A buyers’ market is hardly exceptional in the history of U.S. oil and gas markets. Remember the ‘gas bubble’ of the 1990s when there was more natural gas than pipelines could contractually market, creating a take-or-pay problem? Or remember when domestic oil production brought prices to less than one dollar per barrel, resulting in government proration where supply was reduced to ‘market demand” from the 1920s until the early 1970s? Import tariffs and quotas were also necessary from the U.S.-side to prop up oil prices in this half-century.

An exception to the rule occurred during the 1970s when, not coincidentally, our federal government had price controls on oil and natural gas. The gasoline shortages of 1974 and 1979, and natural gas shortages in the winters of 1971/72 and 1976/77, came from the same cause: federal price and allocation controls that did not let supply and demand naturally mesh. Price controls also caused energy shortages during World War I and World War II.

Price ceilings and inadequate supply go together. “As an economist, whenever I hear the word ‘shortage’ I wait for the other shoe to drop,” stated Thomas Sowell. “That other shoe is usually ‘price control’.”

Oil today at north of $100 per barrel is hardly a buyers’ market, and price controls do not exist to explain it. But political factors around the world add a premium to what otherwise could be considered a free-market price. And the Obama administration’s anti-production policy on oil-bearing public lands, onshore and offshore, creates a ‘what-if’ scenario of more supply/lower price.

The general point is that energy minerals, as other so-called depletable resources, are not unusually scarce compared to the general basket of goods and services. Julian Simon popularized this profound and admittedly counter-intuitive idea by his standing bet that future mineral prices would be less than the present, adjusted for inflation. And he won what was the most famous bet in the history of economics against Paul Ehrlich, John Holdren, et al. with five such minerals over a ten-year horizon.

No doubt that some gas producers will look to government to (artificially) increase demand through special favor. The T. Boone Pickens-led New Alternative Transportation to Give Americans Solutions Act (Nat Gas Act), an opening scheme to convert the motor vehicle fleet from petroleum products to natural gas, is a taxpayer drain in the guise of national energy policy.

But instead of government market-rigging, natural gas producers should practice free-market self-help to reduce supply and increase demand in the face of gas gluts. To this end, domestic producers should:

1. Further penetrate the Northeast home heating oil market, continuing the trend of natural gas-for-oil of the last several decades.

2. Build/rejigger existing import LNG infrastructure to export U.S. gas to high-price markets.

3. Construct gas-to-liquids plants to turn natural gas into gasoline and other liquid products, a global opportunity (and increase exports of the same).

4. Offer long-term pricing deals to lock-in niche transportation markets (fleet vehicles).

Some of the above (#1, #4) are incremental, and some (#2, #3) require lots of capital and lead time. All require dedicated effort in a market where the energy competition is keen. But who said the free market was easy, especially for an industry that is breaking its own records for new production?

Just as the oil industry had to become efficient and sustainable amid the price collapse in 1986 without special government failure (Congress rejected an oil tariff plea), natural gas producers today need to become efficient at $3/MMBtu wellhead prices. This is certainly a challenge, but it is the way forward for the gas industry to win the future.

WASHINGTON D.C. — The interior department announced Tuesday that oil and gas lease sales on public lands increased 20 percent in 2011, generating more than $250 million in profits for taxpayers.  The fact, however, is that oil production on federal lands, lease sales, and revenue have drastically declined during the Obama administration.

“The American people need only to check their electric bills or the price they are paying at the pump to see just how well the Obama administration’s energy policies are working. Today’s announcement by the interior department that lease sales are increasing is misleading and disingenuous. The president promised to make energy prices “skyrocket,” and so he has. The American people deserve the facts about this administration’s anti-energy agenda, not more propaganda from Ken Salazar,” said IER Senior Vice President Dan Kish.

The Institute for Energy Research released the following facts to set the record straight:

Obama Claim:  The administration is increasing lease sales on public lands. Total leases issued on public lands were up 20 percent in 2011.

FACT:  Lease sales on public lands have steadily decreased over the last 25 years.

Obama Claim:  The administration raised more than $250 million in lease sale revenues in 2011, up 20 percent over 2010.

FACT:  Oil production on federal lands is down 13 percent in 2011: 97,721,813 barrels in 2011 versus 112,124,812 barrels in 2010.

FACT:  Offshore lease sales have plummeted more than $9.4 billion since the Obama administration took over. This means that Americans collected 258 times less revenue from offshore lease sales than they did during the last year of the Bush administration.

• 2008:  $9,480,806,620
• 2009:  $1,181,075,491
• 2010:     $979,569,294
• 2011:       $36,751,111

Obama Claim:  The administration is increasing the amount of federal lands available for domestic energy production.

FACT:  The average annual leases issued during the Obama administration is down 35.5 percent from the George W. Bush administration, down 50.7 percent from the Clinton administration, down 69.5 percent from the George H.W. Bush administration, and down 78.9 percent from the Reagan administration.

The President Agrees: Rising Oil Prices Are Bad!

Although we won’t have many kind things to say about the speech, at least the president acknowledged what many interventionists refuse to concede: rising oil prices hurt Americans, in particular working families with kids. Here is the president on this presumably obvious point:

Now, for the last few months, gas prices have just been killing folks at the pump.  People are filling up their tank, and they’re watching the cost rise — $50, $60, $70.  For some families, it means driving less.  But a lot of folks don’t have that luxury.  They’ve got to go to work.  They’ve got to pick up the kids.  They’ve got to make deliveries.  So it’s just another added expense when money is already tight.

