Friday, April 28, 2006

Oil prices, again

It is very important that people understand that oil companies do not set oil prices. Imagine you have an oil well. Let's say it costs you $10 to get a barrel of oil to market. You take that oil to market and people bid on it. If the highest bidder is $20, you make $10 on each barrel. If a new buyer (say, China) comes into the market and starts buying a lot of oil, that barrel might now bring $50. You now make $40 on that same barrel. Your profits increase because the cost to bring that oil to market is about the same. It is the same hole in the ground being pumped by the same pump with the oil going over the same pipeline. Costs didn't increase but the value of the product did.

What does all that mean? It simply means that this is a great time to be in the oil production business. Increased oil prices mean that you can now afford to pump oil that costs $30 to bring to market. Higher prices result in a greater supply. Oil companies are currently drilling in the Gulf of Mexico at a furious rate. This huge profit from increased oil prices mean that companies can sink more wells.

People who blame oil companies for the price of oil don't understand how markets work. A farmer does not set the price of wheat but when the price of wheat goes up, he makes more money. This allows him to plant more wheat, which increases the supply. If the price of wheat were to triple, farmers would do very well and the price of bread would go up. Should we then go after farmers and accuse them of fixing the price of bread or "price gouging"? The farmer doesn't set the price. The price is what he gets at the market. The same goes for oil. It is traded on commodity exchanges. Whatever price oil brings is what the company gets. It is like a big eBay auction. If everyone wanted Cabbage Patch dolls and people on eBay bid up the prices so that Cabbage Patch dolls brought $200 each, would it be fair to pass an extra tax on sellers of the dolls just because people are willing to pay more for them? Is it the seller's fault that the buyers will pay more?

Whenever government gets involved in markets, it ends badly. They end up creating artificial conditions that do not reflect supply or demand and cause problems for either the producer or the buyer. Introducing market inefficiency hurts the end user in the long run. If you tax the oil producer, you extract funds that could go to exploration or increased production and do nothing to reduce prices. If you cap prices, you force people to sell the oil in a different uncapped market. The major oil companies are HUGE. For Exxon, US consumption represents about 10 percent of their global business. Fuel prices are hitting highs globally, not just in the US. Capping prices here simply means that people wont sell their products here resulting in shortages. Again, it causes a market inefficiency.

The best thing we can do is let the market decide. As prices rise, car makers will make more efficient vehicles and people will buy them causing a change in the amount of oil demanded. Makers might also start making alternative fuel vehicles if oil prices rise enough to make those alternatives competitive. Making alternative fuel vehicles will cause a change in the nature of demand. Both of these things will cause the demand/supply ratio to change and act to moderate oil prices. On the supply side, higher prices means more exploration, more drilling, more oil brought to market and again, these things will act to moderate prices.

Nobody likes to pay more at the pump. But please, lets not act on our emotions. Lets think and use our brains and reason our way through this.

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