How incredibly silly can government be? Think of this.
Oil prices have fallen 55% in the last year. The trend defied every expectation and it’s been wonderful. It’s an impressive illustration of how prices work to reveal underlying resource realities.
Technology has blasted away the last decade’s wild and misguided fears of a shortage. Exports and production are at an all-time high in response to unprecedented demand. The stunning events have been a boon to consumers, as downward pressure keeps pushing on prices at the pump.
The market as an institution is giving us oil as never before. It is not failing. It is succeeding beyond belief.
“Experts” keep saying the trend is temporary but no one knows for sure. We could see $20 per barrel before year’s end.
And it is at this very moment, the Department of Energy is proposing that the U.S. add 5 million barrels to the “Strategic Petroleum Reserve.” This program is the hoary leftover from the era of President Ford. It pays oil companies for their products, as the DoE says, “to protect the United States from severe petroleum supply interruptions through the acquisition, storage, distribution and management of emergency petroleum.”
You can tell from the language that this is the most thrown-back program one can imagine. It illustrates a complete lack of understanding of the price system, which is the signaling mechanism that reveals shortages and surpluses in the market. Rising prices signals consumers to consume less and incentivizes producers to produce more. Falling prices signal plenty of supply, encouraging consumers to consume more and producers to produce less.
The price system actually works, unlike these pathetic attempts at government planning. The proposed purchases by the government constitute only one-half a day of production in the U.S. — as if an intervention so small would make the difference between prosperity and disaster.
If it is really necessary to have a Strategic Petroleum Reserve, it would also be necessary to have the same for carrots, beef, iPads, tennis shoes, wine, and so. But, you say, oil is special because it is really, really necessary, so we can’t take the risk. Nonsense. Food, housing, and smartphones are all really necessary but we would never trust government to manage the supply.
Take away our oil and we walk. Take away our food and we starve.
In any case, the Reserve in total covers not even two months of U.S production (which is about 10% of world production). Why not six months or a year? There is no rational way to decide.
And let’s say there really were some weird catastrophe that caused all distribution to stop. Prices would soar through the roof and inspire a gigantic increase in oil production from all over the world.
But let’s say, because of some foreign-policy issue, the U.S. stopped all imports, and then tapped the Reserve. It’s not the consuming public that would benefit. It would be the government itself, making sure that the military and all government agencies stayed running.
In other words, this program is not about you and me. To understand why the Reserve exists, look who benefits most directly: the oil industry itself. It’s a guaranteed market, a kind of subsidy just as food stamps are for big agriculture. Perhaps this is why this proposal is being made again right now, just as prices are falling so dramatically, hint hint nudge nudge.
The subsidy came about during a period in which oil prices were controlled by the government. The oil industry faced very serious financial pressure. The Reserved helped to alleviate that, a classic case of how one intervention leads to other interventions. The SPR was a fix for a “market failure” that wasn’t a failure of markets at all but, rather, a failure of government.
Oil prices haven’t been controlled since the late 1970s, completely removing any objective conditions for why this needs to exist at all. In fact, the only time we ever had gas lines was when we had a “Gasoline czar.”
What harm does the Reserve bring about? It’s a huge waste of tax money. Beyond that, dumping oil on the market from a government-mandated reserve puts downward pressure on the price and reduces the incentive to step up production right when it is needed most.
The Reserve is a perfect illustration of the dangers of any government program. Once one starts, it is extremely difficult to get rid of them. Here we are 40 years later, with massive increases in supply and the technology for refinement and distribution, and we still have this thrown-back central plan for stockpiling oil.
It needs to be completely abolished, just as Ronald Reagan suggested in 1980 (before he later changed his mind to favor its expansion). The SPR is just like the post office in this sense: it exists solely due to that magic combination of economic ignorance plus special-interest pleading.
So, wait, this programme isn’t meant as a huge government subsidy to the big oil producers? =grin=
So, wait, this programme isn’t meant as a huge government subsidy to the big oil producers? =grin=
“If it is really necessary to have a Strategic Petroleum Reserve, it would also be necessary to have the same for carrots, beef, iPads, tennis shoes, wine, and so. But, you say, oil is special because it is really, really necessary, so we can’t take the risk. Nonsense. Food, housing, and smartphones are all really necessary but we would never trust government to manage the supply.
Take away our oil and we walk. Take away our food and we starve.”