We’ll be sure to place this quotation in the file, to deploy it the next time someone from the Obama Administration touts the wonders of a carbon tax or cap-and-trade scheme.

Are Tax Hikes the Way to Boost Production?

Although he started strong by acknowledging the importance of lowering fuel prices for Americans, Obama then strayed into trouble when diagnosing the causes of this dire situation:

[T]his is not a new problem.  For decades, we’ve left our economy vulnerable to increases in the price of oil.  And with the demand for oil going up in countries like China and India, the problem is only getting worse.  The demand for oil is inexorably rising far faster than supply.  And that means prices will keep going up unless we do something about our own dependence on oil….

At the same time, it’s also true that there is no quick fix to the problem.  There’s no silver bullet here.  But there are steps we can take now that will help us become more energy independent….

So I’ve laid out an energy strategy that would do that.  In the short term, we need to increase safe and responsible oil production here at home to meet our current energy needs.  And even those who are proponents of shifting away from fossil fuels have to acknowledge that we’re not going to suddenly replace oil throughout the economy.  We’re going to need to produce all the oil we can.

But while we’re at it, we need to get rid of, I think, the $4 billion in subsidies we provide to oil and gas companies every year at a time when they’re earning near-record profits, and put that money toward clean energy research, which would really make a big difference.  (Applause.)

We at IER agree that the federal government shouldn’t be subsidizing oil and natural gas production; it was the first plank in our recommendations to the new Congress early this year. But neither should the government be subsidizing solar, wind, biomass, electric vehicles, or any other energy technology. Also, when it comes to the matter of subsidies, people need to remember that adjusted for the energy output, subsidies to oil and natural gas are dwarfed by those to the politically-favored techniques. According to new data from the Energy Information Administration, solar is being subsidized by over 1200 times more than coal and oil and natural gas electricity production, and wind is being subsidized over 80 times more than the more conventional fossil fuels on a unit of production basis (ie. the amount of energy output per dollar of subsidy).

Yet if we put aside the principled issue of whether the government ought to be picking winners and losers, there is an inconsistency in Obama’s rhetoric. On the one hand, he argues that the supply of oil is having trouble keeping pace with increases in demand, and that the government should do everything it can to encourage domestic oil production. Then he states matter-of-factly that raising the tax bill on U.S.-based energy companies is the right thing to do.

Just because a firm is having a profitable year, doesn’t mean that the laws of economics suddenly stop applying. By effectively raising taxes (through ending the “subsidies” in the tax code etc.) on oil and natural gas companies, President Obama would reduce their incentives to find and develop new deposits to meet the rising demand. By the same token, if the government suddenly imposed a 50% surcharge on the incomes of Hollywood actors, they would make fewer movies per year, even though their after-tax income would still make them “obscenely rich” compared to most Americans. Incentives matter.

Obama: Taking Credit for Something Companies Would Have Done Anyway?

Let’s return to Obama’s speech and specifically the role of fuel economy standards:

And that’s why we’re here today.  This agreement on fuel standards represents the single most important step we’ve ever taken as a nation to reduce our dependence on foreign oil.  Think about that.  (Applause.)

Most of the companies here today were part of an agreement that we reached two years ago to raise the fuel efficiency of their cars over the next five years.  And the vehicles on display here are ones that benefited from that standard….

And today, these outstanding companies are committing to doing a lot more.  The companies here today have endorsed our plan to continue increasing the mileage on their cars and trucks over the next 15 years.  We’ve set an aggressive target, and the companies here are stepping up to the plate.

By 2025, the average fuel economy of their vehicles will nearly double to almost 55 miles per gallon.  (Applause.)  So this is an incredible commitment that they’ve made.  And these are some pretty tough business guys.  They know their stuff.  And they wouldn’t be doing it if they didn’t think that it was ultimately going to be good business and good for America.

Think about what this means.  It means that filling up your car every two weeks instead of filling it up every week.  It will save a typical family more than $8,000 in fuel costs over time.  And consumers in this country as a whole will save almost $2 trillion in fuel costs.  That’s trillion with a T. [Bold added.]

We’ve asked this before and we’ll repeat the question: If a government intervention into the energy markets is supposed to be so good for business…then why does the government have to force the businesses to do it? Obama should simply fax his suggestions to these “pretty tough business guys” and then, once they see the light (that it took government officials to discover), they’ll gladly produce the more fuel-efficient vehicles without government prodding. After all, it’s good for business, right? Why would the government have to force companies to do something that is profitable, especially if they agree with the claim, as the president is here saying?

CAFE Standards Kill

What Obama is ignoring with his claims of saving trillions of dollars is that there are downsides to raising fuel efficiency standards. The automakers aren’t dumb. They know that gasoline is expensive and that, other things equal, a more fuel-efficient care is more desirable to their customers.

Yet other things aren’t equal. Engineers have already plucked the “low hanging fruit” when it comes to vehicle design. In order to make vehicles more fuel efficient, the increase must come with a sacrifice in some other desirable feature, such as size or weight of the vehicle. That is why interfering with the optimal tradeoff—as it would be determined in a free market—will lead to undesirable consequences, such as more traffic fatalities.

