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Drill, Baby, Drill, The Reprise…

March 26th, 2010 · 22 Comments
Econ 101 · Environmental Econ · Policy

The guys over at Environmental Economics are becoming two of my favorite economists…which is interesting since I’ve never been particularly into the whole environmental thing. I obviously understand that it’s important to save some whales and panthers and polar bears and whatnot (yup, all cute animal examples), it’s just not what I study. What I *do* study, or at least write about, is the disconnect between (good) economics and (less than good) politics.

In general, conservatives tout themselves as being opposed to most forms of government interference in markets. This viewpoint seems to come both from a “stay out of my business” ideology and the concept that interference in well-functioning markets is economically inefficient. However, they apparently don’t let this viewpoint stop them from criticizing others for allowing markets to reach what they feel are undesirable outcomes. From Tim Haab at Environmental Economics:

I’m fairly conservative when it comes to letting markets do their thing. I don’t like it when governments interfere with and regulate fairly well-functioning markets. That’s why it bugs me a little when conservatives blame the President for simple fluctuations in markets that are a result of basic economic adjustments*. Like this:

Gas up $1 a gallon on Obama’s watch: Pressure rises for exploration

Gas prices have risen $1 since just after President Obama took office in January 2009 and are now closing in on the $3 mark, prompting an evaluation of the administration’s energy record and calls for the White House to open more U.S. land for oil exploration…

This excerpt is from the Washington Times, which is known for being a conservatively-oriented publication. (Don’t worry, my notion of an unbiased media died long ago. If yours hasn’t, might I suggest you pick up a copy of Matt Taibbi’s Spanking the Donkey.) It’s nice to see that they don’t let either the principles of economics stand in the way of criticizing the current administration. I also love how the article can basically be summarized by “drill, baby, drill,” since the authors seem to be using market fluctuations as an excuse to push this part of the conservative agenda. (I say this mainly because there are a number of non-drilling ways to get gasoline prices down, for better or for worse.) So is something about the gasoline market broken? The article continues…

John B. Townsend II, a spokesman for AAA Mid-Atlantic, said price increases are a result of the cost of crude oil, thanks to a decision by the Organization of the Petroleum Exporting Countries not to raise production even as economic growth in countries such as Russia and China spurs more demand.

“From all indications, we’re going to see $3 gas again this summer,” he said.

Oh OPEC, how you introduce asterisks and footnotes into the world of the well-functioning market. Furthermore, I want to think that you are all big and evil and restricting supply and whatnot (which you are), but I can’t help but also think that you are inadvertently doing your part to avoid overharvesting a nonrenewable resource for short-term profit at the expense of long-term sustainability.

I am not entirely clear on how OPEC sets production quantities (I am not convinced that they are clear on this either, for that matter), but for the most part the quantities don’t seem to depend all that much on market price, at least not in this case. On the other hand, non-OPEC producers respond to the higher prices by producing more, since the higher prices make oil a more lucrative business. When we look at the entire world supply, then, it is somewhat responsive to prices, just not as responsive as it would be if OPEC wasn’t doing its whole cartel thing. So we get the following supply of crude oil:

Now, I don’t entirely understand how it’s not profit-maximizing for OPEC to raise its collective output somewhat in response to the increased demand, but they’re gonna do what they want to do, so I just take it as given. When you couple this with increased demand for crude oil, you get the following market for crude oil:

Hey, look at that- crude oil got more expensive, just like the article said. Now consider the rise in crude oil prices. Crude oil is what is used to produce gasoline, so if the price of crude oil goes up, gasoline is more expensive to produce. If gasoline is more expensive to produce, it’s less attractive to produce it and companies are in fact going to produce less of it.

Because of the reduction in supply, you get a picture that looks like this for the gasoline market:

Not surprisingly, gasoline prices go up. It could be the case that gasoline prices go up even more in response to increased demand as well, since I find it counterintuitive to think that China and Russia are adding to the demand for crude oil but not to the demand for gasoline. (Maybe they’re making their own gasoline with the crude oil they buy, who knows.) In any case, what you see in this model is a graphical representation of “If something gets more expensive to produce and/or more people want it than before, that thing is going to get more expensive.” It’s not like there’s an evil genius out there (yeah, I’m sarcastically talking to you, Obama) who’s messing with gas prices so as to put those blue-collar workers who drive 20 miles to their jobs into the poor house. Furthermore, I find it funny that in all likelihood these same people would start waving around the Socialist card if Obama DID do anything (at least do anything other than drill) to bring gas prices under control.

