A Short, Speculative Post

Congress is blaming speculators for the barreling rise in the price of oil, as of this writing $126 per barrel.

In late 1998, oil dipped briefly below $10 per barrel. Where were the speculators then? Interestingly, at that time the U.S. dollar had been appreciating for about 4 years. It had appreciated roughly 25% by then from its bottom in 1995. The dollar is not the only factor*, but it is a significant one that explains the oil price. A good deal of today's gain in the price of oil, denominated in dollars, reflects the depreciation of the dollar.

Speculators are agents that transmit fact-based expectations about future supply and consumption trends into present prices. As such, they facilitate economizing between present and future supply/consumption. If the expectation is that future consumption will be high and supplies will be constrained -- or that nominal demand expressed in dollars will be high due to dollar depreciation -- then speculators will bid up the price of oil today. That is happening now.

The opposite happened in the late 1990s, at least with regard to the purchasing power of the dollar. Expectations were that its purchasing power would strengthen relative to the world's currencies. Therefore, speculators bid down the price of oil.

In regard to the general point of whether speculators can manipulate the market, they cannot alter the long-term or fundamental course of markets. Market prices incorporate such fundamental information. If a speculator positioned himself (incorrectly) against the long-term trend, he would be bankrupted very quickly. For example, if a speculator in the mid-1990s incorrectly bet that oil would go up, he would have lost his shirt.

Blaming the speculators is a lot like blaming the gas gauge for showing that your tank is empty, except that the "speculator gas gauge" is even smarter. It accounts not just for the amount of gas in your tank right now, but also for the nearness of a gas station down the road. The "speculator gas gauge" will adjust to reflect the ease with which you can fill up your tank in the future, thus encouraging you to either consume more gas or less right now, depending on those facts.

The speculator's role is very valuable. If the government restricts it, it will make the markets work less efficiently. Ultimately, this will mean less oil availability because it will become more costly to finance oil production and refining. Capital will demand a higher premium to invest in the oil industry if financial liquidity and quality market information about future demand/supply are reduced because speculation has been diminished by law.

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NOTE

*The key fundamental factors keeping oil prices high in real terms (not just nominal terms, which is affected by the value of the U.S. dollar) are restrictions on Western drilling and the nationalization and cartelization of oil over the past 60 years. These two factors have diminished supply by taking it out of the hands of entrepreneurial oil companies and concentrating it in the hands of a smaller number of unproductive, state-run operations.

On the demand side, large new demand from China would act to keep prices high but in the absence of the supply constraints, prices would not have to rise as much as we are seeing, or could even fall. Consider that oil prices in the United States fell for decades during most of the late 19th and 20th centuries even while U.S. economic growth and oil consumption during much of that time grew at a rate comparable to China's growth rate today.

In Defense of Price Gouging

Yesterday the House of Representatives passed a bill outlawing gasoline “price gouging.” Violators would face penalties of fines as high as $150 million or prison terms of up to two years. Price gouging is defined as “taking unfair advantage” or charging “unconscionably excessive” prices for fuels. What is unfair advantage? How does one measure when a price is unconscionably excessive? There is no answer.

This is bad law. First, because it is non-objective. Because no objective definition of price gouging is provided in the law, a gas station owner or oil company can never know when it is breaking the law. There is no way to comply with a law when the crime cannot even be defined. More ominously, a non-objective law becomes a tool to terrorize in the hands of unscrupulous government officials. The businessman is told that he must obey the bureaucrat or face punishment, a punishment he cannot defend against because there are no objective standards. This is a tool of tyranny. Incidentally, this is also the nature of antitrust. Like this anti-gouging measure, antitrust law is completely non-objective.

