Topic: Energy and Environment

Don’t Shoot the Messenger

I’m sorry to bring bad tidings so close to the weekend, but apparently House and Senate conferees have reached agreement [$] on the broad outlines of a Farm Bill.

We will have to wait until Monday to get the full, disgusting details but broadly, we know this about the proposed bill:

  • it will raise the target prices and loan rates for northern crops (i.e., wheat, soybeans, other feedgrains) beginning in 2010
  • raise the sugar loan rate three-quarters of a cent
  • include a sugar-to-ethanol program (whereby the USDA would buy sugar that would otherwise threaten the domestic minimum price and sell it, presumably at a loss, to ethanol plants)
  • an additional $4 billion for conservation programs
  • $10.361 billion extra for domestic and international food aid programs
  • The bill also includes the new “permanent” disaster program (some thoughts on that here), albeit at $250 million less than the original $4 billion request

To pay for this, your representatives in Congress cut the $5.2 billion per year direct payments program (that is the program that pays farmers on the basis of past production and yields, regardless of what they produce now) by 2 percent per year for four years. Recall that the direct payments program, while an offence to taxpayers everywhere, is at least less trade distorting than the price-linked subsidies that the conferees have agreed to increase. And in the final year, when it really counts for purposes of planning future spending levels (i.e., the baseline), the direct payments will go back up again.

The one possible bright light at the end of this sewer-pipe: a presidential veto. No word from the administration on this latest deal, but it does not fit their past definition of an acceptable amount of reform and thus, assuming intestinal fortitude on the part of President Bush (I know, I know), would likely elicit a veto threat.

Happy weekend, everybody.

Evil Exxon

Bill Dunkelberg, a professor of economics at Temple University and former dean of the Fox school of business there, periodically issues random thoughts on public policy as it relates to his arena of academic interest. His April 24 “Notes on the Economy” includes this gem regarding that Great Economic Satan, Exxon Mobil:

Some presidential candidates have decided that Exxon is a symbol of what is wrong with America. Recent ads complain of Exxon’s 40 billion in profits as if Exxon is some evil entity. First of all, Exxon is not a person, it is millions of owners owning over 5 billion shares in their investment portfolios. Vanguard holds over 160 million shares for its clients, Fidelity over 100 million shares. Taking Exxon’s profits for hair-brained government schemes will just mean millions of people will have to work longer to accumulate their retirement assets. And, doesn’t return on investment count? 40 billion may not represent a particularly good return on the capital invested in the company. Size is not the issue, the percentage return is what counts.

And the government takes over 40 cents a gallon in tax, far more than the profit per gallon made by refiners. And the government doesn’t make any gas for you.

Hopefully voters will catch on to this sham. The last thing we need is government confiscating private sector profits and driving stock prices down. No help for our retirement and no help for the economy.

Couldn’t have said it better myself. And in case you’re curious, Cato receives no money from Exxon Mobil … although we’d be happy to take a big check if they were to offer one.

The Remarkable Resilience of Nature

How often have you heard that coral reefs are fragile and would be wiped out by global warming?

If you google “fragile coral reefs” (without the quotes) you’ll get 493,000 hits. So imagine my surprise on stumbling on a news report titled, “Marine life flourishes at Bikini Atoll test site.” The report tells us:

It was blasted by the largest nuclear weapon ever detonated by the United States but half a century on, Bikini Atoll supports a stunning array of tropical coral, scientists have found.

In 1954 the South Pacific atoll was rocked by a 15 megaton hydrogen bomb 1,000 times more powerful than the explosives dropped on Hiroshima.

The explosion shook islands more than 100 miles away, generated a wave of heat measuring 99,000ºF and spread mist-like radioactive fallout as far as Japan and Australia.

But, much to the surprise of a team of research divers who explored the area, the mile-wide crater left by the detonation has made a remarkable recovery and is now home to a thriving underwater ecosystem.

99,000 degrees Fahrenheit! By comparison the upper-bound estimate for global warming is a puny global temperature increase of 11.5 degrees Fahrenheit (less in the ocean). So even if global warming wipes out life on earth, global warming catastrophists can take comfort that nature will, as it inevitably must, reassert itself. Some, convinced that humanity is the problem, may even welcome such an outcome — no humans, but plenty of nature (over time). [Fifty-four years later at Bikini Atoll, recovery is not complete. Perhaps 28 percent of coral species may still be absent.]

