Drill, Drill, Drill and King Dollar

I guess it is safe to say, sadly, that I am more like Larry Kudlow than Paris Hilton after all.

My comment on the Everyday Economist referenced in my Paris Hilton post engendered a thoughtful response from the EE. With his permission, here it is:

1. I mostly agree with your centrist position.

2. The government already uses the SPR to manipulate prices. The government has stopped filling the SPR, which reduces oil demand each day. Also, it uses the SPR when it believes that oil is priced above its fundamental value each time there is a natural disaster that creates supply disruptions and even did so during Desert Storm.

3. I do not believe the oil price reflects fundamentals. This is not to say that I know the correct price (although if you ask Vince Farrell he will tell you that oil typically trades at marginal cost, which is currently around $75). As you know from reading my blog, I do not believe in market failure -- at least as it is defined by mainstream economists. Markets are efficient so long as voluntary transactions are taking place as this signals that each individual is better off. However, we are not talking about free markets here. A large number of oil producers are countries rather than companies. In addition, the world remains awash in liquidity and the Fed is holding interest rates at artificially low levels.

4. A temporary increase in the supply of oil would lead to a decline in the price -- even if individuals know that the increase is likely temporary.

5. The Drill! Drill! Drill! plan will not be successful if real interest rates remain low. If the expectations of future prices are rising anywhere above zero at the moment, it is in one's best interest to keep the oil in the ground. One of my biggest pet peeves is that people fail to mention this on Kudlow's show when the Democratic talking points about unused permits gets thrown around. We need a three step process: (1) release some of the SPR, (2) Begin raising interest rates, and (3) start drilling. The problem is that there are too many players involved to believe that any combination of the three will take place. Instead, we will get promises of windfall profit taxes, rebate checks, "accountability", etc.

We're not way apart, and he his dead on most of his points and his conclusions. I don't hold out much hope for higher interest rates and disagree that drill-drill-drill by itself is not a great step.

It is my understanding that oil fields vary widely and wildly in their marginal cost; the $75/bbl figure he offers would be an average. By opening more fields, I expect they will find some that are more than 75 -- and probably some more than 150. But won't they also locate some more fields that are less than 75? Then they could pump the cheaper ones now at a profit at today's cost. They could leave the more expensive oil in the ground, discounted at his negative interest rate, against future rate increases and expectation of better future extraction technology.

Though I think it would be specious, I suggested it might be good politics to open the SPR and tie additional drilling to refilling. This would silence the "won't help for 750 years" crowd, prop up the Obama campaign, and provide instant additional supply without compromising future protections of the SPR. Drain it and refill it with new production. The feds could even hold futures to fill it as part of the bill.

Me, Larry, and Paris...

Oil and Energy Posted by jk at August 7, 2008 10:41 AM