How can the market price of oil fall so far so fast?

If the oil market is reasonably efficient, then the price of a barrel of oil should reflect something like the cost of production of the highest-cost barrel of oil needed to just satisfy demand. In other words, the market price of oil should reflect the marginal cost of production.

The price of oil on the world market was about $110 per barrel in June 2014 and now sits just under $50 per barrel. Can it be possible that the marginal cost of producing oil was $110 per barrel in June 2014 and is only $50 per barrel in January 2015?

Yes.

Here is how: in the first half of June 2014 oil consumption was very high relative to the then-existing world oil production capability. In addition, existing oil production capability is always declining as producing fields deplete. The marginal cost of a barrel of oil under such tight market conditions has to cover the capital cost of developing new resources as well as the operating costs.

Toward the end of 2014 additions to world oil production capability exceeded growth in consumption, meaning additions to production capability were no longer necessary, meaning the marginal cost of producing the last barrel of oil no longer needed to cover that capital cost. Sure, some oil company somewhere had to make the capital investment necessary to develop the resource, but most of those costs are sunk and competition in the market means they cannot make some consumer cover those costs. The market price under today’s looser market conditions only needs to cover the operating costs of production.

Given the large sunk cost component of investment in developing oil production capability, it is quite possible that the oil market was efficient at $110 per barrel and remains operating efficiently today with prices under $50 per barrel.

NOTE: Related data on world oil production and consumption is available in the U.S. Department of Energy’s Short Term Energy Outlook. Commentary prompting this explainer comes from the UC-Berkeley Energy Institute at Haas blog.

When does state utility regulation distort costs?

I suspect the simplest answer to the title question is “always.” Maybe the answer depends on your definition of “distort,” but both the intended and generally expected consequences of state utility rate regulation has always been to push costs to be something other than what would naturally emerge in the absence of rate regulation.

More substantive, though, is the analysis provided in Steve Cicala’s article in the January 2015 American Economic Review, “When Does Regulation Distort Costs? Lessons from Fuel Procurement in US Electricity Generation.” (here is an earlier ungated version of the paper.)

Here is a summary from the University of Chicago press release:

A study in the latest issue of the American Economic Review used recent state regulatory changes in electricity markets as a laboratory to evaluate which factors can contribute to a regulation causing a bigger mess than the problem it was meant to fix….

Cicala used data on almost $1 trillion worth of fuel deliveries to power plants to look at what happens when a power plant becomes deregulated. He found that the deregulated plants combined save about $1 billion a year compared to those that remained regulated. This is because a lack of transparency, political influence and poorly designed reimbursement rates led the regulated plants to pursue inefficient strategies when purchasing coal.

The $1 billion that deregulated plants save stems from paying about 12 percent less for their coal because they shop around for the best prices. Regulated plants have no incentive to shop around because their profits do not depend on how much they pay for fuel. They also are looked upon more favorably by regulators if they purchase from mines within their state, even if those mines don’t sell the cheapest coal. To make matters worse, regulators have a difficult time figuring out if they are being overcharged because coal is typically purchased through confidential contracts.

Although power plants that burned natural gas were subject to the exact same regulations as the coal-fired plants, there was no drop in the price paid for gas after deregulation. Cicala attributed the difference to the fact that natural gas is sold on a transparent, open market. This prevents political influences from sneaking through and allows regulators to know when plants are paying too much.

What’s different about the buying strategy of deregulated coal plant operators? Cicala dove deep into two decades of detailed, restricted-access procurement data to answer this question. First, he found that deregulated plants switch to cheaper, low-sulfur coal. This not only saves them money, but also allows them to comply with environmental regulations. On the other hand, regulated plants often comply with regulations by installing expensive “scrubber” technology, which allows them to make money from the capital improvements.

“It’s ironic to hear supporters of Eastern coal complain about ‘regulation’: they’re losing business from the deregulated plants,” said Cicala, a scholar at the Harris School of Public Policy.

Deregulated plants also increase purchases from out-of-state mines by about 25 percent. As mentioned, regulated plants are looked upon more favorably if they buy from in-state mines. Finally, deregulated plants purchase their coal from more productive mines (coal seams are thicker and closer to the surface) that require about 25 percent less labor to extract from the ground and that pay 5 percent higher wages.

“Recognizing that there are failures in financial markets, health care markets, energy markets, etc., it’s critical to know what makes for ‘bad’ regulations when designing new ones to avoid making the problem worse,” Cicala said. [Emphasis added.]

Moody’s concludes: mass grid defection not yet on the horizon

Yes, solar power systems are getting cheaper and battery storage is improving. The combination has many folks worried (or elated) about the future prospects of grid-based electric utilities when consumers can get the power they want at home. (See Lynne’s post from last summer for background.)

