Holding out the promise of cheaper gasoline is a popular activity for political candidates right now. They suggest that if we just did a few simple things — research alternative energy, drill offshore or in the Alaskan National Wildlife Refuge, further subsidize biofuels or simply ‘get tough with oil companies’ — we could achieve energy independence and pay substantially less at the pump.
Implicit in these arguments is the idea that we could sever our connection with world oil markets. Then, rising demand shocks from rapidly growing countries like China and India would have no effect on U.S. pump prices. Nor would political disruptions in the Middle East. Cushioned by the domestic production of oil and alternative fuels, U.S. drivers would contentedly fill their SUVs for $2 per gallon or less.
That is a nice fantasy. The problem is that oil is a fungible commodity that is produced in many countries and consumed in nearly all. Crude oil prices are determined by global supply and demand, just as corn and soybean prices are.
In this situation, it is nigh unto impossible to isolate one nation from world market forces. For example, if the United States pays subsidies to farmers per bushel of corn grown, they will increase output and corn prices will drop. But the price drop will reflect the addition to world supply, not just that of the United States. U.S. consumers would capture some benefit from the lower prices, but so would billions of other people around the world.
Similarly, increased production of alternative fuels augments the global fuel supply, not just that of the United States. This world supply increase will be small, and crude prices will decline only slightly. The price drop for U.S. consumers will be small.
Isn’t there some way to insulate the U.S. from these global markets, so that that we can capture all the benefits from our expenditures on developing new supplies, or from bearing environmental costs, and not have the rest of the energy-consuming world ride on our coattails?
There are a few situations in which this is possible. If we produced enough fuel for our own use at less-than-world-prices and then restricted exports, we could have domestic prices that are lower than world ones.
This is what Argentina is doing with grains and oilseeds right now. That thinly populated but agriculturally rich country produces more corn, wheat and soybeans than it consumes. It exports substantial quantities of all three. With no restrictions on exports, its domestic farm prices — and related food prices — would differ from those in Chicago or Rotterdam only by the cost of transportation.
But the Peronist government in power imposes stiff export taxes, reducing the incentives for farmers to export what they produce and keeping domestic farm and food prices lower than they would be otherwise. Argentine farmers, of course, feel abused since they get substantially less for a ton of soybeans than their competitors in Brazil or Iowa.
If we produced more fuel than we would consume at a low price, we could emulate Argentina by taxing what we exported. This would keep domestic prices lower than world prices. This doesn’t work, however, when a country needs to import some fuel to meet its demand.
If we wanted cheap domestic fuel, our government could import oil at world prices and then sell it more cheaply to domestic consumers. That may sound crazy, but many developing countries do just that.
It is a self-destructive policy, but popular with urban consumers who often must be placated by nondemocratic governments. Egypt, for example, spends more on gasoline subsidies than it does on either public health or education.
Sometimes even major oil producers get caught in the subsidized gasoline trap. These subsidies are a major fiscal problem for Iran, Venezuela and Mexico. Iran is a huge oil producer but does not have enough refinery capacity to meet domestic demand at artificially low prices. So it must import refined products from other countries.
Mexico’s cheap domestic gas policy has led to the comical phenomenon of consumers from a rich country crossing over to Tijuana or Juarez to gas up in a poor country for $1.50 a gallon less than at home. There is tragedy in Mexican government funds subsidizing richer Americans rather than Mexico’s many poor, but it is the logical outcome of a bad policy.
One hopes we are smart enough to avoid this trap, but one never knows.
Perhaps there is a huge information problem that is leading markets to fail. Perhaps with additional subsidies into alternative energy research, including prizes for breakthrough technology batteries, we will find cheap alternatives to oil. Then we can impose trade barriers to keep the goodies to ourselves. But I wouldn’t count on it. Until we do, it will be impossible for us to have cheaper oil than everyone else.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.