What To Do About the Oil/Gasoline Prices

Well, this is a follow up to this post on what to do about oil prices. Also, a there are a number of responses in this post on the oil/gasoline situation that are related to the issue of what to do that are worth responding too.

Lets start off with a good suggestion from Dave Schuler and also suggested by commenter Herb,

I’m afraid my objectives are different than most people’s. First and foremost we should stop subsidizing consumption. And we should eliminate the direct subsidies that the oil companies receive (there are lots of them).

This is a good idea. For an industry that is earning tens of billions a year in profits the idea that they need subsidies is just galling in the extreme. Every penny they get in federal and state subsidies should be revoked. With oil and gasoline prices high the oil companies have a strong incentive to produce at near maximum capacity. They don’t need anymore incentive from the taxpayer. Further, taxing the consumers and giving the money to the oil companies is inefficient. So eliminate these subsidies, yesterday.

The next comment is from Steve Plunk,

So far I hear no blame being placed upon the world’s dominate oil cartel, OPEC. Most of these countries dislike the west and benefit from high crude prices. It’s a two-for, hurt us and collect more money. What better way to fund the jihadists.

OPEC countries also limit further development of production facilities in order to keep control away from the private sector and therefore the free market.

Energy is far from a free market commodity. Between OPEC and environmental regulations oil is in reality a heavily regulated good controlled by governments. We know how that turns out.

While it is true that OPEC likes higher prices they aren’t going to push the price so high that alternatives start to look attractive. Further, there is another problem with high prices. Higher prices induce production from non-OPEC members as well as creates an increasing incentive for individual members to “chisel” on the cartel agreement–that is produce above their quota. This has happened in the past. Further, oil prices that are too high could trigger a recession and this by itself will curtail consumption.

This last idea is highlighted in the comment by TJIT. Steve Plunk also brings up the idea of “breaking the cartel”. How? The only way that I see this happening is invading the member countries which wouldn’t go over well even if our military could do it. OPEC’s power as waxed and waned in the past, but that is due more to the internal bickering/maneuverings of member countries and also partly in response to consumer conservation. Breaking the cartel is unlikely to happen and even if it could be done I doubt it would have much impact on prices as the current high prices are so much of a supply side issue (at least in terms of oil) but more of demand side issue.

Countries like China and India are consuming more. This increased consumption at all price levels is very much like a rightward shift in the demand curve. Holding the supply curve fixed this translates both into increased production and increased prices.1 Recall this post where I pointed out that in the futures market oil in contango. This is where the futures price for delivery a few months down the road is higher than the spot market price. When this happens refineries tend to opperate at the “top of their tanks”, that is the storage tanks holding oil are full. So there is plenty of oil on hand, the problem is that the price is high right now, and looks the way the market looks will be higher in the future. The implication is to hold oil, and produce oil.

Barry has a good idea,

One thing we could do is for the state and federal gov’ts to quit mandating all these different blends of gasoline. We need a handful at best: deisel, jet fuel, and a few grades of unleaded.

I doubt this would do much to reduce the price right now, but it certainly could help make the gasoline market less volatile. Whenever there is a shortage in one part of the country production in another part could be shipped to the region with a shortage, thereby mitigating the rise in prices; basically spreading the pain around at a much lower level.

The idea of making building refineries a national security issue is something I’m unsure about. First of all, building a refinery anywhere is going to be a huge and long term process, I’d say at least 5 years. So for prices right now it would do pretty much nothing. Further, I’m not convinced that everything that is deemed “important” should be classified as “national security”. Pretty soon we’d be seeing gay marriage and the opposition to gay marriage couched in terms of national security.

Bithead has touched on many of the topics we’ve already mentioned, but also brings up ANWR and domestic drilling. I doubt that this would do much either. How much could ANWR produce per day? The high estimate is 1.6 million barrels per day, and that would be several years down the road. Perhaps wise from a long term strategy view point, but would do little to affect prices today. Further, another thing to consider is that oil prices are set by a global market and the total global production of oil per day is 85 million barrels. So an additional 1.6 million barrels, while not insignificant, wouldn’t do much to reduce prices.2

Bithead also mentions reducing the taxes on gasoline. While this would have a short term effect of lowering the price of gasoline it would also cost the federal and state governments quite a bit of revenue, and given that these governments are running deficits or would be running deficits without these revenues, that would mean eventually higher taxes. Further, such a reduction in the price would actually encourage more usage of gasoline, not less. Which in the long term probably wouldn’t help the situation. It would be like making heroin cheaper for the addict. While initially it might increase gratification, it would just strengthen the dependency.

