I am leaving tomorrow for London and Aberdeen, to give presentations at the Institute of Economic Affairs and the annual meetings of the International Association of Energy Economics. I am leaving town at the right time, as my Cubs continue to be depressing (although at least Alou’s hitting is coming along, he just hit a single and is 2 for 4 today) and the first heat wave of the summer is coming this weekend. The paper I am presenting at the IAEE meetings is a version of this comment that I submitted to FERC in April in their market structure and design comment period, which I also mentioned below in my GAO post. I’m going to try to post commentaries on some of the papers, since it is an energy conference, as well as some observations as I travel around one of my favorite places on the planet.

Leave it to my eloquent former colleague Virginia Postrel to pick up on an extremely good analysis of the economics of antitrust law by Paul Joskow. I read this article on the plane to San Francisco last Friday, and it was one of the most compelling arguments I’ve seen yet for why actions, institutions and market structures that might look anti-competitive could really be outcomes of market processes. If you don’t take into account transaction costs, you miss them. It’s a great article. Virginia’s column on it is also far, far better than any summary I could write; go read it and enjoy.

Following up on an article in Monday’s Wall Street Journal (subscription required), I’ve been reading up on Irbis Enterprises. Irbis, which means “snow leopard” in Mongolian, is an organization attempting to align the incentives of nomadic herders in Mongolia with not killing snow leopards to sell their coats. As the WSJ article says,

Irbis … marries two causes — wildlife conservation and poverty reduction — that are often at odds … [T]he snow leopard … shares its home with people who have no option but to rely on the land for survival.

Here’s how it works: Irbis trains nomadic herders in crafts using local materials. Herders sign a contract with Irbis stating that they will not kill snow leopards, and they keep the proceeds from the international sales of the items they make. Irbis pays each family a 20 percent bonus if no snow leopards are killed in their area, and if a snow leopard is killed, then all families in the area lose that bonus. This summary of Irbis’ methods lays out the conservation contract and the bonus arrangement. Also, almost all of the individuals working with Irbis (and by association with the International Snow Leopard Trust) are indigenous Mongolians.

OK, how do the economics of this setup align incentives for human well-being with snow leopard conservation? First, Irbis is focusing on creating trust and relationships through developing local institutions, using local people and local knowledge. These informal institutions are the foundation of successful, ongoing commercial relations and trade. Second, the concept of a contract as a binding agreement between Irbis and the herders to trade skill acquisition and profits from crafts for profits from killing snow leopards creates an institution of visible commitment. Third, the payment of a bonus contingent on the actions of a larger group of families, and the potential loss of future profits from the cheating of any one family, decentralizes enforcement of this contract and creates a strong social norm within groups of herders to avoid killing snow leopards. Thus enforcement is cheaper and more effective because it relies on local personal relationships coupled with a potential real economic loss if any one of them cheats.

This set of institutions illustrates many, many of the lessons we learn from game theory. First, repeat the interactions to increase the possibility of cooperation to achieve mutually beneficial outcomes. Furthermore, exploit the already-existing repeated interactions among herding families that travel in groups together to increase the possibility of cooperation at lower enforcement costs. Second, find some way to make commitment credible, as Irbis is doing with their conservation contract and their trust-building activities. Third, use diffuse local knowledge to customize the institution to fit local culture and norms.

There are about 1,000 snow leopards in Mongolia, and none have been killed in the areas where Irbis has signed contracts with herders. Herder consumption of flour and rice has increased. Irbis is planning on expanding the program, which is quite young, into more of the snow leopard’s range. This is very, very cool. Now if we could achieve this kind of institutional success with tiger (my favorite charismatic megafauna!) conservation and human well-being! This PERC policy analysis by Michael ‘t Sas-Rolfes illustrates only too painfully the incentive problems in wild tiger conservation, and how international treaties to end tiger poaching have little actual effect. The Hornocker Wildlife Institute sponsors and performs extensive conservation and habitat research on Siberian tigers, and you can sponsor individual wild tigers, but their program does not address the core incentive problems in tiger poaching in the way that the Irbis approach addresses the incentive problems in snow leopard killing.