Writing for The American Thinker last year, J.R. Dunn summarized the lethal legacy of CAFE standards:

Fuel standards are the longest-lived of an entirely futile array of attempts to address 1970s oil shortages. They first went into effect in the 1975 Energy Policy and Conservation Act as the Corporate Average Fuel Economy program, better known as CAFE. Under the CAFE standards, domestic and foreign automobile manufacturers had to meet a certain mileage standard in their cars and light trucks. They were allowed a very short time to carry this out before fines were levied, so they met the challenge in the easiest way possible: by designing small engines that used less fuel while lowering the size and weight of new vehicles to preserve performance.

…

The new regulations did accomplish one thing — they killed drivers and passengers in large numbers. By lightening cars and removing material, auto companies were inadvertently discarding the armor that protected motorists in the event of a crash. Similarly, the compressed new models lacked space for impact forces to attenuate before causing damage and injury. Drivers in lightweight cars were as much as twelve times more likely to die in a crash. It was once said about American autos that they were “built like tanks.” Many of the new models from the late ’70s onward more closely resembled go-carts — and proved to be about as sturdy.

…

How many deaths have resulted? Depending on which study you choose, the total ranges from 41,600 to 124,800. To that figure we can add between 352,000 and 624,000 people suffering serious injuries, including being crippled for life. In the past thirty years, fuel standards have become one of the major causes of death and misery in the United States — and one almost completely attributable to human stupidity and shortsightedness.

Conclusion

Consumers desire fuel efficiency in their vehicles, but that isn’t their sole criterion—if it were, we’d all be riding bicycles or skateboards to work. The president’s claim that higher fuel efficiency mandates will be good for business is absurd on its face, because if that were true, no mandate would be necessary. In order to comply with the new regulations, automakers will produce vehicles that will be more dangerous. Americans may save money at the pump, but fewer of them will be alive to enjoy the savings.

The Gulf Economic Survival Team, a group of energy and business interests based largely in Louisiana,  had IHS Global Insight and IHS CERA study the impact of faster permitting of oil leases on offshore oil production and the economies of the United States and affected states.[ii] They determined that increased exploration and permitting approval in 2012 would:

• Create 230,000 U.S. jobs
• Increase U.S. GDP by more than $44 billion
• Increase tax and royalty revenues for state and federal treasuries by almost $12 billion
• Increase oil production by more than 400,000 barrels per day (150 million barrels per year)
• Reduce U.S. payments for oil imports by about $15 billion.

Other findings are:

• Almost twice the number of exploration and development plans are pending from the Department of Interior compared to pre-moratorium levels
• Approvals of exploration plans have decreased by 85 percent.
• The median number of days for approving an exploration plan has increased from 36 days to 131 days.

Further, ten oil rigs have left the Gulf of Mexico since the moratorium for more lucrative areas offshore in Egypt, Congo, French Guiana, Liberia, Nigeria, and Brazil.[iii] Although federal officials announced they were lifting the restrictions last October on a moratorium put in place in May 2011, a “de-facto moratorium” remains in effect that lowers oil and natural gas production and impacts businesses in the Gulf region.

The IHS Global Insight and IHS CERA Study

This study evaluated the pace of permitting offshore leases in the Gulf of Mexico by the Bureau of Ocean Management, Regulation and Enforcement (BOMRE), an organization in the Department of Interior. The period of review was from the end of the moratorium on offshore drilling by the Obama Administration in October 2010 until April 30, 2011, 6 months of data. They found that the number of pending exploration and development plans submitted to BOEMRE that have not received final action has increased by almost 90 percent from historical levels. The median number of days a plan is pending approval has increased from 36 days to 131 days. They also found that exploration and development plan approvals are down by more than 85 percent and approvals of drill permits covered by those plans are down by almost 65 percent. The slower pace of approvals will make other investment opportunities more advantageous for the industries involved. Already ten rigs have left the area for opportunities in other areas of the world.

After the spill and the reorganization of the Minerals Management Service into BOMRE, new safety and environmental rules were issued, probably causing a slowdown to both the number of applications and to the approval process.  This study, however, did not determine the causes for the slowdown nor what actions should be taken to fix it. Rather the study evaluated the impact of approving permits faster and reducing the backlog of the permits currently in the pipeline, finding that employment and tax royalty revenues would increase and energy security would improve from the increased production. The results of their analysis are shown in the table below.

Employment would not only increase in the Gulf States, but in states such as Florida, Georgia, California, Illinois, and Pennsylvania. Louisiana’s potential increased revenues of $1.3 billion would cut its budget shortfall by more than 80 percent. The state results are provided below.

The report’s message is that the output of BOEMRE in regard to regulatory oversight and responsiveness should be aligned with the level of investment that oil companies are willing to make in the Gulf. For instance, in June, Exxon Mobil announced a new discovery in the Keathley Canyon area of the Gulf with recoverable oil estimated at 700 million barrels and Shell announced plans to invest $2.5 billion in its Cardamon field in the Gulf.[iv]  Just the royalty to the federal treasury from Exxon’s find at today’s oil price is more than $13 billion.

It generally takes seven to ten years from exploration and development to initial production. And not all drilling activity results in oil production. Generally, only one in seven wells will result in economically viable reserves. So, in order to keep production at or above current levels, it is crucial for exploration to continue at historic rates.

