Great Article on oil!

[willstrickland]

Pete, your link to the Baum article (which incidentally I'd read on Bloomberg earlier) lead me to this question, which is not really part of the oil discussion but more basic:

 

She states: "Now let's suppose suppliers are responsible for forking over the widget tax to Uncle Sam. The seller now keeps only $4.50 of the $5.00 ticket price. Widget sales are less profitable at any given price, which induces sellers to supply fewer of them. The supply curve shifts inward, to the left, reducing the quantity supplied to the market."

 

If the margin on each unit is reduced, and the supplier wishes to generate the same amount of revenue, it seems a simple conclusion to say that they would produce more, increasing the quantity in the market. Fixed costs are just that, so by decreasing production they would further decrease the margin on each unit.

 

Assuming the tax imposed is a percent of sale price rather than a fixed per-unit rate...why would her assertion hold? I know this is a basic question, but I'm looking for an answer. Maybe I just haven't had enough coffee yet.

[Peter_Puget]

Will -

 

Assuming the price to the consumer is unchanged the quantity demanded will not change. They can produce more but will they sell?

 

By the way as a short term accounting trick manufacturers have been known to increase production so that costs can be capitalized rather than expensed in periods of low sales.

[willstrickland]

Ok, that makes sense, but is only half the equation. You basically said: Without manipulating the price the consumer pays, demand should remain constant...so increased production won't help the producer. Easy enough.

 

But her assertion is that they would actually decrease production and I'm still having trouble seeing why this would be the case. She argues that the tax would induce sellers to supply less. I would assume she is saying they restrict supply to drive prices to a level that generates the margin they want and they would just produce less long-term thereby keeping prices high but cutting overall production costs.

 

At some price level the increased fixed cost per unit is offset and the per unit margin increases. The challenge to the producer it seems, would be to create the same cash flow. In any industry with a large capital infrastructure, it seems that this would be difficult. Sure, you reduce labor costs when cutting production, and raw materials costs, but your fixed costs per unit increase and your economies of scale in both production and raw materials likely increase (I'm talking generic business, not oil specifically). Oil is a crazy business environment, nevertheless I do own some XOM shares.

[Loose_Brie]

If the margin on each unit is reduced, and the supplier wishes to generate the same amount of revenue, it seems a simple conclusion to say that they would produce more, increasing the quantity in the market.

 

I would suggest this is a poor conclusion. At any given price there are a number of buyers. The lower the price the greater the number of buyers at that price. Now even assuming the marginal cost of production is a constant (it is not), were the supplier simply to produce more, they would be unable to sell this excess inventory at the higher price. The market will not clear.

[willstrickland]

Yeah yeah yeah. See above.

[jjd]

Assuming the tax imposed is a percent of sale price rather than a fixed per-unit rate...why would her assertion hold? I know this is a basic question, but I'm looking for an answer

 

The market determines what the equilibrium price and quantity of widgets will be. Consumers will be willing to purchase a certain quantity at that price. If the tax is imposed on the consumers, firms lower their price as the demand curve shifts inward. If the tax is imposed on firms, the supply curve shifts inward. The price and the quantity must be lower lower due to upward sloping supply curves and downward sloping demand curves (the laws of supply and demand). Now, who actually bears the burden of the tax is more complicated than just "consumers or producers pay the tax." The relative elasticities of demand and supply determine who actually bears the burden.

 

That article analyzes the question of oil prices from the perspective of a "principles" course in economics (think "Introduction to Microeconomics"). Higher oil prices do not act the same way as a tax; they do however have an effect on consumer spending for everything else. Demand for oil is relatively inelastic and, by its nature, lacks substitutes. That means people allocate fewer dollars to buying widgets at Wally World. Yes, the dollars flow out of the country and back in as direct investment. That is becoming something of an issue for the relative strength of the dollar - take a look at the FX markets for evidence of this.

 

That article also assumes that oil prices are set in a competitive market - they're not. Consumers of oil (I'm talking industry now) take oil prices as given. Oil prices (by way of supply) are determined by a cartel. They are not competitive prices. There IS deadweight loss from this arrangement and a course in intermediate economics would reveal this. The author relies on partial equilibrium in her analysis of the current conditions. General equilibrium would require looking at how firms use oil and the effect that higher costs of production have on the rest of the economy.

 

The bottom line: don't rely on smug commentators who patronize you by suggesting you read a basic economics textbook. Basic, partial equilibrium analysis doesn't tell the whole story. Markets are somewhat more complex than basic economics suggest. <end flagrant understatement>

[Peter_Puget]

JJD -

 

Come on she calls it pretty much correctly. You are flat out incorrect when you state that a competitive market does not create the price of oil. It does. It is not perfect competition but what market is? The basic laws of supply and demand work even in imperfect markets. Besides suggesting that a demand curve will shift does not imply that the market was clearing before the change took place.

edit: So I was a bit aggressive in by response but I do think that the volume targets set by OPEC are have to consider many things not the least of which are the potential for cheating my its members and I also believe that after the targets are set they are often influenced by the cheating of member states.