My main point is that people can’t have it both ways. If you want the government out of your free markets, then you get to absorb the market fluctuations that come along with that. I do understand that conservatives see the easing of drilling restrictions as leading to a more free market, which it does, but the problem comes in when they start using price stabilization as a justification for the change. While it is true that increased drilling, if successful, should lower the average price of gasoline somewhat (by increasing supply, assuming that we could profitably produce gasoline from the new areas), it would not insulate U.S. consumers from market fluctuations*. Instead, we’d just be complaining about how gasoline went from $1.50 to $2.50 rather than from $2 to $3. I say this mainly because it seems that it’s specifically the abrupt changes that generate the public outcry, and it’s specifically the abrupt changes that the increased exploration would not prevent.

Technical note: This is because the added supply isn’t likely to make supply more price elastic, and this is what would be necessary to have smaller price increases in response to increased demand.

Tags: Econ 101 · Environmental Econ · Policy

22 responses so far ↓

  • 1 tim // Mar 26, 2010 at 4:52 pm

    I am not entirely clear on how OPEC sets production quantities (I am not convinced that they are clear on this either, for that matter), but for the most part the quantities don’t seem to depend all that much on market price, at least not in this case.

    Its almost always an interesting read when somebody explores it, and it seems its never expressed the same way twice. As I understood from my last exploration, imagine their greatest economic, policy and technical minds working for hours in smoke and t00-thick coffee with nothing but foot stomping and shouting, with volume equally-weighted to strength of argument…for days!

    Then one guy picks.

    Anyway, I’m not sure the picking of the production targets has to do with their output (and neither are they!).

  • 2 tim // Mar 26, 2010 at 4:58 pm

    If gasoline is more expensive to produce, it’s less attractive to produce it and companies are in fact going to produce less of it.

    Nope.

    If I gave you a company that delivered an inelastic* product and paid you on a cost-plus basis, why would you produce less when the cost when up? You’d produce more, and isn’t that a basic economic argument anyway?

    *anything under $4.50 a gallon and its inelastic. at $4.50 all of a sudden people either choose or are forced to stop driving.

  • 3 econgirl // Mar 26, 2010 at 5:09 pm

    A reduction in supply means that for any given price the amount that firms want to produce is lower. When you are talking about the cost-plus contracts and a cost increase, you need to take into account that the price of the output is also going up. In fact, it is going up by more than the cost is going up, so of course they want to produce more. But there are two related effects there that need to be recognized.

  • 4 Mike // Mar 26, 2010 at 5:16 pm

    I emailed OPEC once and asked them how they set their production quotas. I wish I had kept the email, but the response was shockingly honest and basically provided a list of right-hand side variables for anyone doing a surplus sharing regression. They said that they look at a variety of things like population growth, labor force growth, their own energy needs, etc. These are exactly the kinds of things one would expect individual countries to use in a bargaining problem. “We have lots of unemployed, needy people, so we need a bigger share of the oil revenues this year.”

  • 5 tim // Mar 26, 2010 at 6:27 pm

    I have to admit I’m pretty well versed in some areas and completely vacuous in others 🙂

    I don’t understand:
    A reduction in supply means that for any given price the amount that firms want to produce is lower

    I can see how if you took that all the way back to reserves–as in, the only oil left is harder to find and deliver, and therefor costs more to bring to Oklahoma, especially if the sales price were fixed. But its not–they’re artificially lowering supply, which drives prices higher, which means they get paid more…somewhere on that curve is the greatest profit (which may not be most oil delivered).

    yes, no, almost?

  • 6 Mike // Mar 26, 2010 at 7:27 pm

    “Now, I don’t entirely understand how it’s not profit-maximizing for OPEC to raise its collective output somewhat in response to the increased demand, but they’re gonna do what they want to do, so I just take it as given.”

