings are definitely going to be biased to the upside as the years progress even if cyclicality will remain in play) the damage to the economy would be immense. We're not talking a "shake the weeds out" recession, we're talking potential for global depression. And then yes, the free market will have worked, we'll find a way to get fuel from rudabaga juice or something at $1000/barrel equivalent because it will be cheaper than oil at that point. But trust me, you don't want to live in that world.

Solutions have to come from plans. Plans have to work within the framework of the free market, but you also need to understand that oil is - and always has been for well over a century - a fundamentally manipulated market. Standard Oil, the Seven Sisters, the Texas Railroad Commission, and finally OPEC have all been the final arbiter of the oil price much as central banks are for interest rates (with all the positives and negatives, successes and failures that entails). Plans have to be implementable, and for a market on a global scale for a commodity that literally drives our entire civilization, to think that can be done without governments being a part (not the whole thing, a part) of the plans, is simply to ignore the power and importance of acting with a plan and setting rules and a framework within which the market can work.

I think George Soros' philosophical angle here is correct - sometimes governments get too interventionist and screw things up, sometimes they step too far back and allow greedy market players to screw things up. There has to be a balance between the two. If the classical economic assumptions were true - perfect information, zero transaction costs, no barriers to market entry, etc. - then I would agree with you regarding the importance of letting the pure market take its course. But that is a flawed set of assumptions. I know, I've spent years trying to break into markets that are essentially closed clubs which once you're in allow you to make oodles of money sometimes without even being that smart.

As for the global macro energy picture, I'd say that one definitely needs to be VERY wary of a lot of politicians ideas, there are some incredibly kooky ones out there. That said, the most important ones I think are fairly straightforward and reasonable. The key issue is that global discovery rates of oil have been declining decade after decade. We no longer make the same number and size of giant oil finds as we used to (finds like the recent Tupi field in Brazil used to be commonplace, now they're almost once-in-a-decade occurrences). The result is we consume substantially more (about 4 billion barrels per year if memory serves correct) oil than we discover each year. That doesn't mean imminent end of the world. But what it does mean is that every year we have to work harder and spend more money to develop smaller oil fields to meet rapidly rising global demand. It means more countries are approaching and passing their peak production, and that the world is increasingly reliant on a smaller number of key marginal producers.

Well one really, Saudi Arabia. They're developing their reserves faster than ever, but there's a limit to what they can do. They produce about 9 million b/d, are on their way to having 12.5 million b/d capacity in 2009 to maintain a minimal global spare capacity level, and have said they could develop a maximum of 15 million b/d capacity and don't expect any more because they can't do it and keep the fields from collapsing. Now, compare that to the International Energy Agency's recent long-term outlook that says by 2030 the world is going to need about an *incremental* 15-20 million b/d from OPEC, pretty much all of which would have to come from Saudi Arabia. Now, the IEA frequently gets these long term outlooks wrong, but they could be only half or less right and we'd have a problem.

This is of course the ground where the free market does intervene. Are we ever going to have a 20 million b/d gap between supply and demand? Of course not, the price will adjust and kill demand. Problem is, who gets hurt when that happens, who has to stop using oil? Everyone to some extent, but the poor overwhelmingly get hit first and hardest as fuel represents a large portion of their expenditures and they quickly get priced out. So the poor get poorer and their countries more unstable. But if oil goes to $200, $500, or $1000/barrel it won't be just the poor feeling the pinch, even your average middle class Westerner is going to hurt and have to find alternatives. Problem is, there are few alternatives at present. Will enterprising entrepreneurs find them? Sure, but the price shock is going to come so fast and so sharply that the alternatives are going to be very expensive too and most of society is going to suffer immensely and many, many will die in the process before the new technologies become affordable to the masses.

So what to do? Programs to encourage long-term research into paradigm-shifting "game changer" fuels is ok, governments from the militaristic-focused (US, Israel) to the export economy-focused (Japan, South Korea) have all shown there can be big positive externalities to relatively small goverment expenditures on research. I'd certainly encourage it, but that is frankly a hail mary and shouldn't be considered a practical near- to medium-term plan.

Where the rubber hits the road are things like mandating fuel economy standards, promotion of biofuels that have a proven strongly positive net-energy balance (hint: corn ethanol is not a good example of this, but don't tell that to ADM or Senators from Iowa or the Dakotas), and ensuring fiscal terms for development of reserves are sufficient to bring in the free market investment necessary (fiscal terms for oil development are another area where this market always has been and always will be fundamentally manipulated - oil is an extractive industry with economic rents that governments always have and will take a share of for the benefit of the broader populace, the only questions are how much and in what manner).

Really it just boils down to encouraging more efficient energy usage (controlling demand) and development of new unconventional and conventional supply sources (encouraging supply). These are arenas where the hand of government has always been overwhelming and the attempt to remove it would frankly be unprecedented in over a century and virtually ensure instant economic chaos and collapse. The question is not *if* the government is involved, but how. If the Chinese government were to say today before a major car culture has yet fully developed that all new vehicles have to be hybrids, you are talking billions of barrels in savings of oil usage over time and a major driver which will create private sector innovation to produce better and cheaper hybrids over time.

My random thoughts.

Reach Upward said...

NAA, thanks for your well thought-out and well informed post. I very much enjoy your thoughts. It is true that oil is a heavily manipulated market with only a handful of brokers holding the reigns of power. And it is true that governments (including ours) are involved up to their necks (or higher) in this process. And it is true that manipulation has resulted in a more stable market than we would experience otherwise.

It is debatable, however, whether this has been better overall than a more open market might have been. It's difficult to look into the crystal ball and see what might have developed had oil continued in a wild-wild-West pattern.

You suggest government support of research and development. I think government should do nothing to inhibit R&D. But I have difficulty seeing where government-sponsored R&D has produced better results than the free market. It ends up being a politicized wealth transfer program that focuses on solutions that may not be inferior and even harmful. Your observations about corn ethanol are a good example of how this works.

While there is no rational reason to hope for a hail-Mary solution, it is not out of the realm of possibilities. To suggest otherwise is to engage in the arrogance of assuming that we are so darn smart today that we can already see all future possibilities. This same type of arrogance has been the lot of mankind for millennia. Still, your suggestion to look for varied, smaller solutions is sound.