An Access Advertising EconBrief:
Thank Heavens – Oil Prices are Down 50%! Wait – Oh, No, It’s a Disaster!
For decades, Americans have followed the ups and downs of oil prices with the same obsessive determination they reserve for the stock market and real estate. In the 1970s, the Organization of Petroleum Exporting Countries (OPEC) acquainted us with the meaning of the term “cartel.” Ever since then, we have argued ferociously over whether the “big oil companies” are evil corporate malefactors who manipulate gasoline prices or free riders who benefit from the machinations of OPEC or benefactors who keep the lights on. But we never doubted that high oil prices were bad and low oil prices were good – except, of course, for the “oil patch” in Oklahoma in Texas, which fell upon hard times in the late 1980s when oil-price deregulation ushered in low prices and put the domestic oil business to sleep for a generation.
For once, the economics profession and the public were reading off the same page. Macroeconomics departments revised courses and textbooks to accommodate the phenomenon known as “supply shocks” after OPEC’s oil-price hikes ravaged Western industrial economies in the 1970s. A supply shock was a large-scale cost-increasing phenomenon. Oil-price increases qualify because petroleum was, and still is, a key input is so many diverse production processes that range from fuels (gasoline, home-heating oil) to plastics to energy (electric-utility power). A decrease in supply caused by an increase in cost ordinarily will be limited in its effects because the resources released by the reduction in output will be shifted elsewhere and increase output there. But when supply decreases are ubiquitous – as they were when nearly all sectors are “shocked” by an increase in oil prices – the supply decreases will cause economy-wide declines in output. If the higher prices associated with those decreases are accommodated by increases in the supply of money supplied by the central bank, the result will be simultaneous inflation to accompany the recession caused by the supply shock. This notion of an inflationary recession had heretofore been thought contradictory by mainstream economists. (It had, however, been treated by Austrian economists Ludwig von Mises and F. A. Hayek, whose monetary theory has been eclipsed by the acclaim granted to John Maynard Keynes beginning in the late 1930s.) Thus, economists were firm believers in the merits of low oil prices.
They were until last week, that is. The slats were kicked out from under oil prices, which fell like a monsoon rain. Around the world, stock markets took time out from setting record highs to fall out of bed. And – what do you know – here came the economists, gravely explaining that falling oil prices were responsible for the bear market in stocks!
What’s going on?
The Function of Prices
Ask any American what prices are for and you will get a disheartening variety of responses, many revolving around the notion of fairness. Economists have a precise idea of what prices do. It is the thing they understand best.
In order to be happy, we have to know what we want and how to get it. Unfortunately, the means of satisfying our wants are scarce. We need to value them and coordinate their use. Prices accomplish these tasks and, in so doing, enable all of us to cooperate for our mutual benefit.
Viewed in this light, it becomes clear that the important thing is for prices to function properly rather than to register high or low values consistently. That is, we want prices to accurately reflect the scarcity of means relative to wants. A high price is proper if it correctly reflects an underlying lack of a good or input relative to the demand for it. A low price is indicated if the good or input is plentiful relative to our desire for it.
This abstract viewpoint irritates many people. If everybody drives or rides in automobiles, it seems obvious that low prices for oil and gasoline are a good thing and no ivory-tower theorist is going to becloud that issue. Where is the harm in acknowledging such a simple truth?
The problem with treating prices in purely normative terms is that it quickly occurs to politicians that if a good price is a low price, then we should pass a law mandating that the price shall always be low. There now! Another problem solved by your friendly legislator.
Alas, a price that is required by law to be always low cannot fulfill the necessary functions demanded by economic theory and logic. It cannot coordinate the activities of buyers and sellers because the parameters of demand (consumer incomes, tastes and preferences, prices of substitute goods) and supply (input prices, technology, the number of firms) are constantly changing and price must change with them.
The fact that prices reflect various underlying “real” factors suggests that price changes may convey information that goes beyond the bare meaning of the price change itself. And that leads us to an understanding of the current furor over oil-price changes.
What’s So Bad About Feeling Good, or Why Can’t We Just Relax and Enjoy Our Lower Oil Prices?
This fall, stock markets throughout the world, including the New York Stock Exchange, have ridden a roller coaster. They have alternated climbs to oxygen-starved heights with adrenalin-charged falls to yearly lows. The records highs have been stimulated by central-bank assurances of continuing monetary ease and artificially low interest rates or actual provision of same. The declines have been provoked by various events viewed by market participants as unfavorable.
The wording of that last sentence may seem complicated – why shouldn’t it read just “unfavorable events?” Well, an event might be viewed as unfavorable by people who consummate high-volume transactions in the stock market but actually have favorable long-run consequences. We all might well benefit from a policy of allowing interest rates to find their natural level, for example, even though that would certainly cause those rates to rise in the short-run and remain high for some indeterminate length of time.
And that describes the role currently played by oil prices. The reasons behind their fall are almost all either benign or positively benevolent. The outstanding impetus is the dramatic development of the shale oil and gas market in North America, mostly in the U.S. and Canada. This has enabled the reopening of old fields and inauguration of new ones and has placed the U.S. in the forefront world fossil-fuel production.