Post Script: On the topic of corals and global warming, here’s an article on temperature tolerant corals off the coast of Eritrea, where waters can reach 98.6 degrees F, which incidentally is the average core body temperature of a human being.

Post Post Script: Also check this story from Science Daily: “Coral Reefs Living In Sites With Variable Temperatures Better Able To Survive Warm Water.”

Attention Sen. McCain: Moderation in the Pursuit of Tax and Spending Cuts is No Virtue

Reporters are lighting up my voice mail and inbox with queries about what I make of Sen. John McCain’s call today for suspending SPR fill orders and the federal gasoline tax from Memorial Day to Labor Day in a bid to get gasoline prices down. Color me tepid.

Let’s take these issues one at a time. John McCain is absolutely correct to blame the SPR for helping to drive-up world crude oil prices. Oil economist Phil Verleger, for instance, thinks that federal fill orders for the SPR has driven up the price of crude by at least $10 a barrel and perhaps as much as $30. But why only temporarily stop the madness? Now’s a good time to dump the all federal inventories on the market and shut the SPR down once and for all. If we’re lucky, we’ll burst what may be an oil price bubble along the way and finally have something positive to show for the tens of billions of dollars of taxpayer funds that have been sunk into this white elephant.

The same goes for the federal gasoline tax. John McCain of all people should know that federal gasoline tax revenues are steroids for localized pork and special-interest subsidy. Road construction and maintenance (and the taxes that pay for them) should be turned back to state and local governments. A short-term moratorium on taxes, however, would probably have little impact on pump prices. If gasoline supplies are relatively fixed over the next several months (as I suspect they are), any service station that tried to pass the tax cut on to consumers would find demand increasing beyond where it otherwise would have been, and that increased demand would bid prices back up to where they were before federal taxes were cut. Over the long term, a cut in federal gasoline taxes would indeed reduce pump prices, but that’s not what John McCain is talking about here.

Sen. McCain is on the right track. But half-measures won’t accomplish much.

The World at 350 ppm Carbon Dioxide

According to James Hansen, the Paul Revere of global warming, the safe level for CO2 may be 350 ppm. Hansen is concerned that “ice sheet disintegration, vegetation migration, and GHG release from soils, tundra or ocean sediments, may begin to come into play on time scales as short as centuries or less.”  But currently the atmospheric concentration is 385 ppm. The 350 ppm level was reached twenty years ago in 1988, the same year that James Hansen sounded the alarm over global warming at a Congressional hearing.

Is the world better off today compared to 1988?

Let’s check:

  • Life expectancy in developing countries was 4-5 years lower in 1988 than it is today (62 years rather than the current 67 years). Even in the US, it increased from 74.9 years in 1988 to 77.8 years in 2004!
  • Compared to today, at least 15 more infants out of every 1,000 in developing countries died in 1988 before reaching their first birthdays. In industrialized countries, the infant mortality rate dropped from 9 to 5.
  • India’s per capita income (in constant dollars adjusted for purchasing power) has more than doubled since 1988. China’s has more than quadrupled. As a result, hundreds of millions are no longer living in absolute poverty today. Even the US’s per capita income has increased by 40 percent.
  • Food production per capita in developing countries has increased 36 percent since 1988, despite a population increase of 40% (that is, 1.5 billion more people). [What fraction of this was due to the increase in carbon dioxide in the atmosphere, and petroleum-based and greenhouse gas-emitting fertilizers, all of which stimulates crop growth?].

Much of these improvements are due to economic growth and agricultural activity that fueled the rise of CO2 concentrations beyond 350 ppm. Because of technological change, it is likely that a portion of these improvements would have occurred absent any economic growth (as pointed out in the book, The Improving State of the World ). But had CO2 concentrations been capped at 350 ppm, we would have to forgo many of the above improvements in the quality of life, and not only in the developing world.

But would we want to go back to the world of 1988 — or even 1998 for that matter?

If we can go back to 350 ppm without giving up the real and tangible advances in human well-being that have accrued since that “benchmark” was passed, I’d have nothing against that, but based on the precautionary principle, one needs a stronger reason than the speculative catastrophes that Hansen is concerned “may begin to come into play on time scales as short as centuries or less,” whatever that means.