Somewhat disappointingly nobody has touched on the windfall taxes proposal. The problem with this idea is simple: it will reduce future oil production. Think prices are high now, enact a windfall profits tax and watch the oil production shrink in the future. Here is how to think about it. When an oil firm is thinking of drilling a well and pumping the oil they look at what revenues they expect to earn on that well in the future. As such they try to get an idea of what prices are going to be in the future. This will likely lead to a distribution from say $0.00/barrel (i.e. oil is considered worthless–a highly unlikely outcome) to say an equally highly unlikely outcome at the other end, say $200/barrel. The important thing isn’t the tails so much as the mean and probably the variance of this distribution. If the distribution has a low variance and the mean price is high enough then drilling the well and pumping might make quite a bit of sense. In the end, profit and more oil and gasoline. But a windfall profit that taxes away all the money per barrel over $40 would truncate the distribution (i.e. chop off the top portion). This would lower the mean which could very well mean that oil wells that would, absent the tax, be drilled wont be after the tax. Result, less oil and gasoline, and with increasing demand higher prices. So while the idea of a windfall profits tax might soung like a good idea (finally the consumer can stick it to the oil companies!), it would probably just make the situation worse for the consumer.

Also, as indicated above, finding a way to lower the prices might not be a good move. Lower prices will simply ensure that oil/gasoline are the main forms of energy. The higher prices will eventually lead to substitutes to oil/gasoline. Some people are looking at Exxon Mobil’s $8.4 billion profits (for the first quarter alone) and thinking, “It would be nice to find a way to get some of that!” And some of those people will start trying to figure a way to take some of that money. Take it by competing with Exxon Mobil. Lowering the price will blunt that incentive. Taxing away those profits will likely have the same impact. After all, if you come up with a really great solution to the high gasoline price such as a revolutionary new battery for hybrids what is to keep the government from taxing away your profits. The very same arguments of necessity that pertains to gasoline and oil could be used for such an invention.

This doesn’t mean we have to like the high oil/gasoline prices. I know I sure don’t, but try to find ways to use less. Using less means that is less money the oil companies and oil exporting countries get. It also, obviously, means more money in your pocket as well. It also doesn’t mean you have to like the oil companies. If it makes you feel better hate them for all I care. But the idea that we can some how force the gasoline prices lower, is somewhat of a pipe dream IMO. The former Soviet Union used force to run its economy..and that worked really well didn’t it.
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1Note that the more vertical the supply curve the smaller the increase in production. If the supply curve is vertical (as it usually is in the very short run) then you’ll get no increase in production, but a price increase.
2One could argue that reducing consumption of foreign oil by consuming domestically produced oil is good for a variety of reasons. All I’m pointing out here is that there’d be little impact on prices.

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Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. RJN says:

    The use of ethanol as an automotive fuel is has become a stupid farce. Give it up. It takes much more energy to produce a gallon of ethanol than a gallon of ethanol can deliver to an auto. Much of the wasted energy comes from petroleum.

  2. Christopher says:

    besides ethanol, what subsidies?!? the only that I know of are for domestic oil exploration. how will that effect prices?

  3. Mr. Econotarian says:

    Regardless of the ethanol energy content, its real downfall is difficulty in moving it. Unlike oil and gasoline, it is not hydrophobic, so it readilly mixes with water (as any vodka drinker can attest to). Thus it cannot be sent easilly via pipeline, and other long-distance transfer modalities will be difficult as well.

    Ethanol as a finished product will always be a local commodity, not a global one (like oil).

  4. Steve Verdon says:

    besides ethanol, what subsidies?!? the only that I know of are for domestic oil exploration. how will that effect prices?

    This is bordering on the stupid. Oil is now around $70/barrel and yet they actually need more money per barrel to explore for oil? Have I read that right Christopher? You must love paying the current prices for gasoline. In fact, I think legislation should be enacted so you get to pay the Christopher Surcharge of $5/gallon.

    Good God.

  5. Gawaine says:

    OK, this is probably naive, but my perception is that it’s the perception of a crisis, as much as the actuality of the crisis, that keeps prices high. Witness how prices go up or down at news items that aren’t really likely to have an effect, but get people excited. For example, the price has been known to go down when countries that are already producing at capacity have raised their quotas, and to go up when the quota is lowered to the actual production amount.

    So, with that in mind, I would think there might be a few things we could do to improve the perception of consumption or of demand. ANWAR is a good example for the demand side – it probably wouldn’t put a dent in the worldwide consumption, but it would make the markets calm down a little. On the consumption side, how about requiring all newly aquired federal vehicles (including postal service vehicles, not including tanks) to hit certain fuel standards, or to be alternative fuel powered? I doubt that would make a real cut in the demand, but it wouldn’t hurt, and the perception that something is being done might help calm fears. If the USPS were to buy a thousand Ford Escape Hybrids, I’m sure Detroit would be happy, if nothing else.

  6. Dave Schuler says:

    Last year’s energy bill introduced about $14 billion worth of tax breaks to oil companies. There were already roughly $5 billion in place which haven’t been removed. Additionally, there are still some oil depletion allowances on the books.

    The Federal-Aid Highway Act and its successors are effective subsidies to oil companies, in this case functioning by stimulating consumption. The list of consumption subsidies is enormous going from rebates on fuel taxes paid to the construction of bridges.