Ironically, the talk about the U.S.’s newly found “energy independence” and self-sufficiency is wrong-headed. Prior to the shale revolution, largest share of U.S. imported oil came from Canada, not Saudi Arabia, and Canada still plays a large part in shale production. It is likely that we will become an exporter of both oil and gas, although there are various bureaucratic legal hurdles to overcome first. When that happens, we will not be “self-sufficient” – we will instead be participating in international trade as an exporter rather than an importer because the locus of comparative advantage has shifted. There is no doubt, though, that this is a good thing. Environmental objections, such as those lodged by the state of New York against the practice of hydraulic fracking in shale formations, fly in the face of both theory and years of practice.
Another subject of intense speculation is the role played by OPEC – read “Saudi Arabia” – in stage-managing the decline in oil prices. Again, this mostly misses the point. Rather than argue the role played by the Saudi government and its economic ministry, which is the guiding force behind the OPEC cartel, let us assume for the sake of argument that “OPEC” has deliberately increased its output with the intention of lowering current oil prices. We assume further that this action is done for the purpose of driving North American shale-oil producers out of business so that OPEC producers will sell more oil at higher prices in the future.
This is a very old accusation, first leveled long before OPEC was formed against another powerful oil trust called Standard Oil, owned and operated by John D. Rockefeller in the late 19th and early 20th centuries. The muckraking journalist Ida Tarbell accused Rockefeller of seeking and attaining an oil monopoly by employing “predatory pricing” to drive rivals out of business. In two legendary articles in the Journal of Law and Economics (1958 and 1980), John McGee showed that Rockefeller did not use this tactic, for a very good reason – it would have been counterproductive for him. Instead, Rockefeller bought out his rivals, benefitting both them and him. This also benefitted consumers, who enjoyed years of low prices resulting from the economies of scale and technological innovations Rockefeller introduced.
For some reason, the idea of a fanatical economic super-villain is so attractive to the general public that it paralyzes our analytical faculties. We don’t stop to ask whether the evil practices we ascribe to the evil-doer make sense when viewed in his own profit-maximizing frame of reference. In order to drive his rivals out of business through predatory pricing, Rockefeller would have had to lower his own price dramatically. (How dramatically? That is a point we will take up shortly.) That lower price would apply to every unit of his own output. And he was already the biggest producer of oil output in the country. So he was dealing himself a huge punch in the financial gut every time he (hypothetically) drove each smaller rival out of business. Perhaps most problematic of all was the possibility that the rivals would simply shut down and wait for Rockefeller to raise his price – then resume production and sell at (or slightly below) the higher price he was then charging. Oh no! His sacrifice was now all for nothing – he would either have to repeat the process, give up or switch to a buyout strategy. Why would he deliberately deliver this series of self-inflicted blows when he could instead buy out his rivals? Now he could get the benefits of his strategy immediately instead of waiting and hoping for his future monopoly to eventuate. McGee was not surprised to find that Rockefeller did indeed resort to buyouts rather than the cumbersome, dubious strategy of predatory pricing.
Today, OPEC faces the same range of unappetizing choices as did Rockefeller, with a few more added. They still have to worry about the smaller, more mobile shale producers shutting down and resuming production if OPEC should try to raise prices after too short an interval. Even more vexing is the possibility that new technologies might cut into the future profits earned by an oil monopoly. Shale yields natural gas in copious quantities, and gas can substitute for oil as a fuel and in other applications. Although the trajectory of their development is very uncertain, solar and wind power are potential substitutes for oil.
What is absolutely certain is that by purposely increasing production to lower price as a predatory tactic, OPEC is subsidizing the consumption of the world on a scale that is almost unimaginable. To incur these absolutely certain costs of staggering magnitude in exchange for highly speculative future benefits of very uncertain magnitude would be unwise almost to the point of insanity.
This realization is clinched by the political instability of the OPEC regimes, which threaten OPEC governments with overthrow in the here and now. The notion that that finance ministers will risk life and limb for future profits they will not even be alive to enjoy even if accrued is fanciful.
No, OPEC/Saudi Arabia as international predatory-pricer is the stuff of conspiracy books and Internet websites, not reality. However, this gives us the chance to introduce a very useful piece of economic theory to reinforce the argument against predatory pricing.
The Economic Short-Run Shut-Down Point in Action in the Oil Market
One of the most perceptive oil-market analysts, Tom Petrie of Petrie Partners, was interviewed on Bloomberg TV/Radio on the subject of the oil-price decline. Asked to comment on the complicity of OPEC in declining oil prices and the viability of shale producers in this environment, he went straight to the economic heart of the matter.
Petrie was asked to identify the minimum price at which shale-oil production is viable in North America. To the surprise of his interviewer, he demurred. Instead, he identified two prices of interest. One of them, which he called the net-income price, was the price necessary to support entry and long-term survival in the market. The other price, the cash-flow price, was the minimum price at which firms could “keep the doors open;” e.g., the price at which it was profitable to maintain operations rather than shut down their rigs.