Government’s Expectation of Offshore Oil Production

The Energy Information Administration (EIA) forecasts oil production over the next two years in its Short Term Energy Outlook, which it releases each month. In its latest outlook, the EIA is predicting that offshore oil production in the Gulf of Mexico will fall from 1.7 million barrels per day in January 2010 to 1.34 million barrels per day in December 2012, a drop of 360,000 barrels per day.[v] Prior to the Deep Water Horizon accident and the Obama Administration moratorium, the EIA was forecasting fairly robust oil production from the Gulf at levels averaging 1.7 million barrels a day in 2010 and 2011. Now, the 2011 forecast for offshore oil production from the Gulf of Mexico is reduced to about 1.5 million barrels per day.[vi] Note that the end of the forecast horizon in EIA’s April 2010 Short-Term Energy Outlook was 2011, so comparisons regarding the 2012 offshore oil production numbers cannot be made from a prior forecast.

Conclusion

Studies are showing that we are losing oil production from the Gulf of Mexico from the Obama Administration’s moratorium and its continuing slowness in approving permits or a “permitorium”. The study by IHS Global Insight and IHS CERA is indicating that there are great economic gains to be reaped if the Administration speeds up their slow permit process.  But, the reality is that a slowdown is occurring with the resultant impact of less employment, less government tax revenues, less oil production, and less energy security.

Although the surprise announcement did lead to an immediate drop in the price of crude, the fall was not as much as some might have expected and prices returned to the pre-release levels within 1 week. Economic theory can explain why. Moreover, to the extent that the Obama Administration recognizes that more oil leads to lower prices, it should tap into America’s vast “reserves” located in the Outer Continental Shelf and ANWR. These holdings dwarf the salt caverns of the SPR and tapping them would lead to a real increase in production as opposed to a short-term band-aid “fix.”

SPR Drawdowns and the Price of Oil

As this CNNMoney article reports, the surprise announcement, which added two million barrels a day to the market, caused the price of oil to drop more than 4 percent by the close of the day. (Interestingly, as of this writing—exactly one week later—the world price of oil is higher than it was before the announcement.)

As I have written previously on this blog, economic theory suggests that one-shot sales from the Strategic Petroleum Reserve under normal market conditions would be offset by the response of other players in the market, so that releasing oil from the SPR wouldn’t depress prices as much as one might have originally thought.

Here’s a summary of the argument: People who are sitting on large deposits of oil (the Saudis for example) set their current production rates to maximize the market value of their asset. If a producer extracts and sells more barrels of oil today, he earns more revenue today, but his actions (a) push down the current market price of oil, while (b) leave him with fewer barrels of oil to sell in the future, and therefore also (c) push up the future market price of oil.

Because of reasoning like this, we don’t need to worry about all the major oil producers foolishly selling every last barrel of oil this year. That would be a horrible business strategy, because it would crash the current price of oil while leading to $500-a-barrel oil next year. Since the owners of major oil fields are anything but stupid, they plan their operations out decades into the future. Rather, they decide on current production rates in order to maximize the long-run profitability of their operations.

So if the world oil market were more or less in equilibrium, what effect did the surprise announcement have? All of a sudden, it meant that two million more barrels of oil per day would be coming onto the market, than the major oil producers had previously forecast. That in turn means that the market price of oil in July will be lower (other things equal) than what the major oil producers had anticipated, before hearing the announcement.

Because of the changed circumstances, the original production plans are no longer optimal. Major producers could make more money (in light of the surprise SPR sales) if they reduced their output over the summer months, and deferred the extraction and sale of more of their inventory to the future, after the SPR drawdowns have finished. Even if the total amount of oil hitting the market remained above the original level, private speculators (sensing the prices were artificially low) would have the incentive to buy the excess oil and store it, waiting for prices to return to their normal levels.

If there were no real-world frictions, in principle the SPR announcements would have virtually no effect on oil prices at all. The extra two million barrels coming onto the market from the SPR sales would be perfectly offset by a combination of production cutbacks and private inventory accumulation. Effectively, the Obama Administration would have simply transferred 30 million barrels of its inventories from salt caverns in the southern United States, into the warehouses of private speculators and into the possession of Saudi Arabia in deposits buried under the sand.

Of course, in the real world, there are all sorts of complications with this theoretical benchmark. Oil prices really did drop upon the announcement. But the point remains that economic forces limit the lasting impact that even large-scale inventory sales can have on the world price of crude.

Getting a Bigger Bang

Since the Obama Administration apparently understands the (obvious) point that more oil leads to lower prices, it should heed IER’s long-standing call to remove the statutory and regulatory obstacle to the development of offshore, ANWR, and other oil resources. Whereas the SPR had (before the recent announcement) 726.5 million barrels of oil, the “1002 Area” of ANWR has an estimated 10.4 billion barrels of technically recoverable crude, while the figure for the OCS is more than 59 billion barrels. Thus there are about 96 times more oil “reserves” in ANWR and the OCS, than is contained in the SPR.

