Sunday, October 8, 2006

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What is the utility of price stability?

In the Detroit Free Press, Alejandro Bodipo-Memba has an odd story about OPEC's declining influence over oil prices -- and why this might be a bad thing:

But as the price of crude oil -- the feedstock for gasoline -- creeps back up on news that several members of the Organization of the Petroleum Exporting Countries plan production cuts, it's clear that the cartel no longer wields the power over fuel costs that it once did.

For instance, recent announcements by OPEC members Nigeria and Venezuela that they plan to cut their combined production by 170,000 barrels a day in order to push oil prices back above $60 a barrel did not alter the per-barrel price.

For Michiganders, the diminishing power of OPEC has two key implications.

"In some sense, this is a good thing in that you are taking power away from an oligopoly like OPEC and lessening the influence the group has had on U.S. foreign policy," said Sudip Datta, finance professor and chairman of the T. Norris Hitchman Endowment at the Wayne State University School of Business Administration.

On the other hand, with no consensus among the world's leading oil producers, supplies fluctuate and domestic fuel prices are adversely affected.

Oil prices more than tripled from an average of $21.84 a barrel in 2001 to a record high of $78.40 in July. Meanwhile, pump prices in Michigan more than doubled to $3.11 a gallon this summer, as OPEC continued to cede its power to speculators in the petroleum market. Barring a major supply disruption because of a hurricane or an accident this fall, gas prices are expected to stay at $2 to $2.25 a gallon, according to the Energy Information Administration in Washington, D.C.

Part of OPEC's stated mission is to "coordinate and unify" global petroleum policies and "ensure the stabilization of oil prices" to provide a steady supply of product at a fair price.

The 11-member oil cartel said on its Web site that oil prices were "out of line" with supply and demand fundamentals. It also acknowledged that its influence over petroleum pricing was increasingly limited....

From 1975 to 1990 and the start of the Persian Gulf War, the price of imported oil rarely got above $32 a barrel and Michigan gas prices hovered between 50 cents and $1, in large part because of OPEC's use of production controls that often benefited U.S. consumers.

Today, hedge funds, pension fund managers and investment bankers are placing huge bets that oil prices will keep going up because political unrest in some OPEC countries and the emergence of China and India as major consumers of petroleum will continue to make oil a rare commodity.

This is an odd story for a few reasons.

First, the claim that "OPEC's use of production controls... often benefited U.S. consumers" is certainly an interesting one. Saudi Arabia was certainly responsible for whatever downward pressure there was on oil prices during this period -- but claiming that OPEC kept oil prices low during this period is certainly an interesting one.

Second, if you look at the OPEC statement cited in the story, it becomes clear that OPEC's motives might differ somewhat from what Bodipo-Memba ascribes to them:

The reasons for this protracted volatility are, by now, familiar to OPEC Bulletin readers and relate to an unusual convergence of factors: the exceptionally strong world economic growth and, in turn, oil demand growth, especially in developing countries; the slow-down in non-OPEC supply growth, although this is picking-up again; tightness in the downstream sectors of major consumer countries; geopolitical concerns; major natural disasters; and heightened levels of speculative behaviour....

OPEC is very much aware that the more prices are out of line with demand and supply fundamentals, the more likely they are to lead to increased volatility, and this can be damaging to all the players in the market.

However, the impact of OPECís measures varies according to the market conditions. Throughout the present volatile conditions, OPEC has ensured that the market has remained well-supplied with crude, as well as accelerating plans to increase production capacity, so as to help cater for the continued rise in demand forecast for the coming years. But, since other factors have been primarily responsible for the recent price rises, OPECís influence has been limited.

This assessment has some truth.... but it's also a way for OPEC to say, "Don't blame us for the high prices that are enriching our members."

Finally, Bodipo-Memba overlooks the obvious angle for why Michiganders would benefit from price stability, even if the price of oil is relatively high -- it provides a set of stable expectations for car manufacturers as they plan production for the future.

This raises a few interesting questions:

1) For which commodities is price stability a particular virtue?

2) What is the acceptable premium for keeping a price stable over prices that are lower on average but with greater volatility?

posted by Dan on 10.08.06 at 02:42 PM


For which commodities is price stability a particular virtue?

If you listen to the commodity producers, everything. Especially agricultural products, like milk.

But in reality, I'd immediately say that price stability for agriculture, and anything else that's renewable is in general a bad idea. The price stability tends to lead to overproduction or, failing that, political favorities deciding who's going to fill the quota. Pretty much all of the agricultural supports in the this country were started for "price stability," and in the long run have led to tremendous overproduction.

Even nonrenewables that have the potential of new entrants and new discoveries are going to be tough to avoid overproduction and to actually enforce the price stability without political favorites.

And of course nonrenewables with no hope of new entrants, well, the incumbents have a decent chance of enforcing price stability without our help.

posted by: John Thacker on 10.08.06 at 02:42 PM [permalink]

The other reason price stability is valued for agricultural commodities is the expectation that technology will drive production costs down over time, other things being equal. This value for producers is thought not to be offset by damage to the interests of consumers, because food is a) generally inexpensive and b) influenced only partially by the price paid to producers for commodities like wheat and milk.

With respect to energy -- and keeping in mind the political realities that render this idea impractical -- I cannot forego the observation that this is the time to increase taxes on energy, beginning with gasoline. If we have seen high gas prices, and expect them to return, why would we not seek to limit the impact of their return by reducing energy use now? We know that higher gas and other energy taxes would work to reduce energy use, and we know that when higher market prices for petroleum-based prices return they will hurt more the more energy we are accustomed to use.

As I say, I know why this is impossible from a poltical standpoint -- though as I understand why most politicians do not discuss the idea, I confess to being nonplussed that none of them ever mention it. I only do it here because I want to be able to point out, a year or 18 months from now, that the return of high energy prices that will be shocking and outraging the political world did not at least come as a surprise to me.

posted by: Zathras on 10.08.06 at 02:42 PM [permalink]

I'd quibble at least with both preceding comments. Yes, stability was a major aim of farm programs beginning before the New Deal. (Farmers have tried to stabilize production on a voluntary basis for centuries--but they keep running into the free-rider problem.) And the programs for most crops have been costly. But they don't necessarily lead to overproduction (at least if you spend enough money). Do a google on "wheat prices"--you'll find they're at a 10-year high. Or look at the history of the tobacco and peanut programs (now phased out). By using the authority of the state we were able to stabilize prices without major costs (at least the last 10 years of tobacco).

I'd argue that "punctuated evolution" works as well in economics as Stephen Jay gould said it did in biology. Combine periods of stability with periods of instability: the first allows investment for efficiency; the second destroys the economically unwise units.

posted by: Bill Harshaw on 10.08.06 at 02:42 PM [permalink]

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