The oil price is just plain wrong

January 5, 2015

The price sign outside Costco in Westminster, Colorado, shows gas selling for $1.81.9 for the first time in years

The oil price is still too high, often too low and much too volatile. In other words, this is a market that doesn’t work well for anyone.

The excessive volatility is glaringly obvious. The 50 percent price fall since June is extreme, but the market is only occasionally calm. Since 2000 the daily price has been on average 18 percent higher or lower than six months earlier.

Such variation is uncalled for, especially given the fairly modest shifts in demand. Since 1990, the annual change has never been higher than 3 percent. On the other side, the average cost of supply moves very slowly. Only modest adjustments in inventory and production rates are required to keep the price stable, as the market showed from mid-2011 to mid-2014.

The sharp shifts are as harmful as they are unnecessary. The world can handle any fairly stable price but rapid dramatic changes turn good investments bad. For example, if the oil price stays below $60 a barrel, much of the money spent on developing U.S. shale oil will have been wasted. Conversely, the sharp rise in the mid-2000s devalued energy-inefficient investments which made good sense when oil was cheap.

Of course, the actual price matters. The behaviour of producers of both oil and rival sources of energy should change along with the cost of crude. So should the spending patterns of industrial and household customers. In a world of cheap crude, high-cost oil wells remain untouched and gas guzzlers are economical. When oil is costly, electric cars look better and deep sea drilling makes sense.

The overall global economy gains from having oil as cheap as possible. Anything else is a waste of resources. From that perspective, the current price is still far too high. The production of unnecessarily expensive oil wastes skilled labour and sophisticated equipment. Oil-importing nations end up paying more than they need to for crude. The financial world is troubled by the cross-border cash flow. Exporters gain cash, but high oil revenue often leads to poor governments and weak non-oil economies.

The price could be much lower if more production came from the most efficient fields. No one really knows how much lower, because Saudi Arabia and some other producers with ultra-low cost unused resources have decided not to exploit or explore them aggressively. Still, there is no good reason to think that more than $30 a barrel is needed. That was the annual average in the 1990s, adjusted for inflation, following the calculations of the U.S. Energy Information Administration.

The price for producers is one thing; the cost for consumers is something else. There are good reasons to charge far more than the cost of production. Oil is a non-renewable resource which pollutes as it is used up, and dependency on imports, however cheap, brings political risk.

The correct price for users should be just low enough to keep cars on the road but high enough to restrain usage and to encourage the development of currently more expensive but ultimately more attractive alternative sources of energy. There is no way to calculate the precise optimal price, but the policies in Europe and Japan – taxes account for about 60 percent of the petrol price at the pump – are on the right track.

The United States is an outlier with its low 15 percent tax rate on gasoline. That is clearly too low to give strong incentives for conservation and investment in renewable alternatives. The U.S. government does have many regulations to prod industry in desired directions, but higher taxes speak particularly clearly.

In an ideal world, the price of oil for producers would be lower and more stable than today, while the average price for consumers would be higher and more stable. The world will never be ideal, but oil pricing can be improved.

The best way to get an appropriate producer price is through a weak cartel. Producers should be just disciplined enough to keep the price stable, but too ambitious for market share to allow prices to rise enough to draw in frivolous investments and destructive overproduction. Happily, something like that may be on the way. The recent decision by Saudi Arabia to hold onto its market share, cost what it may in oil revenue, is a step in the right direction.

The best way to keep consumer prices at a sufficiently high level is to let the tax rate on oil vary along with the producers’ price for crude. The recent oil price drop provides an excellent opportunity. Consumers would hardly notice if the price of fuel did not fall, and most governments would welcome the additional tax take.

Unfortunately, governments are more anxious for short-term stimulus to consumer demand than for a sensible long-term approach to energy pricing. The opportunity will almost certainly be wasted.


PHOTO: The price sign outside Costco in Westminster, Colorado, shows gas selling for $1.81.9 for the first time in years, Dec. 23, 2014. REUTERS/Rick Wilking


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“The sharp shifts are as harmful as they are unnecessary. The world can handle any fairly stable price but rapid dramatic changes turn good investments bad.”
The sharp shift downward in prices is intended to be harmful and punish investors. The intent of the Saudis and the small Gulf states is to destroy potential competitors and teach a lesson to investors in not only the shale investors but also investors in alternative energy sources and energy saving.

Posted by QuietThinker | Report as abusive

“The intent of the Saudis and the small Gulf states is to destroy potential competitors” Such as Iran? The Saudis are punishing Iran and Russia as well due to the Syrian and Iranian issues.

Posted by smokeymtnblues | Report as abusive

In the “ideal world” there would be no taxes on oil products

Posted by 23rmfowmef | Report as abusive

What about diesel prices? Oh wait .