 

 

As to long-term/short-term issues consider this:

In 1978 the U.S. consumed more than 18 million barrels of oil every day, when annual GDP was $5 trillion. Today we use only 10% more oil every day than we did then, but GDP has more than doubled. (constant year-2000 dollars)

Edited May 24, 2004 by Peter_Puget

[willstrickland]

jjd,

 

I understand the implications of the supply curve shift and why it should decrease production. I just don't see it as realistic for the reason you said...relative inelasticity of demand. Holding the consumer price constant (i.e. the tax burden is completely upon the producer...and yes, I understand that is unrealistic) and the demand constant, I don't see the production decrease happening. All I see in that scenario is decreasing margins for the producer.

 

The author states: "Widget sales are less profitable at any given price, which induces sellers to supply fewer of them." That's where my point of contention lies. Yes, the S/D basics indicate decreased production.

 

But tell me this: You own XYZ widgets. Because of a new tax, your margin just went down from 30% to 20%. You cannot pass along the costs through price increases. Will you sell as many as you can (assuming you don't have a monopoly you can sell at your historical level or a potentially higher level if you can gain market share) to retain economies of scale and hold down fixed costs per, or decrease production thereby reducing gross revenue?

 

I recognize that oil is a completely different animal. I just find the assertion unrealistic unless the producer has other methods to generate revenue that become more attractive in the new environment.

[j_b]

``The total amount spent doesn't change,'' Laurent says. ``People are allocating more dollars for each gallon of gasoline. But the dollars don't get lost. It's not clear why this should have a dampening effect on economic activity, like a tax. There's no dead-weight loss.''

 

is he really saying that since the same amount of dollars is spent, there won't be any adverse effect on the industries that depend on oil?

 

increased oil prices will be felt in most goods, from food to plastic chairs. and even though the oil industry may rake in as much as it used to, the rest of industries won't, which in turn will eventually affect the absolute amount that people spend.

[Peter_Puget]

I guess the outcome one sees is dependent upon how one views the current rise price. Is it due primarily to demand and uncertainty in the ME or the result of OPEC restrictions? How does the current backwardation play into it? Honestly I have no clue.

[jjd]

You are flat out incorrect when you state that a competitive market does not create the price of oil

 

You may be arguing semantics here, I'm not sure. The price is set on open exchanges around the world. However, 40% of the world's daily oil supply is controlled by one producer: OPEC (I'll post references if you want them). That is imperfect competition and it does create deadweight loss - that is the point I was trying to make. The normal laws of supply and demand are manipulated under a cartelized system like this. The basic theory is that OPEC considers the amount of oil to be supplied in the competitive marketplace (by countries such as Russia) and determines their output based upon residual demand, that is, the demand "left over" after the rest of the world supplies their oil. They set their profit maximizing level of output based upon this information. That is very much imperfect competition. You are right, very few markets are perfectly competitive. However, their is a major difference between monopolistically competitive markets, competitive oligopolies, and cartelized oligopolies. Again, my point was that the cartelized system does create deadweight loss.

 

The second point I was trying to make is that while the mechanics of higher oil prices differ from those of a tax, there are general similarities. In the short run, higher costs for factors of production lead to lower levels of output (that is the similarity I'm talking about-lower output). It is great to see that we have become more efficient in using or oil (in terms of oil per dollar GDP). That is a long run transition; in the short run, it is essentially impossible to find a substitute. This IS a contractionary factor. The high prices are a SYMPTOM of high demand and an uncompetitive marketplace (largely from the former, in my opinion). They will lead to lower levels of production in the short run and substitution (and more efficiency) in the long run.

 

Besides suggesting that a demand curve will shift does not imply that the market was clearing before the change took place

 

Would you please clarify what you mean by that?

[jjd]

I understand the implications of the supply curve shift and why it should decrease production. I just don't see it as realistic for the reason you said...relative inelasticity of demand. Holding the consumer price constant (i.e. the tax burden is completely upon the producer...and yes, I understand that is unrealistic) and the demand constant, I don't see the production decrease happening. All I see in that scenario is decreasing margins for the producer.

 

 

I don't have the time to explain the theory behind why quantity is decreased (I mean this with all respect - I would be trying to explain about 3 quarters worth of micro theory in a medium like this). The answer to why quantity decreases can be answered by looking at a market's (or a firm's) cost curves and demand function. The interaction between all of these factors determines the level of output. I know this doesn't answer your question and I apologize for that.

