Why the Price of Oil Will Not Rise?

The price of oil after reaching nearly $50 per barrel in mid 2016 is rapidly descending to a level below $40 per barrel. The pundits explain this as a problem of Supply and Demand. Supply and Demand is the catchall phrase popular among followers of Keynesian Economics, but it is a superficial explanation. Supply and Demand does not incorporate the thousands of factors that compose the market system. Supply and Demand does not recognize the importance of the two actors in every purchase and sale decision. In every transaction there is a buyer and seller. There is only a completed transaction if the buyer is happy with the offered price and the seller is happy with the given price. Each party has the option of refusing the price offered. The strength of the negotiators will determine the direction of prices not Supply and Demand.

Certainly, the competitive environment can affect the negotiating position of one party over another. The seller will find it difficult to negotiate a high price when other suppliers offer lower prices, but that is not Supply and Demand. That is competition. There is competition, because other suppliers have product they want to sell. Oil sellers would be wise to recognize this competitive environment instead of just throwing up their hands in disgust, they should develop strategies to deal with their competitors. Most products on planet earth exist in a competitive environment. Oil is not unique.

Why is the oil industry so handicapped? One reason is the oil industry origins are not as entrepreneurial as most industries. The oil industry grew out of a monopoly environment where there was no competition. Second, today most of the largest oil companies are government owned, and so vital to their country's economy that they must sell under any conditions. This requirement makes negotiation impossible. This is where much of the world's oil industry finds itself. This situation is not hopeless. It requires creativity, a characteristic not often found in the oil industry.

What can the oil industry do to level the negotiating field? First, leave the field. The industry should seek to find more niche markets to sell in. Instead of the large customers getting price breaks divide the sellers up into smaller segments and sell directly to them at the higher prices they pay to their suppliers. Second go down the supply chain and provide more refined products. Instead of just selling crude oil look at selling partially processed oil that allows smaller and more specialized refiners to buy. This increases the competition for the product and raises prices.

Just one more example. The best strategy for sellers is to refuse to sell at low prices, but how is that possible in the oil industry? One way is to use a financial option to fund the holding costs of the product. Simply leave the oil in the  ground and sell an option to deliver it at a set price (higher than the current market price) one year from today or two years from today. Obviously, these options can not be written for more oil than purchaser's are demanding so it requires some wise constraint.

One last thought, before I move on to another topic. Countries should consider establishing oil banks, storage facilities that serve as security for national currencies. I would certainly prefer having my currency backed by oil rather than a promise to pay or gold. After all, oil is black gold.

Oil seen through Supply and Demand

Gas prices continue to slide. Prices have now gone below the cost of production. Why doesn’t the Law of Supply and Demand intervene and allow prices to rise? Is there something wrong with the market system? Clearly, there is more supply than the market needs. Clearly, there is less demand than there is supply. Why do these factors not equilibrate like Keynes told us they would? What is going on here?

I suppose if I told you Keynes is wrong you would stop reading, so let me put it this way. Keynes neglected to mention the importance of a "normal" market for the proper functioning of supply and demand factors. Let’s look at the special cases in a market. You know when a market is dominated by a single large supplier, it is a monopoly. In a monopoly supply and demand do not equilibrate. You know when a market is dominated by a small group of suppliers, it is an oligarchy. Again prices do not equilibrate. You know when there are many suppliers and many demanders it is a "normal" commercial market. Keynes states in such a situation prices will equilibrate. The oil market has many suppliers, but they are not all equal. What happens under that circumstance?

