Monday, May 16, 2016

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.

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