Posted by deerecub1977 | Report as abusive

if if stops tar sands oil, the price is right

Posted by harrykrishna | Report as abusive

When the USA cracks fusion there will be a worldwide panic as nations with oil-based economies collapse violently.

Posted by Factoidz | Report as abusive

“The United States is an outlier with its low 15 percent tax rate on gasoline. That is clearly too low to give strong incentives for conservation and investment in renewable alternatives.”

The tax on fuel in the U.S. is an absolute amount per gallon, not a percentage. As the price per gallon falls, the tax per gallon stays the same, so the tax measured as a percentage is actually RISING. The average tax is about 50 cents per gallon, so as the price has fallen from $4 to under $2, the percentage of tax has gone from 12.5% UP to 25%. And with increased consumption brought on by lower prices, government revenue collections from the fuel tax will also increase.

Posted by Randy549 | Report as abusive

I for one am happy to see lower gasoline prices. The High prices have been “sucking” the lifeblood out of our economy. When gasoline costs become a much lower percentage of our disposable income, we have more money for other necessities and even luxuries. While the oil companies are crying gloom and doom, I see that their profits are still very high.

Posted by Robert76 | Report as abusive

Steep rises and precipitous declines in price for the energy commodity we are most dependent on destabilizes our economy for sure. Our leaders however are not here to stabilize our economy. They are here to accomplish what the highest bidder demands they accomplish. The typical American is also too ignorant to know what a good energy policy is so the crafty media industry can manipulate the conversation to confuse the majority of people. Good leadership in an almost democratic society like ours depends on an educated populace and thus we are in some really deep cow manure here, because electorate of the US are extremely dumb. Allowing ourselves to become singularly dependent on a resource we do not primarily control is a weak an idiot path. A path we seem destined to remain on since the energy industry itself is so profitable that they have the biggest pot of money with which to buy our politicians. We are also too weak to invest in alternatives and too weak to reduce our consumption because the TV tells us that frivolity and ignorance are our birth rights as americans. The point I am trying to make is that we have choices, but the conversation allowed in the public largely says that we don’t, but clearly that is because the oil industry can buy reporters and politicians to say anything and the typical American cannot think critically about anything. We can choose a different path, but we don’t because we are frivolous and weak and hate work and we listen to the lessons from the TV and as good slaves we do what the masters want, just like Rush instructs us.

Posted by brotherkenny4 | Report as abusive


Posted by Hermist | Report as abusive

Now is the time for a carbon “fee” to reflect the true cost of carbon emissions. Just as fossil fuels were subsidized, the development of alternate energy sources should proceed despite temporarily “cheap oil” so that we can make the transition smoothly to a sustainable economy and a viable environment. Our children and grandchildren will thank us.

Posted by robnbc | Report as abusive

Raising taxes on fuel like in Europe is absurd. The money is squandered to run its socialistic lifestyle…paying for healthcare,low cost housing and so forth. Eventually we will run out of oil…but not yet. T. Aziz had a great suggestion in his day when he suggested $70 a barrel..All of you speculators and Jews has in mind was personal greed. You have made your money. Now leave us poor people be.

Posted by markerwis | Report as abusive

“…consumers will pay too little for a rational economy….”?? We’ve been paying what the consumers have been willing to pay by the industry pushing prices until consumption declined. We have survived without any significant inflationary after effects. Is OPEC maintaining production to force out the recent domestic production? Well, eventually we will see who blinks first. Personally, I believe the Alberta tar sands and domestic production will bury OPEC.

Posted by norcalguy101 | Report as abusive

“Ideal World” Every market is manipulated! We live in a world devoid of capitalism and democracy. Free markets no longer exist. Reckless Keynesian central bank interventions have destroyed all market and risk pricing mechanisms. As far as oil goes, lets watch all the HY bonds default – or will the Fed’s moral hazard mandate allow a “secret” bailout? Euro-zone 10-yr bonds trading below 1% is insanity when many of these countries are insolvent. All ponzi schemes end badly and this one is no exception. Prepare accordingly.

Posted by PlanetPonzi | Report as abusive

This piece is what happens when economics is subordinated to collectivist ideology.

Posted by smartnic | Report as abusive

The only reasonable tax on oil in the United States would be an export tax. Oil leaving the US should be taxed to raise its prices.

Posted by WestFlorida | Report as abusive

Poor oil companies.

Posted by AlkalineState | Report as abusive

This man’s idea of the “correct price” would be considered monopoly pricing and is designed to produce huge profits through overpricing in order to encourage the development of uneconomic energy sources. That is an absurd idea all around. I assume he wants the government to dictate prices by law to gouge the American consumer. I’m sure Putin would approve, but I don’t.

Posted by MassResident | Report as abusive

@MassResident, where does the writer say that?

Posted by AlkalineState | Report as abusive