Econ 101…

Volume 1, Number 15

I got a “breaking news” email alert from the Sacramento Bee on Monday with the shocking news that gasoline had hit $4 a gallon in the bay area, and $3.90 in Sacramento. I found this particularly interesting since I had paid $4.07 in Sacramento two weeks previously. (OK, I buy premium gas and the Bee was talking about regular gas. Minor detail.)

The papers are also full of stories about the rapidly increasing cost of food, and how hard families are struggling to make ends meet with the twin challenges of rising food and gasoline prices.

The two issues are inextricably linked. As the politicians in Washington and Sacramento scramble to offer solutions to their constituents, perhaps they might consider taking an Economics 101 class before introducing what will surely be a slew of legislative proposals to crack down on companies in the energy and agricultural industries.

Here’s all you need to know about what is driving rising fuel and food prices: Mr. Supply, meet Mr. Demand.

The worldwide demand for gasoline and other petroleum products is vastly outstripping available supplies. Not only is demand rising rapidly in nations that are typically heavy users of petroleum products, such as the United States and Europe, but emerging economies in China and elsewhere are gobbling up available supplies as well.  The countries that make up OPEC aren’t stupid—they find themselves in a seller’s market and are doing what anyone else in their position would do, which is to control supply so as to maximize profit. Who can blame them, really? It’s not as if countries like Iraq, Quatar, Saudi Arabia and the United Arab Emirates have a lot to offer the world other than a ready supply of oil. It they deplete their oil supply to keep prices low, my guess is that their domestic entertainment or tourism industries will not make up the difference in their respective national GDPs.

To make gasoline, one needs oil. The price of oil, which is largely determined by OPEC production policies closed at $111.66 a barrel on Tuesday. That’s up over $48 a barrel (75.7%) in the past year.

To grow food, one needs oil, not only for diesel and gasoline to operate farm equipment, but for fertilizers and other products that help crops grow. See above regarding the rise in the per barrel price of oil.

California and the nation have made the foolish public policy decision that we are not going to focus on expanding the supply of oil, but rather bet our economic future on curbing demand. We have gone to great lengths to mandate more efficient uses of diesel and gasoline engines, and we’ve invested billions (trillions?) in developing alternative sources of energy. 

That’s all well and good, but it’s a short-sighted approach to the problem. First, so much of the demand equation is out of our hands. We are not an island, and we exist within a global economy. Emerging economies in China, Mexico and Asia will continue to push worldwide demand for oil.

Think about it this way: China’s population is in excess of 1.3 billion people. Their economy is in its infancy, but growing rapidly. Its demand for energy will explode exponentially. California’s population is about 34 million people with a mature economy and steadily growing energy demands. China is almost 40 times the size of California. At best, our efforts at improving efficiency and conserving the use of gasoline and diesel are but a drop in the bucket compared to the impact that China has on the world market for oil.  It would be as if the use of gasoline in Los Angeles would be impacted if the City of Antioch mandated that all residents of their fine city drive hybrids. It just really doesn’t matter much what Antioch does.

Interestingly, our zeal for finding alternatives to oil has contributed significantly to the rising price of food. We now have a shortage of corn and other grain products in large part because those crops are being diverted to ethanol production. This is because of US government mandates to increase the use of ethanol in gasoline. While this policy apparently has done little to control the cost of gasoline (see $3.90 per gallon breaking news alert above), it is a major factor in corn and grain shortages and resulting higher prices for food.

If we want to have any control over the price of gasoline (and all the other elements of the economy this impacts) we must focus on both expanding the supply of oil and improving the efficiency of which we use this fuel. It would matter if California decided to invest in expanding the supply of oil available to residents of our state and nation, and allowed the strategic exploration for oil off the coast. (I can just hear the gasps now—“drill off our coast? Never!”)

Federal authorities estimate there are 10 billion barrels of oil under California’s coastal waters. That’s enough oil to keep California’s economy humming for the next 15 years. I remember when we did have limited oil production off the coast. Then in 1969 Union Oil Company’s Platform A, located six miles off the Santa Barbara coast, suffered a catastrophic explosion, freeing hundreds of thousand of gallons of crude oil from the ocean floor to seep onto miles of the coast.

Drilling technology has improved considerably since 1969. There is little doubt that oil off the California coast could be produced these days with little environmental risk. However, proposing to do this would be political suicide. It will be interesting to see if economic pressure builds over the next few years, trumping political sensitivities such that we can at least have an intelligent discussion about the subject.

When might that be? Maybe never. But maybe when gas hits $8-10 per gallon. Unless we do something about supply, that’s where gas prices are headed.

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Speaking of economics, I am reminded of a memorable lecture an economics professor at American River College once delivered to my freshman class. He was speaking about the effects of hyper inflation in World War II Germany. Prices were rising so fast that there was an urgency to buy things the day one got paid to avoid having to pay higher prices the following day. He told of German wives running from the bank to the bread store with bags of cash in hand. This, he said, proved the economic value of marrying long legged women.

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Comments

[Jon Fleischman]

Frank, you really nailed it with this column. You do ask a really good question - how long will Mr. Demand be chasing Mr. Supply before someone figures out what you have -- which is that if we don't make Mr. Supply an easier target, Demand may never catch up, and prices will continue to balloon.

[Jim Knight]

The growing demand in asia and other larger countries is apparently already sufficient to absorb any and all surpluses whether from reduced utilization or increased production. Refining capacity has been the same for 30+ years in the US.
Nuclear energy (or "Nuucuuular" as W is apt to call it) is a real alternative (the French use a lot of it) but faces the same "green" barriers as oil exploration.
The political solution from the majority on the left will of course be to artificially set lower prices on oil and gasoline by government fiat (I believe Kucinich is already leading that charge), further decimating the production side of the equation and making scarcity even worse.
Then we'll raise taxes on the "rich", to allow the "poor" to continue to buy cheap gas> This will drive down future tax receipts and produce a collapse in economic productivity along with the attendant loss of jobs and our quality of life.
Medicare and social security are already going upside down independent of the oil crisis.
The boomer generation, now retired and net recipients of government largess, will demand their children make good on the government's IOUs and pay the taxes necessary to keep them happy.
Of course our children can't possibly afford to pay these kinds of bills, so a lot of people will suffer terribly.
You'll know the whooshing sound is next when the first liberal proposes that taxation be asset based like property taxes, since incomes taxes aren't sufficient to cover the bills. And, of course we can just print more money, maybe the world economy won't notice we're doing it.
The most appropriate phrase that comes to mind for all this is "STUPID is FOREVER!"