An Argument against Oil Price Minimums

This article appeared on Wash​ing​ton​post​.com on May 29, 2006.

While many of the suggestions about how Congress might best address high gasoline prices are far fetched, there are a few ideas bubbling just below the radar screen that are a bit more substantive and worthy of attention. One in particular that has gained a lot of support from market analysts and academic economists is for the government to establish an oil price floor. Supporters of this idea argue that the problem isn’t high oil prices in the here and now — the problem is that oil might not be very expensive for long and that this market volatility adversely affects investment in both petroleum and alternative fuels.

If you think it’s counterintuitive to argue that the solution to high gasoline prices is for the government to ensure that they will be relatively high forever, you’re right. The argument, however, isn’t as bizarre as it sounds. But if you shudder at the thought of Congress saddling you with high fuel costs ad infinitum, don’t worry — it isn’t going to happen. And it shouldn’t.

Proponents of a price floor start out on solid ground. They note correctly that oil markets are characterized by distinct boom and bust price cycles. Producers are thus leery of investing billions of dollars to bring new, relatively high cost oil to market because even if that oil would be profitable today, who’s to say the oil could be sold for a profit over the lifetime of the investment, which begins maybe 6 – 8 years after the decision to invest has been made and ends maybe 30 years further down the road?

Price uncertainty also handicaps investments in alternative energy. Automotive biofuels like ethanol might be marginally competitive today in some markets, but investors will take a beating if they invest billions of dollars into ethanol only to find oil prices crashing tomorrow.

Then there’s OPEC. At present, countries in the cartel are happy to trade market share for price. By restraining production, they allow higher‐​cost non‐​OPEC suppliers into the market but gain greater revenues than they would if they produced flat‐​out. But if some fuel came along that could compete with oil in the marketplace, Persian Gulf producers would have little trouble winning a price war. OPEC production costs are so low that former cartel Secretary General Francisco Parra thinks that OPEC members could make a healthy profit even if oil were selling at $5.50 per barrel on world markets.

Price uncertainty also makes energy conservation investments problematic. Consumers are leery of investing in energy efficiency or drastically altering their lifestyle (say, by moving from distant suburbs in order to cut commuting costs) if they suspect that high prices will be here today but gone tomorrow. Moreover, if oil demand craters for whatever reason, prices would drop and conservation would disappear as quickly as it did in the 1990s after the 1986 price collapse. The boom and bust cycle would then resume.

All of this explains why the economy responds slowly to oil price increases and why high prices take so long to address via supply and demand response alone. A price floor would theoretically reduce price volatility while ensuring a much quicker and more efficient response to market disruptions.

Convinced by the case for a price floor? If so, consider this. Given the fact that no Congress can bind future Congresses (laws passed today can easily be repealed tomorrow), what do you think the chances are that a $60 per barrel price floor would survive in a world in which oil were selling for $20 a barrel in world markets? After all, it wouldn’t take long for people to figure out that the gasoline for which they’re paying $2.75 a gallon might only cost $1.35 if Congress would take its boot off the consumer’s throat.

The very real chance that a future Congress would repeal the price floor would discourage both producers and consumers from factoring the price floor in to their investment decisions, and rightly so. Congress is constantly reneging on past promises with regards to public policy. Only a fool would take political promises about future tax or regulatory policy to the bank.

Of course, a price floor won’t make any difference if the depletionists are right that oil prices have nowhere to go but up for the rest of time. The market, after all, would quickly figure out that it’s on an elevator with only one button (that going “up”) and need nothing as far as investment certainty is concerned.

But the silver lining for consumers is that very high oil prices have traditionally been followed by very low oil prices. Trading a world in which transportation fuel prices are very high sometimes but relatively low most of the time for a world in which prices are very high all the time is scarcely a bargain.