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.

World's First Economist

An imaginary conversation with Fan Li

“Okay, what is your best idea?” I inquired of the ancient sage.
“Suspenders.”
“What?”

“Things that work. Suspenders hold up pants. Most economic concepts don’t hold up anything. They need the support of facts, authorities and long-winded explanations. If support exists at all it is usually a contentious balancing act or a weak link.

“That is why I like Chinese and Market Economics. Chinese Economics is taught like Geography. In a Geography class you learn the names of countries. The name is never in dispute or requires a proof. Names are facts. The location of cities, the length of rivers, the height of mountains, and the depth of lakes are all facts. The price of Barbie dolls, the amount of milk fat in a dairy product, the make of new cars sold at the local dealership, the weight of a sack of flour are all facts. The western economic approach is composed of equations and concepts: supply and demand, velocity of money, natural rate of unemployment, monopoly, Income Elasticity of Demand, equity, assets, returns, etc. All these concepts are subject to interpretation,” Fan Li explained.

Fan Li is considered the first economic thinker. He lived south of modern day Shanghai in the 6^th century B.C. near an area of fresh water lakes and lowland agriculture. Unlike the western economic tradition that looks at people as equal and similar acting, Fan Li emphasizes knowing and evaluating customers and suppliers. This gets to the issue of which customers will be granted credit and which will be denied credit. Fan Li states each participant in an economic activity should have their character evaluated. A business person should have the “ability to know people's character. You must perceive evidence of characteristics from experience.” This gets to the idea of whether a person can fulfill the commitment they are making. The western tradition is based on social rights and the legal system’s interpretation of those rights. Does the person have the legal right to enter into a contract? Whether the person can fulfill the contract is left to the party making the contract.

I think you can see where the western tradition leads to trouble like occurred in the Housing Bubble of 2007. Loan originators looked only at the market to see whether they could sell the loans they were originating. The originators felt their responsibility extended only as far as ensuring the loans met the legal requirements of HUD and the GSEs. In the Chinese tradition begun by Fan Li the originator would evaluate the character and ability of the borrower to repay the loan. If such an approach was applied in the United States between 2004 and 2007 there would have been no Housing Bubble.

Fan Li’s system involved evaluating each borrower. This is the way the western tradition began, but it was subverted when the state stepped in to expand the qualifying pool of people. The government’s actions to set qualification hurdle tests destroyed the individual evaluations that Fan Li and early bankers established. Removing this step from the loan qualification system removed the support of reasoned evaluation from the loan portfolio. Everyone was evaluated according to an inflexible set of standards established by HUD. HUD relaxed the qualification hurdle to include groups of people who lacked financial maturity. The result was a built-in failure rate like a circus clown wearing trousers six sizes too big without suspenders. Exposure was guaranteed.

Poverty

Help me out with something. I think poverty can be solved with jobs. Am I a naive selfish right-wing bourgeoisie? Well, not entirely. Maybe I should let you decide. I spent part of my childhood in a public housing project called Rainier Vista in Seattle. We had our own school in the project. I assume so we would not contaminate the strain of people who could pay market rents.

My First Grade school yard was a 50' x 50' fenced enclosure about the same size as the chimp enclosure at the zoo, but without the elaborate play equipment or high fence. Escape was tolerated after check-in. Our teachers explained to us numerous times throughout the year that if we were not in class when attendance was taken the state would not pay the school. It worked on me. I had a job to do. I was there every morning at 8:10 to be counted. Perfect attendance. I was learning. I was surely on the path to college.