  7. anon says:

    Steve,

    You don’t know much about domestic production, do you?

    The large integrateds – Exxon, Shell, etc. – have little to no production in the U.S. What you have are the mid-size guys and bunches and bunches of small, tiny operators. You talk of an industry making “tens of billions of dollars a year”. Take out the world-wide integrateds and look at only the small, domestic-only producers. What are those guys making?

    The “tax incentives” these small guys operate on are the write-off of non-tangible drilling costs in drilling a well. You get rid of this, you shut down hundreds of small domestic oil companies across the U.S. Congratulations.

    And taxes? You don’t even scratch the surface on that. There are taxes on the lease (school and property taxes), taxes on the oil and gas that come out (ad valorem taxes), taxes on the pipeline (oh, you need right-of-way? That will cost you) and then all the other taxes up stream. Keep in mind there are also royalty payments to the land owners, which is usually an eighth to a quarter of all the money off the top that goes to someone besides the oil producer.

    So how about you look at the entire cost structure and tax of domestic production and THEN you can bloviate about what the right tax policy is.

    And your comment
    ===
    (reducing taxes) would also cost the federal and state governments quite a bit of revenue, and given that these governments are running deficits or would be running deficits without these revenues, that would mean eventually higher taxes.
    ====

    How would reducing taxes on a increasing cost basis end up in reduced revenue? I must of missed that day in math, but it seems to me that tax receipts could be held constant or even in line with inflation with a decreased rate on an increased base (and I’ll not get into your belief that the money is the government’s to begin with).

  8. Dave Schuler says:

    Interesting report, anon. Can you provide some links to show us which oil companies are receving the tax breaks and in what amounts?

  9. RA says:

    Excuse me but these subsidies are “tax deductions” like all other businesses get. The oil companies are making about a 9-10 % profit. The government is already taking 40-50 cents a gallon.

    These Democrats don’t care if the price of gas goes through the roof, just as long as they get an ever increasing share of the pie.

    The way to stop price increases is to open all American land and sea to drilling and build more refineries. Also stop forcing the 50 odd blends of gas.

    Its the socialist Democrats and a few RINOs who are subverting our energy policy and they love it. These price hikes are just what the extremist environmentalists want.

  10. spencer says:

    Domestic oil production is now about half of what it was at the peak in 1969 when the price of oil was $3.35. If oil companies have been free to produce all the oil they wanted in the US for some 20 years –from 1980 to 1999 the
    price of oil averaged some $20,and they are now free to get up to $70 — what do you think the Democrats are doing to keep the oil companies from increasing domestic production?

    I would really like to see your answer to that question, especially in light of the fact that the Republicans controlled the White House over most of this period and Clinton could have cared less what the price of oil was?

  11. Last I checked the major OPEC countries were producing oil as fast as they could. See Brad Setser’s weblog and others. Saudi Arabia can’t add any capacity in the short term so OPEC has lost control of oil prices in any sense other than to increase them a la Chavez of Venezuela.

  12. Steve Verdon says:

    As I figured, Anon was a hit-and-run poster who can’t or wont follow up on his comment. My guess is the former because he doesn’t have the data to support his assertions. Ho hum.

  13. Bithead says:

    Thing is, Steve; Anon’s right.

    Do you really think the Oil companies are getting the oil they refine for free, and have no taxes to deal with, and are thereby making $70/bbl?

    LA TIMES:

    Tax Foundation studies have shown that state and federal treasuries profit handsomely from oil industry sales. The average American motorist pays taxes of 46 cents a gallon on gasoline, of which 18.4 cents a gallon goes to the federal government. States and localities pocket the rest.

    The nation’s energy companies are already providing a “windfall” of taxes. According to Department of Energy data, from 1977 to 2004, federal and state governments extracted $397 billion by taxing the profits of the largest oil companies and an additional $1.1 trillion in taxes at the pump. In today’s dollars, that’s $2.2 trillion â?? enough to buy a Toyota Prius for every household in the nation.

    All of which ignores taxes not direcly reflected at the pump.

    Further, as regards taxing the supposedly added profits:

    The last time this country experimented with such a tax was the Crude Oil Windfall Profit Tax Act of 1980. According to a 1990 Congressional Research Service study, the tax depressed the domestic oil industry, increased foreign imports and raised only a tiny fraction of the revenue forecasted. It stunted domestic production of oil by 3% to 6% and created a surge in foreign imports, from 8% to 16%.

    I have added data on my desktop at home, which, for some reason I’m unable to access, just now. I’ll follow on tonight

  14. Bithead says:

    And by the way, Steve; Your comments about ANWR not helping much;

    May I suggest you look again at the original estimates of what Prudoe Bay would produce? Note specifically, that we have thusfar surpassed those estimates by a factor of 10.

    You’ll forgive my not taking seriously the small estimates of oil offered by those who don’t want the area drilled.