An analysis by Moody’s concludes that battery storage remains an order of magnitude too high, so grid defections are not yet a demonstrable threat. Analysis of consumer power use data leads them to project a need for a larger home system than other analysts have used. Moody’s further suggests that consumers will be reluctant to make the lifestyle changes–frequent monitoring of battery levels, forced conservation during extended low-solar resource periods–so grid defection may be yet slower than the simple engineering economics computation would suggest.

COMMENT: I’ll project that in a world of widespread consumer power defections, we will see two developments to help consumers avoid the need to face forced conservation. Nobody will have to miss watching Super Bowl LXXX because it was cloudy the week before in Boston. First, plug-in hybrid vehicles hook-ups so the home batteries can be recharged by the consumer’s gasoline or diesel engine. Second, home battery service companies will provide similar mobile recharge services (or hot-swapping home battery systems, etc.) Who knows, in a world of widespread defection, maybe the local electric company will offer spot recharge services at a market-based rate?

[HT to Clean Beta]

FERC’s Clark looks to states for help with regional markets

EnergyWire reports, “FERC’s Clark looks to states for help fixing dysfunctional markets.”

It is, I guess, a reasonable impulse. Given the way regulatory authority over the electric power industry is currently divided between the feds and the states, there are limits on what the one can do without the other. We saw in the fate of FERC Order 745, on demand response, evidence of the conflict: the court found that FERC’s rule encroached on states’ exclusive jurisdiction. States have also seen their efforts constrained (as, for example, the failure of New Jersey’s effort to subsidize investment in generating capacity).

FERC Commissioner Tony Clark is no stranger to state regulatory perspectives, having served nearly a dozen years on the utility commission in North Dakota, finishing as chair, and a year as president of the National Association of Regulatory Utility Commissioners (NARUC). Still, looking to state regulators, each elected or appointed within the political environment of local state capitals, to adjudge matters of costs and benefits on a regional basis seems to me a case of looking for love in all the wrong places.

RELATED NEWS: The Newest FERC Commissioner, Collette Honorable, was sworn in on January 5, 2015. Like Clark, Honorable was formerly chair of a state utility regulatory commission (Arkansas) and former president of NARUC.

Tragedy of the commons, Yugoslavian apartment building laundry room edition

The tragedy of the commons story is well known and examples abound, but I still enjoy finding new examples in unexpected places. Here is one such example, first published in 1992 but new to me.

The building referred to is an apartment building in Yugoslavia; the time described isn’t exactly identified in the article, but perhaps 1960s or early in the 1970s:

In the cellar of our building there was a washing room with a huge concrete washing basin and three new washing machines. At the beginning, everyone washed their clothes downstairs. There was a schedule hung on the door and each family took its turn once a week. The machines didn’t work for long. To put it mildly, people didn’t take very good care of them. After all, these machines didn’t belong to anyone in person, so no one felt responsible for repairing, or even cleaning them. The first machine broke after about a year, then the second one, then the third. In the washing room, people started to store broken chairs, children’s bicycles, beach umbrellas, charcoal for barbecues, skis, mattresses. … The basins were filled with supplies for winter: bags of potatoes, green and red peppers, and wooden barrels of sauerkraut.

We’d lost our common laundry room precisely because it was common. But by that time the standard of living in the country was high enough so, instead of forty people using three common machines, everyone could buy an imported washing machine for themselves, however unnecessary and irrational this really was. Even our own country started to produce them, except that they all were very expensive. This, strangely enough, became a reason to buy one, to prove that you were earning enough, that your social status was high enough, so you could afford household appliances. Social differentiation, starting with cars and TV sets, continued in bathrooms and kitchens. A washing machine became an item of prestige, and it was good for women, even if it really wasn’t meant to ease their lives in the first place.

From “On doing laundry,”
How we survived communism and even laughed, Slavenka Drakulić.

Drakulić’s description of her grandmother doing laundry (in 1950s Yugoslavia) reminded me of Hans Rosling’s TED Talk, “The magic washing machine.”

I have only read a few of the essays in Drakulić’s book, but so far it impresses me as a good collection of sharply-observed and reported essays on life in communist Eastern Europe.

Weak beer and antitrust economics

Yesterday’s Wall Street Journal brought the story, “Bud Crowded Out by Craft Beer Craze.” While Bud Light is currently the highest selling beer in the United States, the flagship brand Budweiser is fading. The international beverage giant is scrambling to win over younger drinkers to boost Budweiser sales, so the familiar Clydesdale horses are out this holiday season and ads will take on a younger vibe.

On Facebook Alexie Marcoux commented that Budweiser’s decline ought to put the end to the old Galbraithian narratives about corporations so powerful they can dictate tastes and preferences. We can hope (but I’m not hopeful — I suspect the demand for evil dragons to be slain by heroic antitrust economists will keep the myth alive).

The beer giant has been through a few mergers over recent years, and I wondered how Budweiser’s troubles were reflected in the related antitrust analysis. Antitrust theory isn’t built on the work of John Kenneth Galbraith, but antitrust narratives conjure similar images of powerful corporations and seemingly helpless consumers (granted that antitrust lawyers write in more leaden prose than JKG).