What’s even more interesting is that the conventional criticism of expanded domestic production—that it will take years to bring that new oil to the market—turns the economic logic above on its head. Suppose Saudi Arabia has made long-term planning decisions under the assumption that the roughly 70 billion barrels of U.S. crude will remain forever locked-up due to federal barriers. Then the U.S. government surprises everyone by announcing that this oil will actually be coming onto the market in a few years. Saudi officials would realize that their original forecast of the world price of oil over the next few decades was overly optimistic (i.e. too high), and they would rearrange their plans to extract more oil in the present before having to compete with the new U.S. production. This would cause more oil to hit the market in the present, thus lowering the present price of oil—even though the promised U.S. production might be years in the future.

Real-World Facts

Although our economistic reasoning sounds Ivory Tower, we have real-world evidence: When President George W. Bush announced in the summer of 2008 that he was ending the executive branch’s moratorium on offshore drilling, the price of crude dropped $9 per barrel during the speech itself. This was an immediate impact at least as great as the immediate drop in crude prices, following the recent SPR announcement. Yet Bush’s announcement by itself didn’t guarantee a single drop in new production, because the Congressional moratorium was still in place. Just the increased possibility of more future U.S. production, caused prices to drop as much as Obama et al.’s guaranteed delivery of 60 million barrels in the next month.

Conclusion

President Obama and his advisors undoubtedly recognize that Americans are seething over soaring energy and other prices. The drawdown in the SPR did push down prices (at least temporarily), but economic theory suggests that other forces would largely offset its impact. In both theory and practice, we know that opening up domestic energy resources to development would cause much bigger and lasting reductions in the price of energy, not to mention providing economic growth.

In a speech on June 7 in Atlanta at the International Monetary Conference, Fed chair Ben Bernanke downplayed the U.S. central bank’s role in rising oil and gasoline prices. Inasmuch as I recently testified before a Congressional subcommittee saying that Bernanke’s policies have been (partially) to blame, I want to point out the weaknesses in Bernanke’s attempt to shift the blame. Nobody can know exactly how much the Fed has boosted the pain at the pump, but it’s probably much worse than Bernanke is willing to admit.

The Fall in the US Dollar

As I pointed out in my oral remarks and written testimony, there are two main mechanisms through which Fed policy could be driving up oil prices. The first mechanism is that the Fed’s “quantitative easing” programs have weakened the dollar versus other currencies. Because oil is a fungible, internationally-traded commodity, it has to cost basically the same price in every currency, once we adjust for exchange rates. Therefore, when the dollar falls against other currencies, oil necessarily gets more expensive for Americans than for other people.

Bernanke gave two main responses. First, he claimed that the fall in the dollar is no big deal. As an E&E Daily article^[i] reported:

Federal Reserve Chairman Ben Bernanke yesterday moved to dispel an intensifying GOP claim that his central bank’s monetary policy is partly to blame for the current climb in oil and gas costs.

In a speech at the International Monetary Conference in Atlanta, the Fed chief parried the arguments by “some” who link the central bank’s increase in the monetary supply — and the resulting dip in the dollar’s trade-weighted value — to inflation in the price of commodities such as oil. While the studiously apolitical Bernanke did not mention the GOP by name, Republicans lately have ramped up their rhetoric linking the weak dollar to high pump prices that are squeezing consumers (E&E Daily, May 17).

Noting that oil prices are up 160 percent since February 2009, while the dollar has fallen just 15 percent, Bernanke added that “the dollar’s decline can explain, at most, only a small part of the rise in oil and other commodity prices.”

Now this is an interesting defense, if you think about it. The fall of the dollar against other currencies since the implementation of the Fed’s “rescue” policies can explain 57 cents of the price at the pump, as calculated by the Joint Economic Committee. In other words, if the dollar were currently as strong against other currencies as it was at the announcement of the first round of “quantitative easing,” then oil prices would be lower (quoted in dollars) and gasoline prices would be about 57 cents cheaper per gallon.

Most Americans would agree that 57 cents per gallon is a rather significant impact. Yet Bernanke’s excuse above is to say, “Gasoline prices have gone up a heck of a lot more than 57 cents since I began flooding the world with dollars. So clearly I shouldn’t get all the blame for high gas prices.” As I said above, this is a rather odd defense.

Are the Critics Reversing Cause-and-Effect?

Yet Bernanke has one other card to play: He claims that the dollar is falling against other currencies not (just) because the Fed has injected some $1.6 trillion into the financial sector over the last 36 months, but rather because the trade deficit has mushroomed—largely because of rising oil prices!

In other words, Bernanke is saying that oil prices around the world—regardless of which currency you quote them in—have gone up sharply over the past two years. Since Americans have to import so much oil, this factor causes our trade deficit to widen. And a widening trade deficit means (other things equal) that the dollar falls against other currencies. So, in this way, Bernanke is trying to blame the weak dollar on high oil prices, rather than the other way around (as his GOP critics allege).

The major problem with this prong of Bernanke’s defense is that the Fed could be driving up oil prices directly. In other words, it’s not just some fluke coincidence that oil prices around the world (in any currency) have risen sharply, at the same time the Fed has embarked on an incredible expansion of (what economists call) the monetary base. (For those who are unfamiliar with the scale of the Fed’s actions, look at this chart. It is shocking.)

Why might the Fed’s pumping in of more than a trillion dollars cause oil prices to rise? One answer is that investors the world over are worried about the value of their money. With so much liquid funds sloshing around the financial sector, where should investors put their wealth, to protect it from a possibly collapsing dollar? They don’t want to put it in real estate, obviously, but the stock market is also dubious because the economy is on the ropes.