Is There an Oil Price Bubble?

I’m not sure exactly what a “bubble” is. The popular view is that a “bubble” exists when the fundamental value of an asset (the present value of the stream of cash flows that one might expect to receive in the future) deviates significantly from the market price of that asset. But future cash flows are by definition uncertain. Because market fundamentals are based on expectations regarding future events, I don’t know how one can know a priori when a bubble exists unless one has access to a time machine or crystal ball. There are plenty of citations I could offer (like this paper from the Federal Reserve Bank of New York and this paper from Brookings) from very credible economists arguing that the rise in housing prices was perfectly consistent with “non-bubble” economic fundamentals.

Moreover, “bubbles” (that is, market expectations regarding future returns that turn out to be incorrect) can last a long time. Economist Robert Shiller, for instance, analyzed approximately 400 years worth of housing data and concluded that, over time, housing prices track increases in income. But housing markets can – and have – deviated markedly from that fundamental price trajectory for as many as 50 years before reversion to the mean.

Two questions naturally arise. First, is a 50-year bubble really a bubble? Second, are investors irrational (or engaged in irrational speculation) if they invest based on solid data regarding returns from a multi-decadal economic trend? It may be perfectly rational to invest in an over-valued asset if one has good reason to think that one can take the profits and run before the bubble bursts. And it may be perfectly rational to believe that market fundamentals have changed so much that 50 year-old data is no longer relevant to the market at present or future.

I am unsure whether we’re witnessing a bubble in oil markets today. Two “non-bubble” explanations for the price run, after all, are perfectly plausible. First, it may very well be that low-cost crude is running low and/or that demand will continue to surge to such an extent that prices have nowhere to go but up. Second, OPEC member states may continue to invest modestly in upstream capacity in order to maximize revenues, so even if there is plenty of low-cost oil still available in the world, the cartel will prevent new supply from reaching the market. For the record, I am skeptical of both propositions, but I do not dismiss them out of hand.

The initial driver for the oil price increases we’ve seen since 2003 appears clear to me. A combination of tight production capacity and a surge in demand provided the foundation for the current price run. The oil market moves in rather predictable boom and bust cycles, and historic market patterns foretold the timing of this event if anyone was paying attention. For that trend data, see chapter 3 in this book by my colleague Peter VanDoren.

The best argument against “speculation” in the subsequent price spiral is offered by oil economist Phil Verleger, a fellow I think quite highly of. Verleger believes that, whatever truth there might be to the simple “supply-and-demand” story I offered above, those price increases were greatly exacerbated by a huge move of dollars into commodity futures. That influx of cash was not driven by speculation (classically defined). According to Verleger, it was driven instead by the market recognition of the fact that, historically speaking, (i) commodities provided better returns over long periods of time than provided by equities, and (ii) returns on commodity investments are negatively correlated with returns on equities.

Hence, market actors thought they found an investment vehicle that provided a hedge against volatility in stock markets while also promising excellent long-term returns to boot. Even more interesting for our purposes, however, is the fact that this huge flow of cash into commodity futures (with a very large share of that investment going to oil and gas) came primarily from large institutional investors such as pension funds, university endowments, and the like. Those investments tended to be fully collateralized (that is, institutional investors were not borrowing to invest) and they are buy-and-hold investments for the long term. Neither of those two investment strategies is consistent with the popular vision of what constitutes “speculation.”

The most recent Fed actions to combat the deteriorating state of the macroeconomy added even more fuel to the oil price fire. With market actors increasingly convinced that the Fed is willing to entertain inflation in the course of injecting liquidity into the market, investors are looking for investments to hedge against inflation. And what do you know? Returns on commodities have historically been better during inflationary periods than during non-inflationary periods. Ben Bernanke thus sent another strong infusion of cash into commodity futures – again, largely into oil and gas futures.

The increased demand for oil futures drives spot prices because it diverts oil from immediate use into inventories. The stepped-up infusion of oil into public inventories (the Strategic Petroleum Reserve and the emerging state inventory maintained by the Chinese government, for instance) has also contributed to the diversion of oil from immediate use and thus, has further increased prices. Federal mandates for low-sulfur fuel hasn’t helped either.

For what it’s worth, Verleger does not believe that this infusion of cash into oil futures is sustainable. Returns have been modest and there are simply not enough profits available to support these investments over the long haul. “Speculators” – classically understood – have reacted and will continue to react by leaving the market when returns prove disappointing.

