Sunday, January 4, 2009

The Road to Utopia Isn't Paved with Higher Gasoline Taxes

Wow, that was quick. It's been all of 3 months since gas prices have fallen below $3 a gallon, giving consumers a much deserved break in their pocket book, and already the calls for a large gas tax are back.

Leading the way is Charles Krauthammer. Writing in the Weekly Standard, he suggests that we increase the tax on gasoline by $1 per gallon, or as much as is needed to reduce the number of miles the average American drives. He never does gets around to telling us just how big of a reduction is needed in order to achieve all the wonderful, societal, and geopolitical benefits that will flow from the further taxation of the already over-taxed American people. These benefits range from stopping global warming (which he admits to not believing in) to taming the evil ambitions of Russia, Iran, Hamas, Hezbollah and Venezuela.

Don't get me wrong. I have a great deal of respect for the man, and I actually like his idea of reducing the out sized income flows pocketed by the non friendlies of the world due to high oil prices, but there is a better way to go about it, and it doesn't include a single dollar of additional tax. Instead, let's stabilize the value of the dollar at, say, $500 per ounce of gold. If we do, we can get back to the steady eddie oil prices and ultra low inflation we enjoyed from the mid1800's right up until we severed the dollars link to gold in 1971. The volatility in the price of oil that has occurred since the US decided to float the dollar is amazing. Have a look at this chart and see for yourself.

The seesaw of higher, then lower oil prices is, to a great extent, caused by changes in the value of the US dollar and it's effect on the supply of oil, which ultimately effects it's price, and to a lesser extent on the ebb and flow of the global economy effecting demand. Oil is priced in dollars. Change the real value of the dollar and you change the nominal price of everything denominated in dollars, including oil. This is what Charles and the folks at the New York Times just don't, or won't understand. It was the rise in the value of the dollar from 1997 through 2001 that set the stage for the oil price increases of the 2006 - 2008.

Producing oil is a long lead-time business, which starts with exploration to find what you think are oil deposits. Then, there are the various permitting processes to acquire the right to drill. Finally, you drill the actual wells to determine if what you thought was oil really is, and if production in commercially viable amounts is possible. Commercial viability is dependent upon the price of oil and the recoverable quantities available. It is the role the dollar plays in both the price of oil, and what amounts can be recovered profitably based upon that price, that makes the oil business such a high stakes gamble.

Let's imagine for a moment that you are the oil company executive in charge of drilling and production. The year is 1999, and you are watching two related events that are shaping your companies' decisions on oil production. These events are the rise in the value of the dollar and fall in the price of a barrel of oil.

Over the last two years you have watched as the US dollar increase in value by about 30%, pulling down the price of a barrel of oil from $21 to $13, causing your revenues to plummet.

Ask yourself this question: Just how many additional drill sights am I going to want to pour millions of dollars of my companies' capital into, looking for new reserves? Short answer, not many. Longer answer, the worldwide rig count average fell from 2128 in 1997 to 1457 in 1999, and the rig count didn't recover to the 1997 levels until 2001. That's a whole lot of oil wells that didn't get drilled.

What do you think happens when oil companies all over the world reduce the number of new wells they drill? That's right, the supply of oil is greatly reduced, and by more than might be obvious at first.

The decreased number of newly drilled oil wells and the reduction of their flush production ( production higher then the sustainable trend), along with the inevitable decline of older producing wells acted as a cut in oil production. This intensified the supply problem caused by the “drilling holiday of 1997-2001”.

This makes for a world oil market in which inventories are extremely tight, and small increases in demand produce disproportionate increases in price. When the central bankers across the globe, led by our Federal Reserve, poured liquidity into the global economy, the resultant boom sent gold and oil prices rocketing skyward, until we reached new all time highs for both of these commodities.

Attacking a supply problem from the demand side, through a high tax on gasoline isn't the right path to start down. It's actually the Left's road to never ending tax increases on gasoline curtailing your freedom to travel. The real problem is an erratic Fed and it's up, no wait, it's down dollar policy, a policy that helped restrained drilling in the 1990's and created the liquidity fueled growth of the 2000's.

Would we be where we are today if the Fed had maintained a stable dollar monetary policy? Is it possible to add too much liquidity, and at the same time maintain a stable dollar? The answers are No an No! Does the price of oil rise or fall dramatically when the goal of monetary policy is to provides a stable dollar? Again, the answer is no! Is inflation a problem when the dollar is stable? You already know that answer, and it is a resounding No! Do we need to increase the gas tax to implement a monetary policy which stabilizes the dollar? Of course we don't, so why haven't we stabilized the dollar? That's a great question. You should ask Uncle Ben.

1 comment:

Jeff Lehner said...

All fine points, plus there's also the question of whether or not government should play such a role in energy markets as that which those who push for higher gas taxes often advocate. Nothing free market about massive tax hikes to change behavior; an advocate of higher gas taxes for this purpose is no free-marketeer.