The unintended consequences of anti-gouging laws

T. Boone on the potential of natural gas

Energy Economics 101

Beware-of-DemagoguesSounds as if Vermont Senator Bernie Sanders and Connecticut Senator Richard Blumenthal missed Energy Economics 101 in school. But that doesn’t stop them from publicizing their utter ignorance (H/T Byron Hood) of basic energy economics:

Sen. Bernie Sanders, I-Vt. introduced legislation today  that would require the Commodity Futures Trading Commission to impose strict regulations on oil speculators, who some blame for rising gasoline prices.

Sanders said if the agency failed to meet the two-week deadline outlined in his legislation, he would call for the resignation of commission chair Gary Gensler.

The legislation, if passed, would cap the amount of oil that speculators are allowed to buy and sell annually to 20 million barrels, increase the amount of money investors would have to back bets with from 6 to 12 percent and redefine investment banks as speculators rather than hedgers – investors who use the product they are buying for business.

The bill would limit speculators’ influence over the energy futures market. [.  .  .]

“There is mounting evidence that the increased price of gasoline has nothing to do with supply and demand and everything to do with Wall Street speculators jacking up oil and gas prices in the energy futures market,” Sanders said. [.  .  .]

Sen. Richard Blumenthal, D-Conn., a co-sponsor of the bill, said: “These price increases have been absolutely crushing. We need to attack these increasing prices that are the result of gaming and gambling. The CFTC should have acted five months ago.” [. . .]

The instinct of most politicians and much of the mainstream media is to embrace simple “villain and victim” morality plays when attempting to explain price increases in markets or investment loss.

The more nuanced story about the financial decisions that underlie the market fluctuations doesn’t garner enough votes or sell enough newspapers to generate much interest from the politicians or muckrakers.

That’s why we are again enduring demagoguery regarding speculators. Thus, it’s important that citizens who are not familiar with the function of speculation in markets take a moment to learn about its beneficial nature.

For example, check out Mark Perry’s excellent primer on futures trading here, here and here.

Or read University of Houston finance professor Craig Pirrong’s fine overview of how speculation in oil and gas markets actually helps all of us in dealing with rising energy prices.

Or peruse this Matthew Lynn/Bloomberg piece on how bubbles in oil markets are a reason to celebrate.

In Texas, one has to look no farther than Southwest Airlines’ success to understand the beneficial nature of speculation. Over most of the past decade, Southwest has taken advantage of futures markets to hedge its fuel costs (previous posts on Southwest’s hedging program are here). That hedging program has been one of the major factors in allowing Southwest to become the most (and one of the only) profitable U.S. airlines.

So, what Sanders and Blumenthal are really trying to do is restrict the very markets that provided Southwest and many other businesses with the platform on which they hedged fuel-cost and other business risk. The wealth and lower prices that is generated from those hedges is not inconsequential.

Stay informed fellow citizens. Demagogues such as Sanders and Blumenthal can inflict real damage on all of us.

The Persistant Financial Losses of U.S. Airlines

Could this have anything to do with security theater? Check out the synopsis from Severin Borenstein’s new working paper:

U.S. airlines have lost nearly $60 billion (2009 dollars) in domestic markets since deregulation, most of it in the last decade.

More than 30 years after domestic airline markets were deregulated, the dismal financial record is a puzzle that challenges the economics of deregulation. I examine some of the most common explanations among industry participants, analysts, and researchers — including high taxes and fuel costs, weak demand, and competition from lower-cost airlines. Descriptive statistics suggest that high taxes have been at most a minor factor and fuel costs shocks played a role only in the last few years.

Major drivers seem to be the severe demand downturn after 9/11 — demand remained much weaker in 2009 than it was in 2000 — and the large cost differential between legacy airlines and the low-cost carriers, which has persisted even as their price differentials have greatly declined.

Matt Simmons, R.I.P.

The Houston business community is in mourning this week over the sudden death this past Sunday of Matt Simmons, the 67-year-old investment banker, author and pundit whose views were a common topic on this blog over the years.

Matt founded Simmons & Company in Houston in the mid-1970’s with his brother L.E. as one of the first investment banks focusing on the increasingly important oil-field service sector of the oil and gas industry.

Simmons & Company eventually expanded into other areas of the energy industry and, by the late 1990’s, became one of the top energy mergers and acquisitions investment banks in the country.

Around 1983 or so, Matt’s firm and my law firm were on two of the floors near the top of the 700 Louisiana building in downtown Houston, so we developed a cordial friendship over the years by taking innumerable elevator rides together.

I’ve always been involved in a fair amount of oil and gas litigation, so Matt was always interested in that part of my practice.

And during the depression in the energy industry in Texas during the 1980’s, Matt was arguably the most insightful businessperson in Houston at the time on the direction of the industry and how it’s recovery should be structured.

Matt was a joy to talk with — witty, intelligent and interesting. That’s one of the reasons why, over the past decade or so, he became a media favorite for providing his provocative opinions about the energy industry.

Matt enjoyed his new role as one of the media’s energy industry pundits, but that wasn’t the best fit for the chairman of a company that was often advising companies that could be affected by his controversial opinions.

Matt retired from day-to-day management of his company in 2005 about the time his peak-oil treatise was published, but he continued on as executive chairman to help the company maintain client relationships. Matt and the company formally split ties earlier this year when he made his utterly unsurprising public comments in Fortune magazine about the probability of a British Petroleum bankruptcy.

Sadly, I didn’t see Matt again after the split, so I was never able to ask him about it. But my sense is that it was probably not that big a deal for him. He was working hard on his Ocean Energy Institute and I really think that is where his heart was as he segued into elder statesman status in the energy industry.