Petrie, who is an oil analyst rather than an economist, was using the language of accounting in defining terms. For over a century, economic textbooks have presented the argument outlined by Petrie using the more general, abstract language of economic theory.
Short-run costs in economics are divided into two categories: fixed costs and variable costs. Fixed costs do not vary as output varies, while variable costs are a function of output. When we compare price to cost, we must compare comparable magnitudes. Since price an average magnitude – the ratio of total revenue to output – we can compare it to average cost. When we ask ourselves, “is it profitable for producers to produce at a certain price, or should they shut down instead?” we can compare total revenues to total costs or average revenue (price) to average cost. But in the short run, the relevant comparison is between price and average variable cost. As long as price exceeds average variable cost, it will be more profitable to produce than to shut down. The key point to remember in reaching this conclusion is that fixed costs are invariant to output – which means that they will be incurred even at zero output.
A simplified numerical example can illustrate the point. If a firm suffers a price decline to $9 per unit from its former level of $10 per unit, it can calculate its shut-down decision as follows. Suppose its profit maximizing rate of output at that price is 1,000 units per month. Its total costs at that rate of output at $10,000. Of these, $8,000 is variable costs (labor and raw materials). The other $2,000 is fixed costs (contractual salaries, rent, and utilities). If the firm shuts down, it will still owe $2,000, so it will lose this amount. If the firm produces its 1,000 units of output, it will earn $9,000 in revenue and incur $10,000 in total costs, both fixed and variable. Thus, it will lose $1,000 – less than if it shut down. Thus, the firm should stay in business and continue to produce. Its average variable costs ($8000 divided by 1,000 units of output, or $8 per unit) are less than price ($9), which means that although the firm is losing money in the accounting sense, the price is still high enough to cover all variable costs and contribute something to the fixed costs that will be incurred in any event.
The economist’s average variable cost corresponds to Tom Petrie’s cash-flow price, which is the minimum necessary price to keep the doors open. In the long run, price must equal average total cost, which includes all costs including the cost of capital. The concept of fixed cost does not apply to the economic long run because there must a time period long enough to allow a firm to conclude or abrogate contracts, renegotiate real-estate contracts or move – in short, “un-fix” those short-run fixed costs. Long-run average total cost in economics is Tom Petrie’s net-income price.
Oil Prices as Proxies
Why have declining oil prices had such devastating effects on stock-market prices? It’s not so much because oil companies specifically or even energy companies more broadly dominate the stock market. Energy companies comprise about 112 of the companies on the Russell 5000, one of the most comprehensive of all stock-market indices. True, some of those companies – Exxon Mobil being the standout example – are among the world’s largest. Still, Exxon Mobil is sufficiently diversified so that the declines in oil prices have not left it financially devastated. It’s not really because the energy sector is so vital to world economies, although it has been one of the few bright spots in the U.S. economy in recent years.
Stock-market participants are using oil prices as proxy variables. It is not the fact that oil prices have declined that influences stock-market participants in bidding down stock prices. It is the reason for the decline that motivates them. They believe that oil prices are declining primarily because the global economy’s momentum has slowed. They anticipate global recession. They believe the fiscal straits in which most Western governments languish will preclude both fiscal and monetary relief from government. The combination of global recession and lack of government stimulus makes markets nervous because they fear the political instability that this might bring. That would bode ill for economic growth and future stock prices.
Their belief is predicated upon the importance of oil to Western developed economies. Oil is so interwoven within the fabric of our lives that changes in the direct demand for it (as fuel) and the indirect demand for it (as input into a myriad of production processes such as utilities, plastics production and more) are perhaps the best predictors of changes in the overall course of advanced industrial economies. Or so their argument goes.
One may agree with their analysis or not. But note that it depends on the existence of prices as conveyers of information. If politicians interfere with the informational content of prices by passing laws limiting price flexibility, they do so at their own peril. For even if we disagree with the hypothesis of “declining oil prices as leading economic indicator,” the chances are that our disagreement will depend on the information contained in other prices.
It is always tempting for politicians to react to bad news by killing or disabling the messenger of the news. But changing the medium does not change the message itself. Now the message is simply transmitted less well by other means. Or it is not transmitted at all, which may seem good but is almost always bad – how many times in your life have you been able to avoid the consequences of bad news by evading the bad news itself? Did tearing up your grade card prevent your parents from getting the bad news? Did avoiding the doctor keep you in good health? Did steering your car away from the repair shop avoid expenses on maintenance-oriented repairs?
Prices are Like Thermometers
It is continually tempting to take a partisan attitude toward prices, rooting for or against them like cheerleaders for sports teams. The late Milton Friedman instead likened prices to thermometers, which are neutral indices of human internal temperature. Breaking a thermometer or plunging it in ice may destroy it or change its reading, but this superficial change will not change the underlying phenomenon measured by the thermometer. Similarly, government forms of artificial pricing such as wage and price controls, rent controls and minimum wages do nothing to replace the irreplaceable coordinative function provided by prices.
Rather than blaming prices for the actions of people, let prices be prices.