The purchase and sale of crude oil operates in an unusual market. It is a type anti-oligarchy where most participants do not operate in a "normal" standard commercial market. Most of the big oil companies are not companies at all, but surrogates of their government. They do not follow the rules of private companies. They do not need to make a consistent profit to operate. Keynes did not understand the importance of profit. In lean times like these, quasi-government companies will borrow money or seek other concessions from their government to remain operational and producing product. Since in most countries oil is taxed on a per barrel basis governments are not concerned most about profitability, but only the quantity of oil produced (when oil is taxed on the amount produced). Keeping production high is the demand of governments. Making a sizable profit is not their concern. It is barrel count that matters. Or rather it is all about maintaining the tax basis. Oil in the oil patch is not a business, but the primary method for states to obtain tax revenue. The state's revenue is the most important factor guiding operation of the oil patch, not some company's desire for a profit. Consequently, the rule of Supply and Demand is corrupted.

The point is without a necessity for profit a government organization can operate with impunity outside normal commercial channels, so there is no pressure to conform to the pressures of Supply and Demand—or a normal commercial market. Supply and Demand does not operate in this corrupted market environment.

Why does Supply and Demand only work in a market environment? It is profit. When there is a profit constraint on an organization the rules of Supply and Demand come into play and restrain production. If your goal is to make a profit you cannot operate when that is impossible. Those parts of the world with a normal commercial market will be the first to slow the production of oil. Other parts of the world where oil is produced by a quasi-government organization will be slow to act. This mix of private companies and quasi-government organizations will prevent market forces from acting to equalize Supply and Demand. This is a good example of why countries would be wise to outlaw the operation of businesses by government. It is also why oil prices will rise first in the United States where a true market exists.

Oil seen through Supply and Demand

Gas prices continue to slide. Prices have now gone below the cost of production. Why doesn’t the Law of Supply and Demand intervene and allow prices to rise? Is there something wrong with the market system? Clearly, there is more supply than the market needs. Clearly, there is less demand than there is supply. Why do these factors not equilibrate like Keynes told us they would? What is going on here?

I suppose if I told you Keynes is wrong you would stop reading, so let me put it this way. Keynes neglected to mention the importance of a "normal" market for the proper functioning of supply and demand factors. Let’s look at the special cases in a market. You know when a market is dominated by a single large supplier, it is a monopoly. In a monopoly supply and demand do not equilibrate. You know when a market is dominated by a small group of suppliers, it is an oligarchy. Again prices do not equilibrate. You know when there are many suppliers and many demanders it is a "normal" commercial market. Keynes states in such a situation prices will equilibrate. The oil market has many suppliers, but they are not all equal. What happens under that circumstance?

The purchase and sale of crude oil operates in an unusual market. It is a type anti-oligarchy where most participants do not operate in a "normal" standard commercial market. Most of the big oil companies are not companies at all, but surrogates of their government. They do not follow the rules of private companies. They do not need to make a consistent profit to operate. Keynes did not understand the importance of profit. In lean times like these, quasi-government companies will borrow money or seek other concessions from their government to remain operational and producing product. Since in most countries oil is taxed on a per barrel basis governments are not concerned most about profitability, but only the quantity of oil produced (when oil is taxed on the amount produced). Keeping production high is the demand of governments. Making a sizable profit is not their concern. It is barrel count that matters. Or rather it is all about maintaining the tax basis. Oil in the oil patch is not a business, but the primary method for states to obtain tax revenue. The state's revenue is the most important factor guiding operation of the oil patch, not some company's desire for a profit. Consequently, the rule of Supply and Demand is corrupted.

The point is without a necessity for profit a government organization can operate with impunity outside normal commercial channels, so there is no pressure to conform to the pressures of Supply and Demand—or a normal commercial market. Supply and Demand does not operate in this corrupted market environment.

Why does Supply and Demand only work in a market environment? It is profit. When there is a profit constraint on an organization the rules of Supply and Demand come into play and restrain production. If your goal is to make a profit you cannot operate when that is impossible. Those parts of the world with a "normal" commercial market exists will be the first to slow the production of oil. Other parts of the world where oil is produced by a quasi-government organization will be slow to act. This mix of private companies and quasi-government organizations will prevent market forces from acting to equalize Supply and Demand. This is a good example of why countries would be wise to outlaw the operation of businesses by government. It is also why oil prices will rise first in the United States where a true market exists.

