June 2006 Feature--Truth Based Logic

***Oil & Economics 101***

Most literate persons are aware of the centuries old commonplace, which treats economics as a "dismal science," and tends to justify the sort of popular ignorance, which has provided a fertile seed bed for political demagogues and Leftwing conspiracy theories over the centuries.

While we consider much of the present day American corporate management to be extremely short-sighted, with a shrinking moral compass, a basic sense of fairness compels us to rise to the defense of anyone being unfairly targeted by either the contemporary demagogues of American politics or by those susceptible to being misled by such demagogues. Thus we offer this brief lesson, which seems definitely called for, yet will likely please very few outside the oil industry.

Why Oil Prices Have Risen Sharply

There are two basic reasons for the steep rise in oil prices over the last two years. The first, of course, is the one that almost everyone acknowledges: The constraints on supply as contrasted with the explosion in demand, as a new prosperity takes hold among the brighter classes in China and India. The other is the sharp fall in the real value of the American dollar, the world-wide benchmark for oil prices, as a result of the fiscal irresponsibility of the Bush Administration.

The profit margins of the huge (actually gargantuan) oil companies are not excessive, either in terms of general business norms, or in terms of historic margins in their own industry. The large aggregate numbers reflect not price gauging, but the immense size and scale of operations as a result of growth and consolidation. The major participants, now, each represent a vast aggregation of capital resources. To suggest that by reason of such aggregations, the remaining players in the industry should be content with ever lower profit margins, in pursuit of limiting industry profits, in monetary terms, to pre-inflationary levels, perhaps as some sort of public relations measure, is to embrace fantasy over reality. Such behavior would fly in the face of the very motivation for the past growth in investment. It would also be manifestly unfair to the investors.

That the oil industry has consolidated into a relatively few gargantuan players, does not change the fact that many other, less consolidated businesses, have also seen a sharp rise in their gross receipts and profits--as reflected in dollar terms--because of the same inflationary forces. While, admittedly, others, in industries where the price structure is more rigid than that ordinarily encountered in the production and marketing of natural resources, are suffering severe losses in real terms from the same inflationary pressures that are less easily passed on to their consumers.

Economics is not a public relations game. In a healthy, market driven economy, the desire of each individual with capital to employ to maximize the return on his capital, tends to direct capital resources to optimum uses--that is to those uses which offer the greatest return on the capital available. This obvious phenomenon goes to the essence of "Capitalism," and is the single most decisive reason for its clear superiority over every form of central planning. Anything which artificially interferes with such process, whether stemming from a deliberate avoidance of profit by the managers of enterprise, or interference by a central authority in either the pricing of goods or commodities, or by an arbitrary tax (confiscation) of the profits driven by the market conditions involved, can only diminish the ability of a subject industry to produce, putting still greater pressure on the price structure, and rapidly leading to greater shortages.

What Will Happen If Congress Seeks To Limit Oil Industry Profits

There have lately been various proposals bandied about in the halls of Congress--iterated also in statements to the media--intended to demonstrate the concern of elected Senators and Representatives over the high prices being paid by their constituents for gasoline. While these have taken different approaches, they have the common facet that, if implemented, each would result in substantially greater long term shortages, as well as in higher priced transportation, for the foreseeable future. Consider the principal approaches in order to discover the mechanisms--both intended and unintended--which would come into play, to better understand why all paths must end in the same disaster.

First, there are proposals for some form of "excess" profits tax. While these would not, of themselves, reduce or even contain the prices paid at the pump for gasoline, such taxes appear to serve some compulsive need to punish the oil companies--apparently for daring to try to maintain their profit margins in the face of an inflationary spiral--as well as a means for funding activities of Government, which might otherwise cause higher taxes or more inflation. Frankly, the concept is analogous to a dog chasing his own tail. The one thing that such proposals clearly are not, however, are a means to solve an oil shortage, or to contain either the wholesale or retail prices of oil derived products.

The immediate net effect of any excess profits tax on the underlying problem--a shortage of oil to meet a growing demand--would of course be nil. Taxing away the profits of the big oil companies would not bring one new barrel of oil to the current market. Yet far worse than the lack of any immediate positive benefit directed at the actual problem, taxing away the "excess profits" in the industry would reduce the capital available for bringing new production on line. Nor would such reduction, in available capital resources in the industry, likely be offset by any new investment from outside the present circle of participants. Indeed, the demonstration would only tend to reduce the likelihood of any new money coming in. It would, to the extent that it would prove effective, reduce the appearance of potential benefit from any such investment to anyone, old or new, considering putting additional capital into the production of oil.

This should be obvious to anyone with even the most basic understanding of markets or business. Moreover, the same factors which would discourage new investment--which would drive new investment to pursuits where there is less of a political antagonism to normal returns on those investments--to pursuits where the normal profit on sales equals or exceeds the 8% margin typical in the oil industry, and where less capital may be required to increase sales;--those same factors would discourage the existing players in the oil industry from even continuing to put the same percentage of their own profits from existing sales, back into the development of new sources of supply. The established companies would have the same incentives as everyone else to divert their investment dollars into other channels.

While the mechanism for disaster might be slightly different in the event that Congress sought to impose price controls on the oil industry, it would take virtually no time at all to achieve the same result as an "excess" profits tax. By squeezing profit margins, price controls would provide virtually the same disincentives for further investment as would be the case with an "excess" profits tax. In addition, Congress would achieve not only the diversion of future investment into other industries, but the immediate diversion of existing oil supplies--those currently being produced--to markets which were not capped by the arbitrary action of demagogues and politicians. We would very soon see growing shortages on a macro scale, followed by the likely growth of "Black Markets" for the micro diversion of those supplies still in the United States.

What Can Or Should Be Done?

No rational policy, intended to increase production and lower the price of any commodity, would start with a decision to target those, who seek to produce that commodity, with any form of onerous interference. Rather, it would seek to make certain that there are no obstacles created by Government, tending to inhibit the production and movement of the subject product. This is, once again, an illustration of the fact that while Government is almost always a failure when it seeks to reform others, Government can and should look for ways to reform itself--to limit any negative impact it may have on the people it is supposed to serve. Yet even here, there needs to be some caution in how Congress proceeds.

We certainly do not suggest an immediate repeal of all regulations intended to protect the land and sea scapes of America from various forms of pollution. Long term considerations that pull in different directions must always be carefully weighed. While we are sure that there are areas where unreasonable restraints have been put on those who would develop additional sources of fuel, we certainly would not want to see a reckless disregard of reasonable regulations, designed to minimize the possibility for creating new problems. Here, as in every other area of public or private concern, the fullest perceivable context for any decision or proposal should be considered. This is equally so whether we are considering how best to encourage more off-shore drilling, drilling on the Northern slope of Alaska, developing alternative sources for automotive fuel, or dealing with whatever other possibilities may arise.

We realize that our treatment of these phenomena will please very few of those who ordinarily demand Governmentally derived solutions for personal problems. Yet rather than offer a flippant response to those, rather unlikely to ever visit this web site, we would suggest that this "issue" affords one more obvious illustration of an oft repeated point: The proper role of Government, in any economy, is to facilitate rational private decision making--not seek to direct it;--to provide stability through the promotion of common standards, currency, communications and transportation, with courts to resolve disputes; yet never to seek to impose the arbitrary notions of politicians, or the grasping wishes of collective interest groups, on those whose resources have been put at risk.

The real hope, here, is that the speed with which politicians rushed to release statements that made no economic sense whatsoever, will help to wake at least the better informed of our countrymen to the increasingly sorry state of American politics in the 230th year of our Independence!

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