Two interesting stories today illustrate some very important points about how world oil markets are evolving. This Bloomberg News story describes how Russia and Norway are changing the dynamics of OPEC’s ability to restrict output to raise prices:

Russia and Norway plan to end six months of output cuts and cooperation with the Organization of Petroleum Exporting Countries on July 1, increasing world supply at a time when demand is rising at half of normal levels. A drop in the U.S. dollar has weakened OPEC further, because its oil sales are priced in the currency.

Increasing non-OPEC production, the coincidental economic downturn of the past year, and the weakening dollar have all put tremendous pressure on OPEC’s market share. The Bloomberg story concentrates on Saudi Arabia’s need for revenue, which will keep it from being able to reduce output in the short run (aside: this pattern suggests that Russia and Norway increasing production makes demand more elastic, or more responsive to price changes — a hallmark of increasing short-run competition). Apparently the price increase resulting from the reduced output over the past six months has not increased Saudi Arabia’s oil revenue, and the country is thus in a pretty steep recession. The same incentives are keeping the oil flowing in Venezuela. Add to that the improving Russia-U.S. relations and the declining Saudi-U.S. relations, and you get a big change in the political economy of OPEC. The article also notes that

Russia is spending billions to rebuild its industry after the collapse of the Soviet Union. Russia in 1991 was the world’s largest oil producer, pumping 9.3 million barrels a day, compared with 7.1 million a day last year.

Russia also is encroaching on traditional Saudi customers. AO Yukos Oil Co. has sent a cargo of Russian crude into the U.S., investigating the possibility of further sales.

This is a fundamental, and probably long-lasting, shift in the dynamics of the world oil market, as Joe Becker and I argued in a Harvard Caspian Studies Program Policy Brief published in April. As Brenda Shaffer, Research Director of the Caspian Studies Program, stated in her introduction to the publication,

Russia has emerged as the number two oil producer in the world market and its production share is estimated to continue to grow, especially due to the privatization of Russian oil companies. Russia’s independent behavior in the oil market has caused a significant erosion in OPEC’s monopoly power.

Second, this Chicago Tribune article today leads off with the implications of uncertainty in the Middle East for U.S. fuel price volatility. The article points out something that oil market analysts have seen for the past six to nine months — a $5-6 per barrel “war premium” on crude oil prices that reflects the market risk associated with ongoing political tensions. The OPEC output restrictions of the past six months have also contributed to the price staying above $20 per barrel, but it has not had that much of an affect, as mentioned above. Still, crude prices have been hovering around $25 per barrel for several weeks, notwithstanding the seasonal move into increased summer demand and the variability of the political tensions in the Middle East. As mentioned in the Bloomberg article and this one, part of this price stability is due to the slow increase in U.S. demand because of slow economic recovery, and the tendency early in recoveries to focus on increased efficiency and doing more with less. The article provides this concise summary of the current state of affairs:

Three weeks into the summer driving season, a gallon of regular unleaded gasoline, at an average price of $1.38, is 22 cents cheaper than a year ago, according to the AAA Chicago Motor Club. Even in Chicago, which has had notorious gasoline price spikes for two summers running, a gallon of regular unleaded gas averages $1.56–20 cents less than last year at this time, AAA said.

Crude oil prices, a key component in the price of gasoline, are still being propped up by a war premium and by a tough output quota imposed by the Organization of Petroleum Exporting Countries. At Wednesday’s OPEC meeting in Vienna, the 10 OPEC member countries with quotas in place are widely expected to extend their current export curbs through the third quarter.

What’s the punch line? U.S. crude oil and gasoline inventories are pretty high in historical terms for early summer, the recovery is slow, so demand is increasing slowly and contributing to keeping prices stable and lower than last year. Another important factor in this dynamic is the 15 percent decline in jet fuel demand relative to the same time last year, which has meant that refiners have turned more crude into gasoline.

Finally, this article points out something important that often gets overlooked when we think about gasoline supplies: the production substitution between home heating oil and gasoline:

He [John Felmy, the American Petroleum Institute's chief economist] noted that a year ago the U.S. also was coming out of a very cold winter that had compelled refiners to produce more home heating oil, which put them behind in preparing supplies of gasoline in anticipation of the summer months.

This example illustrates just how complex the interaction is among all of the determinants of gasoline prices.