    Collusion is an attempt to mitigate the effects of competition. If one of the cartel members raises its quantity, it results in a negative externality for the other members (all firms, in fact). So, successful collusion involves successfully internalizing that externality. Failure to internalize the externality means somebody is cheating on the cartel. Now, it may be profitable for the cartel to increase output as demand increases, but resisting that increase may also be the cartel’s way of getting back to the collusive outcome, which successfully internalizes the externality. That is, the OPTIMAL cartel output may have increased as demand increased, but it is well-known that OPEC usually operates above the optimal level of output. Also, since we’re talking about externalities, I am pleased to see you note that OPEC has positive environmental effects in that it restricts supply relative to the free market outcome. There is a pollution externality associated with petroleum, and I’m fairly confident it hasn’t been solved yet. So, OPEC actually mitigates that externality, though I’m sure it isn’t part of their objective.

  • 7 Warren Jensen // Mar 26, 2010 at 8:38 pm

    The point conservatives are trying to make (sometimes inadvertantly, and not very well even then…) is that we, the US, are not allowed to drill for more oil to increase supply and, supposedly, to decrease the price of oil products such as gasoline.

    Many conservatives believe the benefits of whatever reasons oil drilling is restricted (usually environmental) are not worth the cost of increased gasoline prices. Of course, I havn’t met anyone who could reliably quantify the change in gasoline prices if, say, oil drilling were allowed again off California’s coast, producing X bbl of oil per year. So, it is arguing from a rather ignorant perspected, to be honest.

  • 8 econgirl // Mar 26, 2010 at 10:19 pm

    @ Mike: I 100% get what you are saying. The cartel is certainly restricting supply to less than a competitive level in order to keep price higher and extract positive economic profit. However, even a firm (or group of firms in this case) acting like a profit-maximizing monopoly would increase production somewhat in response to an increase in demand. That is why I was confused. I think we are generally in agreement- you seem to be saying that if OPEC was already producing more than more than the optimal level anyway, there wasn’t necessarily a reason to increase production in response to the increase in demand.

  • 9 econgirl // Mar 26, 2010 at 10:28 pm

    @ tim: I can see why it’s confusing. The appropriate explanation depends on whether you are talking about an entity that is large enough to move prices or not. In other words, if I am a relatively small player in the oil market, I can basically assume that the market price of my output is given to me, since I can’t noticeably move the market price due to the fact that I don’t have the capacity to do so. So I take the market price as given and decide what production quantity maximizes my profit. On the other hand, if I am OPEC, I am big enough that my production choices affect the market price. In this way, I have to choose a related price-quantity pair that maximizes my profit. This quantity will generally be lower than if I was taking the price as given, and, because the quantity is lower, the market price is higher than it would be if I didn’t have any market power.

    That said, the reduction in supply statement holds regardless of whether firms have market power or not.

  • 10 econgirl // Mar 26, 2010 at 10:29 pm

    @ Warren: I would love to see this sort of quantification, since it could lead to intelligent discussion as opposed to vague ideological argument.

  • 11 Tim // Mar 26, 2010 at 10:44 pm

    I think I’m following you, but I dont think it applies…maybe it’s a philosophy/real world schism. If I’m any smaller than OPEC, I CANT change prices, and my profits are based on my ability to produce. If I’m OPEC (sans Saudi) I can encourage or discourage demand by allowing prices to violate their gates: too high and nations change policy. Too low and they can’t make enough money to support themselves…that sweet spot in the middle though…

  • 12 Charles Dolci // Mar 27, 2010 at 5:46 pm

    Maybe the price of gas isn’t going up. Maybe the value of dollar is going down.

  • 13 EnergyGradStudent // Mar 27, 2010 at 8:34 pm

    @Charles, It is true that in the time period considered, the US dollar index has gone down from about 87 to 77(approx. ), but foreign exchange rate is itself linked to imports and exports of goods. So a part of the reason for change in dollar value is due to the import of oil in the US. It gets really complicated to analyze this route because of the endogenous links between price, quantity imports, dollar value.

    Now, Industrial Organization 101: Considering the dominant firm and fringe model, if OPEC is acting purely to maximize its profits, we can frame an equation and find out what the ideal OPEC supply should be. BUT(there is always a BUT!!), there is a problem of compliance in the OPEC, which might be substantial enough to influence prices, there are political reasons and pressures(which I wish we could quantify, but cannot !) that might influence the behavior, and move it away from purely profit maximizing behavior.

  • 14 holmegm // Mar 28, 2010 at 9:20 am

    Hmm.

