In the last day or so there has appeared in the news a sudden interest in regulating the global market for crude oil. This is almost certainly the unveiling of a coordinated plan.
What’s behind it?
Action is being proposed on both sides of the Atlantic, with the Wall Street Journal editorial page serving as the index megaphone. Today the Journal ran a commentary by UK Prime Minister Gordon Brown and France President Nicolas Sarkozy, which alleges that “for two years the price of oil has been dangerously volatile, seemingly defying the accepted rules of economics.” The evidence cited by Brown and Sarkozy consists of price volatility:
First [the price of oil] rose by more than $80 a barrel, then fell rapidly by more than $100, before doubling to its current level of around $70. In that time, however, there has been no serious interruption of supply. Despite ongoing conflict in the Middle East, oil has continued to flow. And although the recession and price rises have had some effect on consumption, medium-term forecasts for demand are robust.
The oil market is complex, but such erratic price movement in one of the world’s most crucial commodities is a growing cause for alarm. The surge in prices last year gravely damaged the global economy and contributed to the downturn. The risk now is that a new period of instability could undermine confidence just as we are pushing for recovery.
Brown and Sarkozy claim that price volatility “damages both consumers and producers,” and for that reason, “[g]overnments can no longer stand idle.”
Those who rely on oil and have no substitutes readily available have been the victims of extreme price fluctuations beyond their control — and apparently beyond reason. Importing countries, especially in the developing world, find themselves committed to big subsidies to shield domestic consumers from potentially devastating price shifts.
Presumably, the unnamed governments Brown and Sarkozy are concerned about are shielding domestic consumers only from rising prices, such as the aforementioned $80 per barrel price increase, and not from the subsequent $100 per barrel decline. Messrs. Brown and Sarkozy do not say why these governments are committed to subsidizing consumption, nor do they explain why governments that have decided to subsidize consumption are not hedging against the risk of future price increases by purchasing options.
With respect to their own countries, Brown and Sarkozy say “we also know how the price of crude dictates the price of petrol at filling stations and the effect on families and businesses.” Although this seems to imply that increases in crude oil prices have a significant effect on French and UK consumers, they don’t. Both countries have petrol taxes that are so large they exceed the cost of both crude oil and refining. High taxes have the practical effect of reducing the retail effect of volatility in crude oil markets. Retail prices in France and the UK are high irrespective of the price of crude. Chris Vernon says that in 2006, taxes in the UK comprised 64% of the retail price. A 20% increase in the price of crude would raise retail price 8.5%.
The high relative taxes in France and the UK are illustrated in the graph below, which shows tax rates in Euros per liter for petrol (gasoline) and diesel for each OECD country in 2000 and 2006. The graph is somewhat hard to read because it consists of a series of four vertical bars with three different shades of blue. To make it easier, we’ve highlighted France, the UK, and the US. During this period, France reduced its tax rate from about €0.6 per liter to about €0.40. The UK kept its taxes at about €0.7 per liter. In the US, however, federal and state gasoline taxes were less than €0.1 per liter. Among OECD nations, volatility in global crude oil prices has the most effect in the US.
Therefore, even though Brown and Sarkozy cite price volatility as the reason for their concern, it is almost certain that something else motivates their interest in regulating the world oil market. What can it be?
It’s not climate change. Brown and Sarkozy express concern that price volatility is reducing the demand for oil:
Extreme fluctuations in price are encouraging energy users to reconsider their reliance on oil. The International Energy Agency, for instance, has cut its long-term forecast of oil consumption by almost a quarter. Producers are in danger of finding out that oil is losing its market and its long-term value.
But this is a good thing if you’re worried about carbon emissions.
So, is there anything else? As it happens, yes: Brown and Sarkozy are not worried about price volatility, they are worried about prices falling:
More immediately, we as consumers must recognize that abnormally low oil prices, while providing short-term benefits, do long-term damage. They diminish our incentives to invest not only in oil production but in energy savings and carbon-free alternatives.
Upstream investment world-wide is already down by 20% over the past year. And with some sources of supply in decline, such as Alaska and the North Sea, the resource we will all need as the economy recovers is being developed in neither an adequate nor a timely way.
The market “failure” they are worried about is that prices fall when markets conclude that oil is overpriced. Their prescription is “government supervision” of the oil market to keep prices high:
We are committed to the ongoing dialogue between producers and consumers through the International Energy Forum. Saudi Arabia and the Organization of Petroleum Exporting Countries (OPEC) have expressed interest in this as well.
OPEC’s interest in maintaining high prices is obvious. Why it is in the interest of consumers worldwide is not so clear.
The potential scope and scale of this proposed “government supervision” appear to be quite large. Brown and Sarkozy are seeking a global regulatory regime that would “reduce damaging speculation” and “serve the interests of orderly and adequate investment in future supplies.” The commentary provides no insight concerning what social benefits are obtained by “orderliness,” or how much speculation is “damaging.” Indeed, Brown and Sarkozy follow a well-worn path by criticizing “speculators” for driving prices up (or, in this case, down). Every futures contract has both a willing buyer and a willing seller.
Futures markets serve an important public purpose–they provide price discovery–and, ironically for Brown and Sarkozy’s argument, they tend to reduce price volatility. Regulatory restrictions on speculation should be expected to increase uncertainty, and thus exacerbate volatility. But as an analysis of the Brown-Sarkozy commentary shows, price volatility is not the problem they are actually worried about. They are trying to figure out how to use regulation to keep prices high and make it seem as if this is a good thing for consumers.