I agreed with your article except for this bit that shows a distinct lack of understanding of a just in time inventory system that basically all businesses use to save money. All stores only keep a 3 day supply of any item for 2 reasons. the 1st is in the case of perishable item to keep fresh items on the shelf and 2nd because they are taxed on the value of there inventory as well as how much they sell. Now how do these items get there? Trucks lots of trucks, the petrol reserve isn’t and never was intended for public consumption but to ensure there is a way to transport food. Now I will be the 1st one to say that the government has proven itself terrible at disaster relief but that isn’t the point here. The point is if you take away the oil we do starve as there will be now way to run the tractors to grow the food and no way to run the trucks to get the food to people.
“If it is really necessary to have a Strategic Petroleum Reserve, it would also be necessary to have the same for carrots, beef, iPads, tennis shoes, wine, and so. But, you say, oil is special because it is really, really necessary, so we can’t take the risk. Nonsense. Food, housing, and smartphones are all really necessary but we would never trust government to manage the supply.
Take away our oil and we walk. Take away our food and we starve.”
I agreed with your article except for this bit that shows a distinct lack of understanding of a just in time inventory system that basically all businesses use to save money. All stores only keep a 3 day supply of any item for 2 reasons. the 1st is in the case of perishable item to keep fresh items on the shelf and 2nd because they are taxed on the value of there inventory as well as how much they sell. Now how do these items get there? Trucks lots of trucks, the petrol reserve isn’t and never was intended for public consumption but to ensure there is a way to transport food. Now I will be the 1st one to say that the government has proven itself terrible at disaster relief but that isn’t the point here. The point is if you take away the oil we do starve as there will be now way to run the tractors to grow the food and no way to run the trucks to get the food to people.
“Food, housing, and smartphones are all really necessary but we would never trust government to manage the supply.”
Three words: National Raisin Reserve. I kid you not – this is a thing. http://en.wikipedia.org/wiki/National_Raisin_Reserve
“Food, housing, and smartphones are all really necessary but we would never trust government to manage the supply.”
Three words: National Raisin Reserve. I kid you not – this is a thing. http://en.wikipedia.org/wiki/National_Raisin_Reserve
What is really ironic is that the government could lease out the oil storage capacity, make $2,000,000,000 per year renting the capacity, and let the oil companies and commodity speculators finance the oil inventory.
Rick, I am shocked, shocked I tell you, to hear that this giant, un-killable government boondoggle isn’t even very effective as a subsidy to the big oil business interests! lol
What is really ironic is that the government could lease out the oil storage capacity, make $2,000,000,000 per year renting the capacity, and let the oil companies and commodity speculators finance the oil inventory.
Rick, I am shocked, shocked I tell you, to hear that this giant, un-killable government boondoggle isn’t even very effective as a subsidy to the big oil business interests! lol
Many private interests are selling crude futures three years out at $70-75 per barrel, buying domestic oil at spot today for $45 per barrel, and seeking to store today’s $45 purchase for a certain $75 sale in three years. depending on storage costs, at today’s interest rates, that is one hell of an arbitrage.
The storage that is being rented, in tankers, or shore based terminals are much more expensive than the salt domes used by the DOE.
Don’t tell me, let me guess. If I bought a property with a huge salt dome that would be suited to oil storage, I would never be able to get permits to store oil there, right? Because only the powerful-in-government can do such important work. If I did the same exact thing, it would be an environmental violation. Or as Mel Brooks once quipped, “It’s good to be the king.”
Many private interests are selling crude futures three years out at $70-75 per barrel, buying domestic oil at spot today for $45 per barrel, and seeking to store today’s $45 purchase for a certain $75 sale in three years. depending on storage costs, at today’s interest rates, that is one hell of an arbitrage.
The storage that is being rented, in tankers, or shore based terminals are much more expensive than the salt domes used by the DOE.
Don’t tell me, let me guess. If I bought a property with a huge salt dome that would be suited to oil storage, I would never be able to get permits to store oil there, right? Because only the powerful-in-government can do such important work. If I did the same exact thing, it would be an environmental violation. Or as Mel Brooks once quipped, “It’s good to be the king.”
It’s surprising how many people don’t understand the basic price mechanism. I had a conversation with my roommate Bob a few months ago where he wanted to convince me that prices fall when demand increases. Then I said: “Assume that a bakery offers one last bread and has initially one client, and suddenly four more people enter the bakery. Do you think the baker would increase or decrease the price, if he was free to charge whatever he wanted for this last bread?” Bob said:”Pfff, if demand increases, companies lower prices to attract even more demand.”