In this environment, many investors think that a good chunk of their overall portfolio should be in commodities, the idea being, “No matter what happens to the banks and Wall Street, people still need wheat and oil.”

This interpretation is plausible, because commodities in general have soared over the last two years. In other words, it’s not simply oil that’s skyrocketed. Since the crisis first struck in the fall of 2008, for example, gold and silver prices are up 80 percent and 210 percent, respectively. Surely that doesn’t merely reflect the “fundamental” demand going up in India and China—more people giving jewelry as gifts? Surely people are flocking to gold and silver to protect themselves from a possible surge in dollar price-inflation.

Conclusion

Ben Bernanke hasn’t exonerated himself. He simply takes it for granted that commodity prices have nothing to do with monetary policy, when there is plenty of circumstantial evidence—as well as common sense—saying that the two may have an intimate relationship.

In any event, American policymakers besides Ben Bernanke have options to provide immediate relief to motorists. For one thing, they could reduce the 18.4-cent per gallon federal tax on gasoline. More generally, they could expedite the permitting process and allow the development of American energy resources.

• Renewable energy subsidies were 49 times greater than fossil fuel subsidies when evaluated on a Btu (British thermal unit) basis of production. In other words, when making a comparison based on the amount of energy produced, renewable subsidies were 49 times greater than fossil fuel subsidies.
• On a straight amount-of-subsidy basis, renewable fuels received over 6 times more tax revenue dollars than fossil fuels received, as estimated by the Joint Tax Committee.
• Renewables received a 77 percent share of total federal energy incentives in 2009, while fossil fuels received a 13 percent share but produced more than 7 times the energy.

The April CRS Analysis

In April, the CRS produced a report that discussed the reasons why governments provide subsidies, listing the estimated tax revenue losses as a result of  U.S. energy-related subsidies for 2010 to 2014. According to the CRS, governments provide subsidies to fix market failures, i.e. to correct distortions in energy markets, or to achieve an economic objective. But, as CRS notes, tax policy is determined within a political system with compromises, which complicates the process and can either mitigate or compound the distortions. Current and past policies have been used in an attempt to reduce imported oil through greater use of domestic resources and to decrease environmental emissions by promoting renewable energy and conservation.

The total tax revenue lost due to energy-related federal subsidies for the 5-year period from 2010 to 2014 is estimated at $71 billion with renewables getting the lion’s share of $49 billion or 69 percent. See table below.

The May CRS Analysis

The May CRS analysis, like the one above, is based solely on Federal tax incentives targeted to energy. It does not include federal support that is also available to other industries or forms of federal financial support such as research and development funds, nor does it include state energy incentives. The tax expenditure estimates are from the Joint Tax Committee and are projected revenue losses, not actual losses.

The study found that in 2009, estimated tax revenue losses for the energy sector totaled $19.9 billion. Of the $19.9 billion, renewable energy received $15.4 billion in tax breaks, while fossil fuels received $2.5 billion. Another $2 billion worth of tax breaks went toward conservation, efficiency, alternative vehicles, and other energy-related tax incentives. Alcohol fuels and biofuels received the largest share of tax breaks in 2009, consisting of estimated tax revenue losses of $12.5 billion. Over half of this amount was for black liquor qualifying for a tax credit as an alternate fuel mixture—a tax credit that was discontinued after 2009. Black liquor is a fuel obtained from digesters in the process of chemically pulping wood that is burned in a recovery furnace to extract certain basic chemicals.

Tax Incentives by Category, 2009

Source: Congressional Research Service, http://assets.nationaljournal.com/pdf/051411_CRSsubsidies.pdf

CRS used primary energy production data reported by Energy information Administration (EIA) in its Annual Energy Review to compare the amount of production from each source. The following figure provides the distribution of primary energy production in 2009 by fuel type using EIA data. Fossil fuels represented 77.9 percent of total energy production in the United States in 2009, while nuclear fuel represented 11.4 percent, and all renewable fuels combined represented 10.6 percent. Of the renewable share, biomass represented the largest portion, exactly half at 5.3 percent, with hydroelectric power second with a 3.7 percent share. Wind and solar energy represented a combined 1.1 percent of the 10.6 percent renewable production share.

Primary Energy Production by Source, 2009

Source: Congressional Research Service, http://assets.nationaljournal.com/pdf/051411_CRSsubsidies.pdf

One way to compare subsidies is based on the amount of energy produced. When evaluated on a unit of production basis, fossil fuel estimated subsidies were $0.04 per million Btu (British thermal unit) and renewable fuel subsidies were $1.97 per million Btu. In other words, renewable fuel subsidies were 49 times greater than fossil fuel subsidies on a per Btu basis.

Alcohol and biofuels, excluding black liquor, received estimated subsidies of over $6 per million Btu based on production of 981 trillion Btu in 2009. Alcohol and biofuel subsidies on a Btu basis of production were over 150 times higher than fossil fuels subsidies. While biofuels and other oxygenates received the largest share of subsidies, these fuels only produced  3.9 percent of total petroleum products supplied in 2009, according to EIA.

