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.