The recent run-up in gasoline prices has led to
a number of proposals by Washington politicians. It has also caused many people
to be angry toward oil companies. What we are seeing looks like a replay of
discussions and policy proposals that started in 1973 and continued throughout
the 1970s. In the late 1970s, I became an energy economist because I saw President
Carter devising some hugely destructive policies that perpetuated and extended
the destruction that his predecessors, Presidents Gerald Ford and Richard Nixon,
had brought to the energy sector. Most of what I said or wrote back then was
the application of straightforward economic analysis to the energy issues of
the day – very little of it was controversial among economists. And virtually
everything I wrote then is applicable today. What follows is a brief look at
eight controversies; each brief look could easily be expanded to a major column,
but time does not permit. How does any of this relate to issues of war and peace?
Question One: Aren't today's higher gasoline prices due to oil-company greed?
In a literal sense, yes. If oil companies were not greedy – that is, if they
were not trying to maximize profits for their stockholders – they could set
prices a few pennies a gallon lower and still survive. But the claim is also
misleading and relatively uninformative. Just a few weeks ago,
gasoline prices were about 50 cents a gallon lower. Were oil companies not greedy
then? Did they become greedy only in the last few weeks? As Charles Hooper and
I point out in our book, Making
Great Decisions in Business and Life, to explain a change in something,
you must point to something else that changed. Oil-company greed, just like
consumer greed – you want to get the best deal you can, don't you? – is a constant.
Therefore, it can't explain the change in prices.
Question Two: So, what did change?
Two things, both of which made gasoline prices higher. Spot prices for crude
oil (prices paid on the spot market) have risen by about $10 a barrel in the
last few weeks. There are 42 gallons per barrel, and so the crude-price increase
alone can account for about 24 cents of the roughly 50-cent increase in the
price of gasoline. That's a bit of a simplification. The reason is that a barrel
of crude doesn't produce only gasoline. That means that an increase in the demand
for gasoline, which tends to happen at this time of the year, can cause an even
higher increase than our 24-cent-per-gallon estimate. Second, as the Wall
Street Journal pointed out in an excellent
editorial (subscription required), the Bush energy bill is responsible for
some of the increase. Why now? Because oil companies, afraid of being sued for
using MTBE, the ingredient in gasoline that ethanol will replace, are using
the congressional requirement that MTBE be used as a shield against lawsuits.
The energy bill ends that requirement effective May 5, 2006, thus ending the
shield. So companies are scrambling to buy ethanol to replace MTBE. The sudden
increase in demand for ethanol has driven its price higher. The Energy Department
estimates that "a few pennies" of the higher price of gasoline are
due to the increase in the price of ethanol.
Question Three: Because this is all about supply and demand, doesn't that
mean that there's nothing government can do to bring down gasoline prices while
Absolutely not. There's a lot that government can do to bring down prices.
Start with the main culprit: crude oil prices. Why did crude oil prices suddenly
rise? The rise coincided with President Bush's threats of war on Iran. When
war is going on in an oil-producing region, it's hard to produce as much oil.
And when less oil is produced, its price rises a lot, even for a relatively
small reduction in supply because what economists call the elasticity of demand
for oil is relatively low. So if you want to blame one single person for the
increase in the price of oil, blame a president who is trying to pick a fight
with a government that poses very little threat to the United States.
Question Four: But wouldn't a war with Iran, even if it reduced oil supplies,
cause a price increase only in the future?
No. An anticipated reduction in the future oil supply will drive up
the futures prices. Arbitrageurs, noting a higher futures price, will buy oil
now at the lower spot price and sell it on the futures market at the same time,
in order to make a profit. But the profit will be small because, as they buy
it now, they bid up today's spot price until the difference in prices between
spot and future covers just interest, storage, and insurance. The arbitrageurs'
goal is simply to make money. But like most other participants in a free-market
economy, they are doing society a huge service that is not part of their intent:
by driving up today's price, they give us an incentive to conserve today and
save the oil until the time of a predicted lower supply. If some problem were
to happen in the future, wouldn't you want an early warning system? That's what
the futures market is.
Question Five: Then doesn't this mean that that the Senate Judiciary Committee,
which voted last week to amend the antitrust laws to make it illegal for oil
and gas companies to withhold oil from the market with the intent of driving
up prices, is insane?
No, but they do seem stuck on stupid. Right now, congressmen, with some exceptions,
seem to be trying to figure out where the American people want to go and then
getting in front to lead them there. They don't seem to actually be thinking
about the problem.
Question Six: Wouldn't a "windfall" profits tax on oil companies
be a good idea?
Let's see. We're upset that oil prices are so high, and so the solution is
to tax the companies that produce oil? Taxing a particular industry discourages
more production from that industry. So, the tax's effect on prices will be to
increase them. It will also strengthen the power of OPEC.
Question Seven: But isn't it unfair to let oil companies take advantage
of higher oil prices?
No. They took a risk. There was no guarantee that prices would rise. And if
the government taxes them more on their profits on inventory, they have less
of an incentive to produce in the future. That seems like a bad consequence.
Moreover, it's stunning to see people who own houses that have tripled in value
in the last 15 years argue that oil companies should be taxed on their higher
profits. Would they advocate that they themselves pay a special tax when they
sell their homes? The analogy is imperfect, but in a direction that makes my
case stronger. A special windfall profits tax on oil will reduce its supply
and the make the world price of oil higher. A windfall profits tax on housing
would reduce its supply, too, but with less-drastic effects. There is no OHEC
(Organization of Housing Exporting Countries) waiting to take advantage of the
Question Eight: But doesn't it at least make sense for Congress and the
rest of us to excoriate oil company executives, especially those at large oil
To the extent that the oil companies are large, it's because they're producing
more. If we're upset about high prices, it makes no sense to attack those who,
by their very productive activities, are making oil more plentiful than otherwise.
If a minister is upset about the low turnout of his congregation, should he
express his anger at those who bothered to attend?
Copyright © 2006 by David R. Henderson. Requests for permission to reprint
should be directed to the author or Antiwar.com.