CRS also compared the 2009 estimated tax revenue losses by tax subsidy category to the estimated tax revenue losses estimated for 2010. The alcohol and biofuels tax subsidies decreased from an estimated $12.5 billion to $6.3 billion because black liquor is no longer eligible for the subsidy, but those for other renewables increased from $2.9 billion to $6.7 billion. The latter increase was mainly due to the section 1603 grants that are provided for qualifying investments in lieu of tax credits. Those grants allow solar plants and wind farms to get an immediate rebate of 30 percent of their investment cost instead of taking the 30 percent over time as a tax credit. That change increased the lost tax revenues due to those subsidies from $1.1 billion in 2009 to $4.2 billion in 2010. The decline in tax revenue losses for alcohol fuels was due to the scheduled expiration of the excise tax credit at the end of 2010. That tax credit, however, was temporarily extended through the end of 2011 by the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 (P.L.  111-312). The tax revenue losses from subsidies for energy efficiency improvements to existing homes also saw a large increase, rising from $0.3 billion in 2009 to $1.7 billion in 2010. The revenue losses from tax subsidies for fossil fuels were estimated to decline from $2.5 billion in 2009 to $2.4 billion in 2010. Total revenue losses due to direct energy subsidies in 2010 were estimated to be $19.1 billion, 4 percent less than in 2009.

Conclusion

While renewable energy advocates do not want to admit it, renewables get the lion’s share of direct energy subsidies both on a total dollar basis and also when compared to the amount of energy produced. Fossil fuels garnered an estimated 13 percent of 2009 energy tax incentives, while renewable energy received 76 percent. Alcohol and biofuels subsidies received the largest share of renewable tax incentives in 2009. In 2010, total tax incentives were estimated to be 4 percent less than in 2009, but fossil fuels still only garnered an estimated 13 percent, while renewables totaled an estimated 68 percent. And, on a unit of production basis, renewable subsidies in 2009 were 49 times as great as fossil fuel subsidies.

The questions for policy makers are: “What market distortions are the subsidies trying to fix? Are the distortions mitigated or compounded by the subsidies? Are benefits being reaped?”

I am an economist, not a legal expert. In the present article I won’t comment on whether the individual traders “manipulated” markets in violation of the Commodity Exchange Act. Rather, I will argue that penalizing “manipulation” of markets is actually economically counterproductive. Furthermore, even if these allegations are true, these particular traders had little to do with the huge run-up in oil and gasoline prices in the first half of 2008. As the government’s case itself alleges, the defendants pushed oil prices up and then back down a few weeks later.

The Allegations

As reported by the New York Times:

The suit says that in early 2008 [the defendants] tried to hoard nearly two-thirds of the available supply of a crucial American market for crude oil, then abruptly dumped it and improperly pocketed $50 million.

In the case filed Tuesday, the defendants — James T. Dyer of Australia, Nicholas J. Wildgoose of Rancho Santa Fe, Calif., and three related companies, Parnon Energy of California, Arcadia Petroleum of Britain and Arcadia Energy, a Swiss company — have told regulators they deny they manipulated the market.

The commodities agency says the case involves a complex scheme that relied on the close relationship between physical oil prices and the prices of financial futures, which move in parallel.

In a matter of a few weeks in January 2008, the defendants built up large positions in the oil futures market on exchanges in New York and London, according to the suit….At the same time, they bought millions of barrels of physical crude oil at Cushing, Okla., one of the main delivery sites for West Texas Intermediate, the benchmark for American oil, the suit says. They bought the oil even though they had no commercial need for it, giving the market the impression of a shortage, the complaint says.

At one point they had such a dominant position that they owned about 4.6 million barrels of crude oil, estimating that this represented two-thirds of the seven million barrels of excess oil then available at Cushing, according to lawsuits.

The traders in mid-January cashed out their futures position, and then a few days later began to bet on a decline in oil futures, with Mr. Wildgoose remarking in an e-mail about the “inevitable puking” of their position on an unsuspecting market, the federal lawsuit says.

In one day, Jan. 25, they then dumped most of their holdings of West Texas Intermediate oil, and profited by the drop in futures.

The traders repeated the buying and selling in March 2008, and were preparing to do it again in April but stopped when investigators contacted them for information,the suit says.

What Goes Up, Must Come Down

The most obvious problem with blaming these particular traders for any large moves in the oil market is that they held their position for less than a month. Even if the allegations are perfectly accurate, then the traders began accumulating the physical crude for a few weeks in January, reversed their position in the futures markets (to position themselves to profit from a fall in price), and then dumped most of their physical holdings on January 25. They apparently repeated the process in March, and shied away from trying again in April because of heat from investigators.

The crucial point about the alleged scheme is that it was self-reversing. The strategy worked by (a) buying futures contracts at low prices, (b) hoarding physical oil in order to drive up the futures price, (c) cashing out the futures contracts and even taking a net negative position, and finally (d) driving the futures price back down by dumping the physical oil. In other words, the traders allegedly made money both driving oil prices up and then back down. Since they had more insight into the large swings in inventory to which other traders would react, these particular traders were allegedly able to make money both ways.

Therefore, even if these traders behaved just as the government claims, their actions can’t possibly explain the jump in crude prices from about $92 per barrel in December 2007 to a whopping $134 per barrel (average monthly price) in June 2008. Hoarding and then dumping physical oil—in bursts of a few weeks—at worst can make oil prices more volatile; it can’t drive them systematically higher for months at a time.