Keynes belittled famous Chinese economist

Many of you have read my article about how Keynes belittled Jean Baptiste Say and Market Economics. Keynes built his reputation by dismissing his rivals. Keynes also belittled the most famous Chinese economist, Fan Li, the first scholar to engage in economic analysis. Keynes when asked if he knew about Fan Li's theory stated he did, "Buy low, sell high." Keynes was ahead of his time. He twice misstated a rival's economic views to belittle them and by inference advance his own theory. This is precisely the technique employed by today's media economists to promote their viewpoints.

Let's spend a few moments looking at some of Fan Li's ideas and see if he deserves to be dismissed. We should use his proper Chinese name, Tao Zhu Gong, in this discussion. First, we should acknowledge that Tao Zhu Gong's ideas are still studied and applied in China and Chinatowns throughout the world with great outcomes. Whether it is Singapore, Mumbai, Dubai, New York, London, Paris or San Francisco, Chinese business people are highly admired for their expertise. This expertise is founded on principles first expressed by Tao Zhu Gong. His ideas stressed that an entrepreneur should be decisive, but cautious in borrowing, never procrastinate, but be flexible and accommodate change.

Many of Tao Zhu Gong's business principles seem very modern. He emphasized being sensitive to customer wants and needs. In the 1980s Michael Porter's five forces theory was seen as the basic tool of business management. The idea was that a firm's survival rested upon defending against competitive forces. One of those forces was the power of customers to switch loyalties. It took companies like Walmart and Costco to deliver customer's desires for quality and low price to reveal the flaws in Michael Porter's model and support the basic ideas of Tao Zhu Gong. Walmart and Costco became the model for "customer-oriented" product offerings and "single-minded" in their determination to control costs (Tao Zhu Gong ideas in quotes). Apple is another company that followed the path Tao Zhu Gong set out, "Be captivating in your sales promotion." Their TV advertisements sticking it to the IBM machine followed this Tao Zhu Gong dictum. Amazon is another company that achieved great success by following another Tao Zhu Gong's dictums, "Be selective to recruit only the best." Amazon is well known for seeking the best people.

The loyal followers of Keynes and Marx spend all their time trying to justify why their leaders economic pronouncements did not meet with success when implemented. On the other hand, followers of Tao Zhu Gong and Jean Baptiste Say can list thousands of examples of real world success and draw a straight line from a modern example to one of the principles of the Tao Zhu Gong.

Government Investment

One of the great ironies of foreign aid is that it creates poorer countries. The assumption of foreign aid is that the government of the receiving country can make an infrastructure 'investment' that will pay dividends. But as we look around the world we cannot find any examples of that happening. In fact, most of the time the foreign money is diverted into the pockets of corrupt politicians and placed in remote banks were the funds remain on account. Where the funds are not lent or used to expand bank borrowing in the deposit country, but simply left to be slowly eroded by fees or spent on luxuries from the donating countries.

Even when the funds are used for road construction or bridge building it does not help the receiving country since the contractors are either government agencies or private companies owned by politicians. In the first case the funds are not an investment since the government does not pay a dividend on the expense. An investment is an expenditure that makes a return in future years. In the case of a bridge built by a government agency the cost will be excessive since it is necessary to feed all the government leeches that will need to be nourished and the techniques used to construct the bridge will need early replacement and early maintenance. Government contractors have no motivation or incentive to be efficient or maintain high quality standards.

In the second case of a hand-picked private contractor there are still fewer incentives to be efficient or maintain high standards. The focus in this situation is to hide their crime and loot the project as early as possible. Consequently, the project team is concerned with falsifying documents and bribing regulators to file false reports.

A private investment achieves an economic push that is not possible with a donation to a government agency. On the other hand, a private investment puts money into a local bank to make more private loans and fund secondary projects that can sustain a tax-paying cash flow for bridge maintenance.