The other reason why this law should not be passed is because it is anti-capitalist. It attacks the heart of the market economy, which is the price mechanism. Prices work to harmonize the interests of buyers and sellers when they are allowed to freely rise and fall. This type of law, to the extent it is enforced, will function as a price maximum. Price maximums, enforced by the state, have one predictable consequence, shortages. This is true in all eras and for all commodities. The pricing principle is an iron law of economics, as solidly and universally valid as the law of gravity. Violate it by imposing price controls and artificial shortages will develop. The principle that price controls cause shortages is an iron corollary of the iron law of prices.

Price controls cause shortages because of two reasons. First, suppliers provide less gasoline (or any other controlled commodity) because they cannot make money selling at the lower price. They cut production until they no longer lose money. Second, at the lower price, customers want more of the product. Combine these two effects – reduced supply and enhanced demand – and you have a shortage. Supply and demand are no longer in equilibrium.

America has already walked down the path of price controls, for energy and many other products and services. In energy, the long lines at gasoline stations in the 1970s were solely due to the price controls imposed on the oil industry. Only when price controls were lifted in the late 1970s/early 1980s did the lines vanish. Notice that there were no gasoline lines during either Iraqi invasion, despite serious reductions in Middle Eastern oil production during both wars. Gasoline prices rose, but there were no lines. Supply and demand were brought into equilibrium, both by increasing supply and tamping down demand until they met. In the 1980s, the first decade after oil prices were liberated, U.S. oil production rose, defying the doomsday predictions of the 1970s pessimists who thought the world would run out of oil by the end of the century. In nearly every year since the removal of price controls, proven global oil reserves have increased. When prices and profits were determined by the market, it paid to explore and drill for new oil.

The sad consequence of all attempts to squeeze the profit out of the oil companies, whether through price controls, windfall profits taxes or other means is less production of oil. Oil companies that cannot charge market prices or earn market profits will invest less in the entire oil infrastructure, from gas stations, to oil refineries, to drilling platforms.

We pay high prices for oil for several reasons, all of them a consequence of our government failing to enforce rights, or actively violating them. One is the banning of oil drilling on certain lands, such as the Alaskan tundra, or the oceans off of Florida and California. Another is a shortage of refineries caused by the effective banning of construction of new refineries through NIMBY (Not In My Back Yard) local politics, and environmental rules that make the construction of new industrial facilities prohibitively expensive. Another reason for high oil prices are all the prior episodes when price controls and windfall profit taxes were imposed. The memory of these events and knowledge that they might be re-imposed further discourages oil executives from building new infrastructure.

Looked at from a broad, historical perspective, high oil prices are the consequence of decades of appeasement in the Middle East. The U.S. government allowed the Iranians to confiscate American oil fields in Iran in the 1950s, and then the rest of the Arab governments followed suit in succeeding decades. Today, the U.S. government stands mute when Venezuela and Russia expropriate Western oil properties. On the other hand, the U.S. government did take action to bungle the War on Terrorism by incompetently conquering Iraq while leaving true enemies such as Iran and Saudi Arabia untouched. These actions and others, such as stoking the Palestine-Israel conflict, push oil prices higher by engendering worries that Middle Eastern turmoil will disrupt supply.

With the anti-gouging bill, the House of Representatives is grandstanding at our expense. In an effort to curry votes from ignorant voters, the House lays the groundwork for new gasoline shortages. Moreover, it diverts attention from the party responsible for high oil prices, themselves.

Mikhail Khodorkovsky: Victim of the New Soviet Union

On Monday of this week, the Russian Prosecutor General levied new criminal charges against Mikhail Khodorkovsky. The new charges mean it is likely that Khodorkovsky will remain imprisoned at a Siberian labor camp past 2008, when he is currently up for parole. Khodorkovsky has been incarcerated since July 2003 after being charged and then convicted of tax evasion, stealing and sundry similar charges.

What is really going on here?

