Sensitivity Training

Like subatomic particles, far left politicians appear to be be in two places at the same time. The Iraq war is to blame for high oil prices, while at the same time Bush went to war for cheap oil. Big Oil engineered high oil prices, yet domestic oil production is evil and must be banned. They feel the common man’s pain at the pump, but also want to outlaw gas cars in 10 years by overhauling the US economy. Interestingly, the combined events of high oil prices, the Iraq war and Democratic insistence on oil production being done outside of the US have increased knowledge of what drives oil prices. The evidence shows that the solution to high oil prices is well at hand.

With a few spikes, the real price of oil has stayed around $25 per barrel for nearly a century, only recently exploding to about five times that amount. Prior to the US becoming substantially dependent on foreign oil sources in the early 70′s, the price of oil was amazingly steady. What portion of its oil the US needed from foreign sources was provided by relatively friendly countries like Iran and Venezuela. In short, the world supply of oil was in reliable hands. Of course the oil crises of 1973 and 1980, along with hostilities from Iran, Iraq, and later Venezuela shattered this regime. The volatility of oil prices sharply increased thereafter. On top of that, domestic oil production topped out due to environmentalist blocks.

For most markets, if a few suppliers went south, the market would quickly adjust and prices would not change much. The world could easily make do if Pepsi shut down because Coke and Cadbury would take up the slack and provide good substitutes. Even if there was no substitute for Pepsi, people could make do quite well without sugary soda of any kind. Oil is nearly unique in its resistance to the market forces that otherwise quickly correct for disruptions:

• Despite what the environmentalists say, there is no economic substitute for oil. Alternatives like electric vehicles are much more expensive to acquire and operate, and their usefulness is limited by the fact that nothing packs more energy into a confined space than gas.
• The lifespan of a car is quite long, and the cost of switching to a new car is high. Sales taxes alone are several thousand dollars. Even if a better alternative to cars existed, it would take years to transition.
• If substitution is difficult, avoidance is harder still. People will not give up driving because the cost of not driving is still much higher than the cost of operating a car with $4 / gallon gas. Nearly every product for sale is based on some amount of gas consumption, making going without unthinkable.
• When the price of a commodity goes up, the normal result is increased production, thus returning the price to equilibrium. Oil is different because the free market is not fully present. Oil is substantially in the hands of foreign despots and domestic far left loons. No sensible person would invest in Venezuela, Russia, or Iran, because he would rationally expect his assets to be confiscated by a dictatorial thug. Until recently, Iraq was also on that list. Domestically, people like Sen. Reid, Speaker Peolsi, and Sen. Obama want to punish oil producers with windfall profit taxes, a similar disincentive to investment and development.

What all this amounts to is that oil is especially price insensitive. That is, it takes a huge increase in price to create even a modest decrease in consumption or increase in production. The price of gas had to more than double for consumption in the US to fall just 0.5%. The bright side of this, however, is that it takes only a small increase in production to lower prices substantially.

Another universal aspect of markets is that uncertainty raises prices. Without snoozing through too much academia, the more uncertain or variable the expected payout, the higher the return an investor will demand. The oil nations have made supplies uncertain, so investors demand higher returns. The Pelosis and Reids of the world blame speculators, but they are the symptom, not the illness. Speculators are just as willing to bid down oil futures based on well know and immutable principles of the derivatives markets. Those who wish to scapegoat speculators should rather consider inflation, the falling dollar, Chavez, Putin, and Ahmadinejad, all much more potent market forces. Like so many regulatory spirits, Mr. Reid thinks only within his playpen. As soon as rumblings began that speculation in oil would be outlawed in the US, Hong Kong announced plans to open oil futures trading. Fortunately, collectivists like Mr. Reid are quite powerless to prevent free trade, including oil speculation, due to its international nature.

If Iraq has lead to higher oil prices, the swift success of the surge has made them fall. The very week that Iraq announced plans to nearly double its daily oil production through new exploration, oil began its collapse of more than 20%. The initial production increase is expected to be about 1 million barrels per day, which is about the same as the production estimate for ANWR.

Just as important to oil prices as anticipated increased production, stability is the other good news from Iraq. Even long time war skeptics like Sen. Obama have given in and admitted that the surge has worked and Iraq is increasingly stable. This is important, because for the first time in 30 years, Iraq is an attractive investment. Oil companies are flush with billions in profits and are eager to invest in more production. With the US off limits, Iraq is a new option to enable their mission to produce oil. No fool would invest money with Husein, but the new Iraq has at least a fighting chance for stability, thanks to the surge.

If Ms. Pelosi thinks ANWR production will have no impact on oil prices, just consider Iraq. A shift in policy there caused oil to fall 20%, years before any expected increase in production. Domestic oil production bears far less sovereign risk than in Iraq, not for the House Speaker and Mr. Reid’s efforts to the contrary. Their response to the clear need for increased domestic production was to try to take away drilling rights from companies who were too slow for their tastes. Imagine the organization behind the Postal Service and the FAA chiding private industry for being too slow.

The evidence suggests that a little stability and increased production go a long way toward lowering oil prices and calming speculators. The mere announcement of ANWR, shale oil, and offshore oil drilling would likely result in another immediate 20% drop in oil prices, or more. Speaker Pelosi was against drilling, then maybe for it, and now against it again. The poor girl is in quite a bind, pressed between her extreme environmentalist base and the 75% of Americans who demand more domestic production. Perhaps Congress will do her a favor someday by relieving her of this horrible burden.