I learned other skills. I learned to tell time, so I would know how long I had to wait for recess. What I didn't learn in class I more than made up for with the learning experiences at recess. On the playground the girls played hop-scotch on the paved half, and the boys played marbles on the dirt half. All the boys played marbles in circles scratched into the dirt. My family was too poor to buy a sack of marbles, and I was to shy to ask anyway. One day my friend, Jerome, and I were digging around the drain cover at the edge of the playground when we got the cover loose. Inside half buried in the mud we found six marbles. We split the loot. Over the next couple of months I watched the other boys play on the dirt patch and practiced on the carpet at home. Carefully I started to play at school and did surprisingly well. I eventually had a lunch sack of marbles, maybe two pounds of glistening round gems. I even named a couple. My books stayed at school, but my marbles traveled everywhere with me. Then one spring day an older boy walked on to our schoolyard and challenged me. He was good. He could balance a marble on his thumb, use his fingers to rise above the dirt circle and send the marble through the air striking a pack of sleeping marbles in the center of the circle. I used the typical grade school technique with a shy marble poking out from a curled fist cave like a hot dog sticking its head out of a bun. I lost two things that day; all my marbles and my confidence. I learned a lot on the playground and nothing in the classroom where I specialized in coloring, tracing and keeping my head down, so I wasn't called on.

But did I learn about poverty? Not really, I was too young to understand what was happening around me. What I did learn about is want and disappointment. These are the scars of poverty. My stupid question to you is this: Do the poor want free medical care, food subsidies, transit subsidies, good condition used clothes, or do they want the ability to support themselves? Do they want some of your money, or do they want their own money?

Humor me. Assuming poor people want their own money, how would you go about that? Would you have the government create more jobs. Recognize if the government does that, it would be a huge expense to you. It might put you and your children in debt for the rest of you life and their lives. And then how would you pay off the debt? Government's only source of revenue is taxes. Each paycheck government will take a little of your earnings to repay the debt. There is a way to avoid dying a pauper. To keep the government out of your pockets, the business sector has to create the jobs and pay the salaries. Think about it. Do you have enough extra money to pay another person's salary? The business sector is the only sector that can afford it. They have a trick to create new money. They use new ideas to create new jobs, and profit to pay for those jobs. The two horrible P's, profit and productivity allow the business sector to provide jobs without taking our money. They do it by providing services and products we want to spend our money on. Instead of kicking and screaming when the government takes our money, the business sector can get us to give up our money willingly. Somehow by making me happy with new products and services, business is able to provide jobs to the unemployed.

Okay you say, but that is not always the case. Sometimes the economy is too weak to support new businesses. What can we do in that case? Appeal to the government for help?

That is a blind alley. The government is not a source of solutions. Government is simply a source of funding. New ideas must originate outside of government. They must have a private sector structure.

Government should be an reservoir of needs. The government can poll their constituents for a list of services or products that they want. For example they might state they want childcare for two hours after school. The next step for government would be to seek solutions from the business community, simply asking the business community how to solve this problem with a private sector solution. The government can require that a certain percentage of employees come from the ranks of the unemployed. The government can require the business firm use only private sources of funding. Maybe, the firm can get some funding from Kellogg's to test taste new cereals? Maybe, Mattell will pay to test some new games? Maybe, Randomn House will pay to have the children rate different books? Maybe, Amazon will pay to wear test some clothing? Maybe, Safeway will pay to test some vegetable dishes and teach a class on nutrition? I can imagine an entire curriculum developing from private sector involvement.

Here is another example. Citizens might ask for more drug abuse councilors. A private company could step forward to train unemployed people to work as councilors for their company in exchange for the education. The government could sweeten the burden on the training company through tax credits that the company could sell.

So what am I proposing? A system that uses a private company to provide a service or product and reduce the government's burden to provide these services and products to their community. The initial operating costs (tax rebates) might reduce tax revenues over the short term, but overall if structured properly the tax revenue and income from new workers is going to expand the economy and increase the overall wealth in the private sector. Public sector financial burdens should be reduced. It is a true win-win.

If this technique is employed properly by government, the bidding for service and product supply rights could become a source of revenue. Imagine bidding out security services at airports, or ambulance services, or taxi services, or even fire protection services. Huge national companies will develop providing thousands of jobs with world class performance levels. All this paid for by the users of the services, reducing the administrative costs and tax collection bureaucracy of government. Win-win.