    So conservatives “tout” themselves as wanting less government interference, but they are clearly off base and hypocritical here, because they, ah, want government to back off and let them drill …

    Those wacky conservatives! 🙂

    Yes, large or sudden price increases do tend to focus our attention. True ’nuff. Whether it’s “rational” to let that focus your attention is up for debate, I suppose. It’s natural, in any case.

    The basic conservative thrust on the issue – that government is artificially increasing scarcity – seems pretty sound to me.

  • 15 Brad // Mar 30, 2010 at 9:49 am

    If you like animals, the blog “naked capitalism” has one or more animal pictures with the daily links. You can view them with your naked eye.

  • 16 Kirk // Mar 30, 2010 at 8:02 pm

    The drill baby drill rhetoric also tends to ignore that in many cases, oil in the ground can be economically infeasible to pump. If you put more money in to start the pumping than you get out at reasonable recovery rates for oil, that oil is not pumped. By the same virtue, like the tar sands of Alberta, if you are putting in more energy in the form of natural gas than you get out in oil, you are pumping a “dead” well. The tar sands are profitable due to the current price levels of oil prices, but they are also producing the lowest grade oil available at the lowest margins of their peers. In the case of areas like the Arctic National Wildlife Refuge, you are looking at the possibility of both conditions. The area cannot be serviced for transport of the oil out by any means other than convoys of trucks. These trucks can only run during approximately 4-6 months depending on weather conditions as they must cross large sections of permafrost that can be unstable during the rest of the year. There have not been any full accounting of the oil content of the wells in ANWR, but the initial reports were largely high sulfur content, and low quality oil.

    Given these extraordinary logistical challenges and the low quality of the output, even if all political hurdles to the project were removed, I would be shocked if you ever saw a major extraction actually underway. The headlines this week from the Falklands echo this dynamic perfectly, what was once a very promising find turned into a complete lemon when the oil quality was found to be economically infeasible due to the low quality of oil they would be able to extract. As the truism says, oil in the ground is not necessarily money in the bank.

  • 17 econgirl // Mar 30, 2010 at 8:20 pm

    @ Brad: Oooooooh, you’re right. This one is my favorite:

    I will use this at some point to illustrate rivalry in consumption…

  • 18 joshua corning // Apr 5, 2010 at 7:04 pm

    The oil market is awash in oil.

    The problem is not that we are running out of oil or that there are to many people buying it.

    The oil market, as with every market in the world, is also awash in US dollars.

    As a consequence of so many US dollars floating around their value has dropped in the world market and so it takes more of them to buy a barrel of oil.

    Obama has been throwing trillions of US dollars out of helicopters for over a year now. So yes he is to blame for high oil prices.

  • 19 Kurt Streich // Apr 5, 2010 at 8:25 pm

    Though drill baby drill is such a catchy little chant, the consequences of doing such a thing has environmental effects that go far beyond the actual process of drilling. Increased supply of oil will only lower the price, leading to a greater quantity being purchased by the consumer, and seeing how last time I checked we are still completely dependent on cars at the current oil price state, a future with less burning of fossil fuels will be even more distant.

    It may sound super american to be energy independent from arab nations, but how long can this last? How long can american oil prices be competitive on the world market? Eventually, american oil prices will higher than the oil-rich countries, even if a tariff is imposed. At that point, we’ve wasted years of technological advances in producing electric cars and investment in other types of transportation. There’s much more to the story than the 3 word phrase Sarah Palin and the likes of her entertain their puny minds with.

  • 20 joshua corning // Apr 6, 2010 at 5:23 pm

    leading to a greater quantity being purchased by the consumer

    Oil consumption in the US has recently peeked and per capita consumption has been dropping for some time all this despite relatively inflation adjusted low oil prices.

    Your premise is incorrect. Oil is a cost and no matter the price so long as it is not free there is always an intensive to use less.

    It may sound super american to be energy independent from arab nations, but how long can this last? How long can american oil prices be competitive on the world market?

    At curre3nt consumption levels there is enough coal and oil shale that can produce 40$ a barrel of oil for the next 200 years. Of course now that oil consumption has peeked and is going to drop from here on out that 200 years is actually longer.

    So to answer your question “how long can this last?”

    It will last long enough that it no longer matters.

    Just as the stone age did not end because they ran out of stones the oil age will end with plenty of oil still in the ground.

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