Saturday, July 19, 2014

Oil and the Free Market

As a dynamical system, oil prices have long displayed a rather unstable behavior. A number of factors have contributed: a long history of exponential growth in demand, the long time constant of the feedback of prices on supply, and the unpredictable nature of the discovery of new oil resources. As a result, oil prices and oil supply suffered from dramatic swings, and as the world became more oil dependent, these swings wrecked every widening paths of economic destruction. One of the first to clearly realize this was John D. Rockefeller, and his answer was the Standard Oil Trust. Besides giving him and his investors immense personal profits, Standard created safer standardized oil products and regulated production to maintain stable (and high) prices.

Motivated in part by Ida Tarbell's scathing exposes, the Trust was ultimately dismantled, and consumers got lower prices but also an unstable market. The ferocious competition unleashed that drove down prices also resulted in a number of inefficiencies (like overpumping, leading to premature exhaustion of oil formations) and created local economic havoc in oil country. Eventually, the Texas Railroad Commission, which for peculiar historical reasons wound up in charge, imposed a quota system which brought more predictability to the market.

In later years, the giant combinations of the international oil companies performed a similar function, until "their" oil concessions were expropriated by national governments, and later, for a while, by OPEC. These quotas and combinations imposed a cost - higher prices - but there were also often benefits. When middle eastern oil production exploded, the US domestic oil production would have blown away in West Texas dust storms were it not for import quotas imposed by Eisenhower.

A key reason for this sort of quota was the central strategic position of oil. Oil transitioned from just another commodity to the central strategic commodity when Winston Churchill switched the Royal Navy from coal to oil a bit over 100 years ago. Since then, it became ever more dominant. Without it, armies could not fight, industries could not function, planes could not fly, and people could not get to work.

It's economic role has often been neglected. Jimmy Carter's presidency was unsuccessful mostly because the events of 1973, 1978, and later led to oil prices more than quadrupling. The resulting deep recession crippled his presidency. These price rises triggered an explosion of exploration and development oil resources as well as dramatic conservation measures around the globe. By 1981, when Ronald Reagan took office, the new oil produced by the exploration and the conservation measures had started eroding oil prices, and by 1985, oil prices were in collapse. Carter had no more influence on the oil price rise than Reagan did on the oil price fall, but the first produced "malaise" and the second, "Morning in America." Luck is singularly important in politics.