If anything, these lawsuits demonstrate just how difficult it would be for speculators to drive up oil prices significantly above the level justified by the “fundamentals,” especially if they wanted to make it a “sure thing.” Even though they apparently gained control of two-thirds of the excess Cushing inventory, these traders only made $50 million from the scheme. That’s a lot more money than I made in 2008, to be sure, but it can hardly explain giant movements in the world price of oil.

Speculators Perform a Useful Function in Markets

As I have explained in previous posts, speculators perform a useful function in markets. To the extent that they correctly anticipate future price movements, they actually dampen the volatility in the spot price. This is obvious: Speculators earn profits when they buy low and sell high (or short-sell high and cover low). So if a commodity such as oil will have a price rise in the near future, speculators start pushing up the price now in anticipation. Conversely, if a commodity is current overvalued (in the sense that it will drop in the near future), then successful speculators start the process right away by selling.

The twist in the current story is that (allegedly) the traders were dabbling in both the physical and futures markets. So it’s true, their “speculative” trades smoothed out prices. However, one could argue that their buying and selling in physical crude actually introduced far more volatility in the spot price than their futures trading softened.

This may seem a pedantic point, but it’s important for people to understand the role of futures markets. To say it in other words: It was not their “speculating” on futures prices that actually caused the volatility in oil prices, but rather their accumulation and then dumping of the physical crude. (Of course, the reason they allegedly acted this way in the physical market, was because it allowed them to earn speculative profits in the futures market.)

Now for the tough question: Was there something illegitimate economically about hoarding and then dumping physical crude inventories? According to the various press accounts, I have not seen any allegations of actual fraud on the part of the traders. For example, they didn’t buy the oil, blow up one of their warehouses, and then falsely tell the police, “We lost all of our oil in the blaze.”

No, it appears (on the basis of the press accounts) that they simply purchased large holdings of physical crude, and others in the market assumed that the oil was being used for refining or other purposes. It was thus a surprise when the oil was dumped back into the market at the end of January, a few weeks later.

To repeat, to the extent that this “trick” really worked, it didn’t change the long-term price of oil (or gasoline). The $50 million profit reaped by these traders would have come largely at the expense of other oil traders (not average consumers) who were caught with their pants down both on the way up and on the way down in the futures market.

Going forward, savvy competitors presumably would have tried to avoid such a trick in the future. If they saw an apparent tightness in the Cushing physical market, they would think twice before pushing up the futures price, since it might come crashing down a few weeks later. People can’t simply make $50 million automatically, month after month, in the commodities and futures markets, the way the critics seem to think. Other speculators would adapt and quickly stamp out such opportunities.

The problem with giving government regulators the task of stamping out such “anti- social” trading is that they will mute the ability of the market to respond to genuine threats of crude shortages. Because of the lawsuits, oil traders will be less willing to acquire physical inventories even if they believe the fundamentals justify a rising price over time. Such traders would be afraid that the government would accuse them of causing the movement in prices, even if they were genuinely just trying to anticipate it.

Conclusion

So long as they don’t use violence or fraud, people in a market economy generally make profits by serving others. This is easy to see in the cases of successful entrepreneurs like Bill Gates or Oprah Winfrey. It’s not as easy to understand when it comes to successful traders in the futures market, but the presumption is still present. Whether or not the defendants in the recent CFTC case actually broke the law, the charges against them will weaken the market’s ability to adapt to future supply and demand conditions in the oil industry. Finally, people should always keep in mind that speculators drive prices down in response to good news. When President George W. Bush announced the end of the Executive Branch moratorium on offshore drilling, oil futures prices fell $9 during the speech.

With gas prices still at a sky-high average of $3.84, Americans are getting squeezed at the pump.  But the pain doesn’t just stop at the gas station – rising energy costs affect the price of almost everything that we buy.  If this challenge is not properly addressed, the American economy will remain at risk of another job-killing recession. 

Fortunately, our nation holds the key to solving this challenge.  According to the Congressional Research Service, America is home to the largest fossil fuel resource base in the world.  With such vast domestic energy resources, we have the ability to immediately decrease the price of oil and, consequently, the price of gasoline.

In order to lower prices at the pump, Washington needs to do only one thing: get out of the way.  America’s oil and gas resource are being held hostage by Washington.  As a result, billions of barrels of oil currently lay idle while increasing global demand is causing oil prices to rise.

“Markets respond to future expectations,” said Thomas Pyle, president of the Institute for Energy Research.  “In 2008, the price of oil dropped over $9 per barrel as President Bush announced the end of the executive moratorium on drilling in the Outer Continental Shelf.  The price dropped again after Congress reluctantly let their moratorium expire.  If Washington makes a real commitment to increasing access to America’s 155 billion barrels of oil, the price would respond even more dramatically than in 2008.”

“The United States is the third largest producer of oil in the world, yet our domestic production is set to flat line as the developing nations of the world are demanding more and more oil to fuel their growing economy.  Our only hope for remaining competitive in the global marketplace is to increase production of domestic energy so that we rely less and less on state-owned energy companies from unstable foreign regimes,” said Pyle.

Check out IER’s Gas Page to learn more about what’s driving high gas prices and how we can solve this problem.