I think the US ought to produce more energy. I think we probably ought to produce more oil and gas. But I do not believe that we should do these things so that we can keep the price of oil low in the USA. I keep hearing people talk about oil or energy self-sufficiency as a means to keep oil prices low in the USA. This is crazy talk or maybe just wishful thing. Let’s produce more oil here but let’s not raise expectations about something that isn’t going to happen. We are not going to become self-sufficient and even if we did it would not allow us to control the price we pay for oil.
We can no more protect US citizens from the global price of oil than we can stop a tsunami going 550 miles per hour. Oil prices are determined by global supply and demand. In economics we often begin our thinking about pricing as a process of determining full cost and then adding a mark-up for a reasonable profit. This makes us think about production and distribution costs. Let’s suppose it costs about $60 to produce and distribute a barrel of oil. Add a $20 profit and you get a price of $80 per barrel. I don’t know if those numbers are accurate but let’s suppose they are close. But that’s nothing but a starting point for the price of a barrel on the world market on a given day. If the world economy is booming and the demand for oil is very high, then firms will produce more and that raises their costs – and may also be a time when they take higher profits. So a barrel might be priced at $100 or more when the world experiences strong economic growth. Next consider a time when the demand for oil is very low – it is possible that the price of a barrel of oil is only $60 on that day. Add psychological effects, speculators, government or OPEC announcements and you can easily see why the price on a given day could be well above $100 or well below $60. Fun, eh?
But you might protest. If we can produce a bunch of oil in the US – who cares what the world price is? We produce it here and we consume it here. Suppose we are self-sufficient. We could price US barrels at US prices. With lots of US production we could keep the home price low. That’s a nice story but it ignores two other economic ideas about prices – opportunity costs and replacement costs.
An opportunity cost is what you have to lose in order to gain something else. Let’s see how opportunity cost comes into play if the US were to be self-sufficient in oil. If I can sell a barrel of oil on the world market for $100 and I can sell that same barrel of oil in the US for only $60, then what is a barrel of oil really worth and where would I want to sell it? You can play the Star Spangled Banner all you want – but in that case economics says the price of oil is $100 and the economy is made more efficient and productive when we buy and sell at the market price. Clearly US suppliers would rather receive $100 per barrel and they will attempt to do so. Resurrecting legal and other barriers to prevent this sort of behavior is possible but not consistent with a market economy. If, on the other hand, temporary conditions had the world price of oil at $40 while US prices were $60, you can bet you’d see the benefit in letting US consumers buy oil on world markets.
More production in the US marketplace does not insulate us from world oil prices. The replacement cost story arrives at a similar conclusion. I fume about replacement costs every time my local gas stations are so quick to raise prices after a rise in world oil prices. It seems to take them only 10 seconds to translate a rise in the world price of oil into another 10 cents per gallon for gas in Bloomington. I may fuss and fume but this is really good business on their part. Sure, the gas in their pumps at that moment came from cheaper oil. But what does it take to replace the gas in those pumps? What is the real price of oil? It is now higher and the gas station would be wasting resources if it charged for its gasoline as if oil prices were much lower. If higher oil prices are a sign of relative scarcity then stations that do not quickly raise prices are wasting a scare resource by setting gas prices as if oil with highly abundant.
In short, oil prices reflect the world demand and supply of oil. While a country or a single business can deviate from the world price for a time, it makes no sense to continue to do so. The more you try to create barriers between your price and the world’s, the more pressure there is to subvert your effort – because strong global economic forces will be impacting those who demand and supply the oil at home.
Consider the issue in a broader sense. All of us trade. There was once a day when we lived in caves and we did everything for ourselves. We learned quickly that families could form and they could allocate specific assignments to the members. This division of labor made it possible for individual family members to specialize with the result that family leisure and output would increase. Some members were hunters and some were gatherers – and then they traded. This result from division of labor and specialization continues today. We trade unthinkingly for almost everything. Most of us are very specialized and we trade the money we earn from this specialization for everything we need. All countries trade and we have learned that the benefits of trade come regardless of the size or income of a country.
We are not forced into trading – we do it to reap the benefits of division of labor and specialization. The United States buys a lot from the rest of the world and oil is part of that trade. We may not like it when the world price of oil rises but we clearly gain overall from not doing everything ourselves. Trade is a net positive for us despite the fact that there are times when we feel imprisoned by it.
The best thing the US can do is to try to influence the world demand and supply of oil. Since we are a very large and influential nation we have the clout to try to raise world supply relative to world demand. If we want the price of oil to be lower we should forget about separating ourselves from world markets and do the opposite – engage with other countries to solve the problem. After the oil shocks of the 1970s we learned that both conservation and production incentives can succeed. These lessons need to be applied on the world level. Most nations are like the US – primarily importers of oil who would gain from a lower world price. So we should have plenty of allies as we seek real solutions. Engagement is the key. We have a strong selfish incentive to work harder at home on production and conservation. Success means fewer imports and a stronger trade balance. A stronger trade balance means higher growth and less needs for foreigners to support our international debts. The idea here is NOT to be self-sufficient and to make our price lower than the world’s price. The idea here is to contribute to a more orderly world market for oil and energy.
In summary we may never be able to control oil prices at home but there is plenty to gain by working hard at home while negotiating with trading partners to raise world energy supply while incentivizing conservation of these scarce energy resources. Even if other countries do not follow, A US plan to conserve and produce oil and other forms of energy will pay dividends.