Russian President Vladimir Putin, a former KGB officer, has been ruthlessly stamping out all forms of opposition. He is re-nationalizing companies and closing down independent television stations and newspapers. He now appoints provincial governors who used to be elected. While he has been in office, more than 40 journalists have been assassinated. Under his watch, none of these crimes has been prosecuted. He is confiscating foreign business interests in Russia, using the pretext of violations of meaningless environmental laws. Such a tactic was used to partially confiscate the $20 billion Sakhalin oil project, after Royal Dutch-Shell had invested billions in the project.

When he was an active KGB officer serving in the Leningrad (now St. Petersburg) district, one can only imagine what crimes Putin committed or witnessed. The recent polonium murder of Alexander Litvinenko in London is an example of the type of KGB-sponsored actions that were frequent in the old Soviet Union and have now been resurrected in the new Russia.

Putin is going out of his way to make sure that a man like Mikhail Khodorkovsky spends more time in the gulag. Why is he such a threat?

Men like Khodorkovsky are a threat to dictators everywhere because they are independent. Khodorkovsky was a double threat to the dictator, a man independent in his thinking and independently wealthy. Khodorkovsky was not just the wealthiest man in Russia at the time of his arrest in 2003, but he was the architect of Yukos, the second largest oil company in Russia. Under his leadership, Yukos became the first large Russian company to report accounting figures using internationally accepted “GAAP” (Generally Accepted Accounting Principles) standards. By doing so, Khodorkovsky raised the standard for other corporations to follow in Russia, a standard that would facilitate modern capital markets and greater foreign investment in Russia. Khodorkovsky brought in Western managers to modernize Yukos’ business practices, including U.S. citizen Steven Theede, who was brought in as Chief Financial Officer of the company, and became its Chief Executive Officer after Khodorkovsky’s arrest.

All of the business steps Khodorkovsky took resulted in Yukos’ oil production growing at a nearly 20% annual rate during the last three years before his arrest and the Russian government's confiscation of Yukos. The proof of his Western managerial style was in these results.

Based on the public information available, Khodorkovsky’s actions are those of a highly competent, intelligent and successful business executive. His rise was a remarkable sign that Russia had changed, that the old Soviet Union was giving way to a new Russia that was more free and more Western than it had ever been before.

One of the charges against Khodorkovsky is that he unfairly acquired the assets that formed the base of Yukos during the corrupt privatizations of the 1990s. This may be true, but it is irrelevant. In a Communist society, no one “owns” the industrial plants, equipment and resources. The state was not the owner; it was the confiscator of property that had been formerly owned by private individuals prior to the Revolution. Such property would lie fallow until men like Khodorkovsky stepped forward to make it valuable. This process is similar to the appropriation of land by the Homesteaders in the United States in the 1800s. Vacant land was occupied by settlers who farmed it, and it became theirs. That was the same status of the property that had been abandoned by the Communists when the Soviet Union collapsed in the early 1990s.

That men such as Khodorkovsky stepped forward to appropriate such property, and make it far more valuable than it had ever been under the Communists, we should all be thankful. By doing so, he created wealth that he enjoyed and all those who did business with him enjoyed. That wealth was created, after having been dissipated by the Communists before. By doing so, he also helped bring the rule of law through modern business practices and accounting standards to Russia.

Stated in simplest terms, the proof of Khodorkovsky’s moral right to the property that formed the base of Yukos is the fact that he made it productive. He was a Homesteader.

Moral leaders in the West have said little about Khodorkovsky’s imprisonment (under horrible conditions, he was recently slashed by a fellow inmate). In the United States, leaders such as President Bush, who himself excoriated American businessmen and imposed punishing new rules on them such as Sarbanes-Oxley, have been incapable of taking a moral stand in support of Khodorkovsky. Instead, Bush, speaking of Putin, utters such grotesque inanities as, “I looked the man [Putin] in the eye. I found him to be very straightforward and trustworthy. // I was able to get a sense of his soul; a man deeply committed to his country and the best interests of his country.” With statements like that backing him up, it is no wonder that Putin feels morally empowered to stamp out the independent minds in Russia.

I wish Mikhail Khodorkovsky well. May justice prevail.