[Peter_Puget]

You are flat out incorrect when you state that a competitive market does not create the price of oil

 

You may be arguing semantics here, I'm not sure. The price is set on open exchanges around the world. However, 40% of the world's daily oil supply is controlled by one producer: OPEC (I'll post references if you want them). That is imperfect competition and it does create deadweight loss - that is the point I was trying to make. See my post above. I was being a smarty and changed my post but my point was that the imperfections of markets are to my mind often overstated and the beneficial impacts understated. The normal laws of supply and demand are manipulated under a cartelized system like this. The basic theory is that OPEC considers the amount of oil to be supplied in the competitive marketplace (by countries such as Russia) and determines their output based upon residual demand, that is, the demand "left over" after the rest of the world supplies their oil. They set their profit maximizing level of output based upon this information. That is very much imperfect competition. You are right, very few markets are perfectly competitive. However, their is a major difference between monopolistically competitive markets, competitive oligopolies, and cartelized oligopolies. Again, my point was that the cartelized system does create deadweight loss.

 

The second point I was trying to make is that while the mechanics of higher oil prices differ from those of a tax, there are general similarities. In the short run, higher costs for factors of production lead to lower levels of output (that is the similarity I'm talking about-lower output). It is great to see that we have become more efficient in using or oil (in terms of oil per dollar GDP). That is a long run transition; in the short run, it is essentially impossible to find a substitute. This IS a contractionary factor. The high prices are a SYMPTOM of high demand and an uncompetitive marketplace (largely from the former, in my opinion). They will lead to lower levels of production in the short run and substitution (and more efficiency) in the long run.

 

I agree with you in general, Iguess I find that short-term and long-term to be difficult subjects to define. In 1978 I would have felt that 2004 was a lifetime away now I look and think what large changes the US economy has made.

 

I do think that higher prices caused by demand will entice producers to increase output. What do you think of the backwardation of the current market. I know little of oil markets but find it an interesting situation

 

Besides suggesting that a demand curve will shift does not imply that the market was clearing before the change took place

 

Would you please clarify what you mean by that?

[jjd]

What do you think of the backwardation of the current market. I know little of oil markets but find it an interesting situation

 

I am going to do a little research to see if this is "normal backwardation" or if the markets are normally contango - I don't really know what the historical trend is. Give me a few minutes to check the NYMEX.

[Peter_Puget]

Find out about inventory levels too!

[jjd]

I just looked at some of the historical spreads and it looks like the markets are normally backward. I don't have the time to find some of the academic papers that are out there, though I suspect there are some that address this issue. Here's the link to the NYMEX historical page for light sweet crude futures http://www.nymex.com/jsp/markets/lsco_fut_histor.jsp?

 

You can draw spread charts for various futures to verify the general trend.

 

Here's the most recent inventory data from the DOE http://tonto.eia.doe.gov/oog/info/twip/twip_crude.html

 

I'll talk to my Futures and Options professor tomorrow to get some more information about the structure of oil markets. He might be able to shed some light on why oil markets are backward.

[Peter_Puget]

Last week June 2004 and June 2005 were approx. $42 & $35 respectively. That seems like a steep discount.

[jjd]

Perhaps the markets are expecting reduced tension in the Middle East? It could also be that the markets are expecting a reduction in the growth of oil consumption?

[jjd]

Also, how does the relationship compare with respect to spot prices? The wider spread makes sense when you consider the level of spot prices.

[Peter_Puget]

Perhaps the markets are expecting reduced tension in the Middle East?

 

My thoughts were the above.

[Peter_Puget]

great link

[olyclimber]

Oil as a natural inorganic product. Interest article...interesting people backing the idea....

[Dru]

way to misquote the deep hot biosphere theory.... the oil is produced by the activity of extremophiles, not "attacked" by them

[olyclimber]

way to misquote the deep hot biosphere theory.... the oil is produced by the activity of extremophiles, not "attacked" by them

 

Time for a vision check or a new monitor Dru. It says 'attached'.

[Dru]

way to misquote the deep hot biosphere theory.... the oil is produced by the activity of extremophiles, not "attacked" by them

 

Time for a vision check or a new monitor Dru. It says 'attached'.

 

the actual quote is

Dr. Gold strongly believes that oil is a "renewable, primordial soup continually manufactured by the Earth under ultrahot conditions and tremendous pressures. As this substance migrates toward the surface, it is attached by bacteria, making it appear to have an organic origin dating back to the dinosaurs."

 

that's just bad English. "Attached by bacteria" is not an acceptable phrase. Is it attached TO bacteria, or attacked by bacteria? Since the extremophiles would be eating the oil, attacked by seems more reasonable.