What's Suddenly Gone Wrong with the Oil Market?
Market failure or something else?
8 Jul 2009 in Regulatory Economics, Regulatory Policy
In the last day or so there has appeared in the news a sudden interest in regulating the global market for crude oil. This is almost certainly the unveiling of a coordinated plan.
What's behind it?
Action is being proposed on both sides of the Atlantic, with the Wall Street Journal editorial page serving as the index megaphone. Today the Journal ran a commentary by UK Prime Minister Gordon Brown and France President Nicolas Sarkozy, which alleges that "for two years the price of oil has been dangerously volatile, seemingly defying the accepted rules of economics." The evidence cited by Brown and Sarkozy consists of price volatility:
The oil market is complex, but such erratic price movement in one of the world's most crucial commodities is a growing cause for alarm. The surge in prices last year gravely damaged the global economy and contributed to the downturn. The risk now is that a new period of instability could undermine confidence just as we are pushing for recovery.
Brown and Sarkozy claim that price volatility "damages both consumers and producers," and for that reason, "[g]overnments can no longer stand idle."
Presumably, the unnamed governments Brown and Sarkozy are concerned about are shielding domestic consumers only from rising prices, such as the aforementioned $80 per barrel price increase, and not from the subsequent $100 per barrel decline. Messrs. Brown and Sarkozy do not say why these governments are committed to subsidizing consumption, nor do they explain why governments that have decided to subsidize consumption are not hedging against the risk of future price increases by purchasing options.
With respect to their own countries, Brown and Sarkozy say "we also know how the price of crude dictates the price of petrol at filling stations and the effect on families and businesses." Although this seems to imply that increases in crude oil prices have a significant effect on French and UK consumers, they don't. Both countries have petrol taxes that are so large they exceed the cost of both crude oil and refining. High taxes have the practical effect of reducing the retail effect of volatility in crude oil markets. Retail prices in France and the UK are high irrespective of the price of crude. Chris Vernon says that in 2006, taxes in the UK comprised 64% of the retail price. A 20% increase in the price of crude would raise retail price 8.5%.
The high relative taxes in France and the UK are illustrated in the graph below, which shows tax rates in Euros per liter for petrol (gasoline) and diesel for each OECD country in 2000 and 2006. The graph is somewhat hard to read because it consists of a series of four vertical bars with three different shades of blue. To make it easier, we've highlighted France, the UK, and the US. During this period, France reduced its tax rate from about €0.6 per liter to about €0.40. The UK kept its taxes at about €0.7 per liter. In the US, however, federal and state gasoline taxes were less than €0.1 per liter. Among OECD nations, volatility in global crude oil prices has the most effect in the US.
Therefore, even though Brown and Sarkozy cite price volatility as the reason for their concern, it is almost certain that something else motivates their interest in regulating the world oil market. What can it be?
It's not climate change. Brown and Sarkozy express concern that price volatility is reducing the demandfor oil:
But this is a good thing if you're worried about carbon emissions.
So, is there anything else? As it happens, yes: Brown and Sarkozy are not worried about price volatility, they are worried about prices falling:
Upstream investment world-wide is already down by 20% over the past year. And with some sources of supply in decline, such as Alaska and the North Sea, the resource we will all need as the economy recovers is being developed in neither an adequate nor a timely way.
The market "failure" they are worried about is that prices fall when markets conclude that oil is overpriced. Their prescription is "government supervision" of the oil market to keep prices high:
OPEC's interest in maintaining high prices is obvious. Why it is in the interest of consumers worldwide is not so clear.
The potential scope and scale of this proposed "government supervision" appear to be quite large. Brown and Sarkozy are seeking a global regulatory regime that would "reduce damaging speculation" and "serve the interests of orderly and adequate investment in future supplies." The commentary provides no insight concerning what social benefits are obtained by "orderliness," or how much speculation is "damaging." Indeed, Brown and Sarkozy follow a well worn path by criticizing "speculators" for driving prices up (or, in this case, down). Every futures contract has both a willing buyer and a willing seller.
Futures markets serve an important public purpose--they provide price discovery--and, ironically for Brown and Sarkozy's argument, they tend to reduce price volatility. Regulatory restrictions on speculation should be expected to increase uncertainty, and thus exacerbate volatility. But as an analysis of the Brown-Sarkozy commentary shows, price volatility is not the problem they are actually worried about. They are trying to figure out how to use regulation to keep prices high and make it seem as if this is a good thing for consumers.