Maybe that is what happens if they previously sold their product way above marginal costs and it also depends on the price elasticity of demand. I didn’t try to explain this to him. I must admit that I gave up, because Bob is always right.
It’s surprising how many people don’t understand the basic price mechanism. I had a conversation with my roommate Bob a few months ago where he wanted to convince me that prices fall when demand increases. Then I said: “Assume that a bakery offers one last bread and has initially one client, and suddenly four more people enter the bakery. Do you think the baker would increase or decrease the price, if he was free to charge whatever he wanted for this last bread?” Bob said:”Pfff, if demand increases, companies lower prices to attract even more demand.”
Maybe that is what happens if they previously sold their product way above marginal costs and it also depends on the price elasticity of demand. I didn’t try to explain this to him. I must admit that I gave up, because Bob is always right.
@katharina
I think his experience as a younger person comes with goods like software with very low fixed costs, where margins are high, so that revenue is the key determinate in profitability.
In capital intensive cyclical industries, like commodities production, your analysis is correct.
@katharina
I think his experience as a younger person comes with goods like software with very low fixed costs, where margins are high, so that revenue is the key determinate in profitability.
In capital intensive cyclical industries, like commodities production, your analysis is correct.
Jeffrey, in some parts of the world, you can use oil as a currency. This is the real reason behind the government program. All the talk about market insurance is just a load of hooey. The government is doing what it’s always done- acquiring valuable materials that it can use as capital at some later point.
Jeffrey, in some parts of the world, you can use oil as a currency. This is the real reason behind the government program. All the talk about market insurance is just a load of hooey. The government is doing what it’s always done- acquiring valuable materials that it can use as capital at some later point.
@rrule That’s why I added that it’s possible if you initially sold your product above marginal costs and, hence can still make profits if you lower your price. There’s also a second line of reasoning: Increasing demand leads to rising prices, which signals producers that they should produce more. If they produce “too much”, they may want to lower prices.
@rrule That’s why I added that it’s possible if you initially sold your product above marginal costs and, hence can still make profits if you lower your price. There’s also a second line of reasoning: Increasing demand leads to rising prices, which signals producers that they should produce more. If they produce “too much”, they may want to lower prices.
Katharina
note that the response that you describe are exaggerated in capital intensive, cyclical industries like energy. Because the industry is so capital intensive, the supply response to declining product pricing and margin shrinkage is delayed as producers produce down to cash extraction cost, sacrificing accumulated capital. Similarly, supply responses in a rising product price environment is delayed because of the time and capital required to increase production.
Industries where imput costs and volume maximization are the key ingredients in profitability will respnd differently to industries that are more capital intensive
Katharina
note that the response that you describe are exaggerated in capital intensive, cyclical industries like energy. Because the industry is so capital intensive, the supply response to declining product pricing and margin shrinkage is delayed as producers produce down to cash extraction cost, sacrificing accumulated capital. Similarly, supply responses in a rising product price environment is delayed because of the time and capital required to increase production.
Industries where imput costs and volume maximization are the key ingredients in profitability will respnd differently to industries that are more capital intensive
@rrule I didn’t want to imply that the price mechanism always functions immediately, free of errors and homogenously (independent of production technology and/or type of product). I am aware that there are differences in production and also demand, differences in price elasticities etc. There are endless amounts of papers about the functioning of the price mechanism, for a reason. So it is simply impossible to cover all exemptions in a simple comment. Explaining the price mechanism was never my intention anyway. I just used Bob as an example. And this discussion I quoted from really took place. (It was a bit longer though, I might even publish an entire article, just about this one discussion.) Bob and I were talking about bread and Soda, and he still didn’t agree that higher demand, assuming that production cannot be increased in the short term, will usually lead to rising prices. I should have mentioned that we were talking about bread and soda.
@rrule I didn’t want to imply that the price mechanism always functions immediately, free of errors and homogenously (independent of production technology and/or type of product). I am aware that there are differences in production and also demand, differences in price elasticities etc. There are endless amounts of papers about the functioning of the price mechanism, for a reason. So it is simply impossible to cover all exemptions in a simple comment. Explaining the price mechanism was never my intention anyway. I just used Bob as an example. And this discussion I quoted from really took place. (It was a bit longer though, I might even publish an entire article, just about this one discussion.) Bob and I were talking about bread and Soda, and he still didn’t agree that higher demand, assuming that production cannot be increased in the short term, will usually lead to rising prices. I should have mentioned that we were talking about bread and soda.