In January 2013 the U.S. Department of Justice Antitrust office filed a lawsuit challenging Anheuser-Busch InBev’s acquisition of a 100 percent stake in Grupo Modelo. Here is what Justice was worried about just over a year ago:

The Department of Justice filed a civil antitrust lawsuit today challenging Anheuser-Busch InBev’s (ABI) proposed acquisition of total ownership and control of Grupo Modelo.  The department said that the $20.1 billion transaction would substantially lessen competition in the market for beer in the United States as a whole and in 26 metropolitan areas across the United States, resulting in consumers paying more for beer and having fewer new products from which to choose.

Americans spent at least $80 billion on beer last year.  According to the department, ABI’s Bud Light is the best selling beer in the United States and Modelo’s Corona Extra is the best-selling import.  Because of the size of the beer market in the United States, even a small increase in the price of beer could result in billions of dollars of harm to American consumers, the department said.

According to the department’s complaint, the U.S. beer market is already highly concentrated, and prices are increased by strategic interactions among the largest brewers, including ABI and MillerCoors. ABI generally acts as the price leader, implementing annual price increases in the sub-premium, premium and premium plus segments of the U.S. beer industry. MillerCoors and other brewers have typically joined the ABI price increases, while Modelo has not. By pricing aggressively, Modelo–through its importer, Crown Imports–puts pressure on ABI to maintain or lower prices, especially in certain parts of the country. As a result, Modelo has become a particularly important competitor in the U.S. market.

The press release manages to divide the industry into for segments, from “sub premium” (i.e. Busch and Keystone) to “high end” which is described as including Corona, Heineken, “and a variety of craft beers.” This brief mention, as just a fraction of a segment of the industry, is the only mention of craft beers in the press release. Justice’s formal complaint mentions craft beers three times, each time more or less as an aside — they missed the real market action.

In the resulting agreement, the United States federal government sought to promote competition in the beer industry by, among other things, extracting a promise from the company acquiring a few AB-InBev assets that it would expand the capacity of a brewery in Mexico to at least 20 million hectoliters of packaged beer annually.

For this heroic antitrust effort beer consumers in the United States offer a heart-felt yawn. How many of our tax dollars when into deciding whether the Mexican brewery needed a capacity of 20 million hectoliters, rather than 15 million or 23.5 million?

Meanwhile, actual competition in the market continues to force international beverage giant AB-InBev to scramble for new customers.

NOTE 1: See full collection of Justice documents here.

NOTE 2: It isn’t just the Department of Justice, the private think tank the American Antitrust Institute is also worried about concentration in the beer market. Just a few days ago AAI sent a letter to the Department of Justice expressing concern about rumors of a AB-InBev merge with SABMiller. That letter follows AAI’s lengthy report, Global Beer: Road to Monopoly, which two years ago worried about a then-rumored merger between AB-InBev and SABMiller and the prospect of creating “a huge entity with great market power.”

I keep wondering how great the market power can be in a world without barriers to entry? No real secrets in how to brew beer. I suspect the biggest threats to competition emerge because alcohol distribution is highly regulated in the United States — not because one brewery in Mexico has a smaller than desired production capacity — but I suspect the Department of Justice will not be challenging the post-prohibition three-tier system anytime soon.

Price gouging in a second language

Research on differences between decisions made in a person’s native tongue and decisions made in a second language reminded me of an unexplored idea in the social dynamics surrounding price gouging.

I’ve devoted a few posts to the question of whether or not price gouging laws get applied in a discriminatory fashion against “outsiders,” primarily thinking of immigrants or cultural minorities. My evidence is slim, mostly the casual reading of a handful of news stories, but consider these prior posts and possible examples from Mississippi, New Jersey, and West Virginia.

In the New Jersey article I speculated it was possible that “outsiders” were more likely to engage in price gouging behaviors, and observed, “Social distance between buyers and sellers can work both ways.”

Some support for my speculation comes through communication research by Boaz Keysar of the University of Chicago, who has documented the view, as the subtitle of an article in the journal Psychological Science puts it, “thinking in a foreign tongue reduces decision biases.” Part of the explanation Keysar and his coauthors offer is the “foreign language provides greater cognitive and emotional distance than a native tongue does.” (The work was mentioned in a recent Freakonomics podcast.) An immigrant hotelier or retailer may not connect as emotionally as a native does with laws expressed in the native’s language or with customers when transacting in that language. When exchange is seen as impersonal rather than personal, price-setters are less constrained in their pricing decisions.

Interestingly, Keysar is also coauthor on a study concluding that moral judgments are markedly more utilitarian when problems and responses are conducted in a second language. Economic analysis tends to support the view that “price gouging” in response to sudden shifts in demand is the correct utilitarian response (as flexible prices help goods and services move toward those who value them most).