Large institutional investors, however, are less sensitive to changing price signals given their “buy-and-hold” strategy and relative lack of market sophistication. But sooner or later, Verleger thinks that they, too, will take much of their cash out of the commodity markets. Historically correct observations about past returns in commodity markets will not hold. They reflect observations about a market that was absolutely tiny compared to the size of the present commodity market (inflated as it is with institutional cash) and profits have and will be dissipated.

Verleger goes so far as to put the “bubble” tag on oil markets, but again, he does not attribute that bubble to simple speculation. Nevertheless, he predicts a (big-time) crash, but does not predict when that crash will occur. I am less certain about the “bubble” tag (see my introductory paragraph), but I wouldn’t bet against it. I think Verleger’s narrative regarding the root causes of the oil price boom is better than any other I’ve run across.

Oil Subsidies in the Dock

Yesterday, Congress summoned the heads of BP, Shell, Chevron, ConocoPhilips, and ExxonMobil to defend the prices they’re charging at the pump and the subsidies they are receiving from the federal government. The former issue is of less interest to me than the latter.

The main issue is the so-called Section 199 tax credit passed in 2005. The credit is available to all domestic manufacturers - not just to oil and gas companies - and it allows the oil industry to write-off $13.6 billion over ten years that might otherwise be sent to the federal treasury. While a good case could be made to get rid of Section 199 in toto – the feds shouldn’t be in the business of artificially making some business activities more economically attractive than others – limiting that deduction for oil and gas companies and oil and gas companies only will compound the underlying economic distortion and encourage investors to put relatively less money in oil and gas production and more money in other industrial sectors. How is that a good thing with oil prices topping $100 a barrel?

Oil companies are already paying a staggering tax bill. In 2006, for instance, big-bad ExxonMobil faced an effective tax rate of 44 percent on a profit margin of around 11 percent, a figure that actually understates things because corporate revenues sooner or later find their way to oil company employees, contractors, shareholders, and those who do business with the same, and that revenue is taxed again via the personal income tax.

“So what?” you ask? Well, the more you tax “Big Oil,” the less return investors will get on money plowed into oil production. The less return on investment, the less investment there will be. Less investment equals less production, and less production equals higher prices. This is fact, not theory. Analysts at the Congressional Research Service report that the 1980 Crude Oil Windfall Profits tax reduced domestic oil production by 3-6 percent and increased oil imports by 8-16 percent for exactly that reason.

If the Congress were really interested in ending oil and gas subsidies, it could eliminate preferential tax treatment afforded intangible domestic drilling expenses, increase the amortization period for geological and geophysical expenditures from five years to seven, end preferential expensing for equipment used to refine liquid fuels, close the exemption from passive loss limitations for owners of working interests in oil and gas properties, and eliminate accelerated depreciation allowances for small oil producers, natural-gas distribution pipeline investments, and expenditures on dry holes. Such a plan would reduce – rather than compound – economic distortions produced by the tax code and deliver about $8.3 billion for the Treasury over 10 years. Congress is presumably less inclined to offer such a plan because those subsidies are far more important to “Little Oil” than they are to their “Big” brethren, and it’s the former – not the latter – that has most of the political clout in Washington.

Regardless, if getting rid of subsidies is such a good thing, then why does Congress propose to take those subsidies away with one hand but to reallocate them to the renewable energy business with the other? If renewable energy is economically competitive, it doesn’t need the subsidy, and if it’s not economically competitive now – with energy prices setting records across the board – then what makes anyone think that federal subsidies will make any difference? After all, they never have in the past. Ethanol has been lavished with government subsidy for 30 years, yet ethanol is still about $1.20 per gallon more expensive than conventional gasoline on wholesale markets last week after we adjust for the differential in energy content between the two. Nuclear energy has lived off a plethora of federal subsidies for five decades now, yet rather than being “too cheap to meter,” it’s still more expensive than any other conventional source of electricity once we account for the cost associated with building the reactor. Examples of similar subsidy boondoggles are legion.

Getting rid of energy subsidies is a fine thing, and Democrats are right to argue that those subsidies are even less warranted at a time when energy prices – and thus, energy profits – are relatively high. Too bad they aren’t serious about translating their rhetoric into legislative reality.