So, the local energy industry has lost a big part of its personality with the death of Matt Simmons. Many folks in the industry did not agree with some of Matt’s often controversial views, but that never stopped him from expressing those views and forcing energy businesspeople to think about the issues and formulate alternative viewpoints toward them. That is a resource that is vitally important to all industries, particularly one that is facing the current challenges of the U.S. energy industry.

Yes, Matt Simmons will be missed. Rest in peace, friend.

Stuff happens

groupthink (1) In this NY Times op-ed, Richard Thaler picks up on a theme that Ken Rogoff and James Hamilton raised last week ñ the similarity between the miscalculation of risks relating to the Gulf of Mexico oil spill and the Wall Street financial crisis:

AS the oil spill in the Gulf of Mexico follows on the heels of the financial crisis, we can discern a toxic recipe for catastrophe. The ingredients include risks that are erroneously thought to be vanishingly small, complex technology that isnít fully grasped by either top management or regulators, and tricky relationships among companies that are not sure how much they can count on their partners.

For the financial crisis, it has become clear that many chief executives and corporate directors were not aware of the risks taken by their trading desks and partners. Recent accusations against Goldman Sachs suggest the potential for conflicts of interest among banks, investors, hedge funds and rating agencies. And it is clear that regulators like the Securities and Exchange Commission, an agency staffed primarily with lawyers, are not well positioned to monitor the arcane trading strategies that helped produce the crisis.

The story of the oil crisis is still being written, but it seems clear that BP underestimated the risk of an accident. Tony Hayward, its C.E.O., called this kind of event a ìone-in-a-million chance.î And while there is no way to know for sure, of course, whether BP was just extraordinarily unlucky, there is much evidence that people in general are not good at estimating the true chances of rare events, especially when human error may be involved. [.  .  .]

How can government reduce the frequency and the severity of future catastrophes? Companies that have the potential to create significant harm must be required to pay for the costs they inflict, either before or after the fact. Economists agree on this general approach. The problem is in putting such a policy into effect.

Suppose we try to tax companies in advance for activities that have the potential to harm society. First, we have to have some basis for estimating the costs they may inflict. But before the recent disasters, companies in both the financial and oil drilling sectors would have claimed that the events we are now trying to clean up were, well, one-in-a-million risks, suggesting a very low tax.

Alternatively, an offending party could be made to pay after the fact, by holding it responsible for the costs it imposes. BP has volunteered that it will pay for all damages it considers ìlegitimate,î but we can expect a fight over how to define that word.

.   .    .  Suppose a company worth only $1 billion was responsible for this accident. It would go bankrupt and we would be unable to collect. And if we arenít careful, we will encourage companies that have enough money for collection to leave the drilling to those that donít. [.  .  .]

We are left in a difficult place. Neither the private nor the public sector seems up to handling these kinds of problems. And we canít simply wait for the next disaster, because, as people might say if they had to use G-rated language, stuff happens.

Professor Hamilton zeros in on the group dynamic that leads to the underestimation of risk:

I think part of the answer, for both toxic assets and toxic oil, has to do with a kind of groupthink that can take over among the smart folks who are supposed to be evaluating these risks.

It’s so hard to be the one raising the possibility that real estate prices could decline nationally by 25% when it’s never happened before and all the guys who say it won’t are making money hand over fist.

And this interacts with the forces mentioned above. When the probability of spectacular failure appears remote, and moreover it hasn’t happened yet, it’s hard to set up incentives, whether you’re talking about a corporation or a regulatory body, in which the person who makes sure that the risks stay contained is the person who gets rewarded. When everyone around you starts thinking that nothing can go wrong, it’s hard for you not to do the same. It can become awfully lonely in those environments to try to be the voice of prudence.

Finally, Cato’s Gerald O’Driscoll, Jr. notes the futility of reacting to the oil spill by implementing even more regulation:

What is the missed lesson from all this? When President George W. Bush had his Katrina moment, the federal government’s bumbling response was blamed on him, on the Republicans, and on conservatives. Now it is President Obama’s turn. His administration’s faltering response to the disaster in the Gulf is attributed to his personal failings, staff ineptitude, communication failures, etc. And, of course, the two administrations have shared responsibility for the poor handling of the financial crisis.

A big-government conservative administration failed in crisis, as has a big-government liberal administration. The regulatory state did not prevent excessive risk taking whether in financial services, nor perhaps in offshore oil drilling. Government response to crises once they occur is slow and inept. All this is not because either Republicans or Democrats are in power, but because big government doesn’t work. It can’t deliver on its promises. Big government overpromises and underdelivers. In reaching to do more, big government accomplishes less. That is not an ideological statement, but an empirical observation.

In the case of financial services, virtually all the proposed regulatory reform offers more of the same. Additional regulations will be added to existing ones without addressing why existing ones failed to prevent the crisis. The same process will likely happen with respect to offshore drilling.

The oil spill has triggered an important debate about the value of off-shore drilling, and that debate might conclude that off-shore drilling generates more harm than benefit.

But despite the nightly photos and videos of the oil spill on television, itís important to remember that drilling produces benefits in addition to its costs. Deep-sea drilling has been ongoing for decades with relatively few incidents that even come close to the current spill.

So, while this spill may reveal that deep-sea drilling is too risky, itís also quite possible that this incident was simply the result of poor decision-making combined with bad luck, and that there is a nominal chance that it will reoccur.

And it is very difficult to regulate bad decision-making and bad luck.

ff happens, indeed.

Futures trading 101

futures graph As noted many times over the years on this blog (recently here and here), the instinct of most politicians and much of the mainstream media is to embrace simple "villain and victim" morality plays when attempting to explain investment loss. The more nuanced story about the financial decisions that underlie the failed investment strategy doesn’t garner enough votes or sell enough newspapers to generate much interest from the pols or muckrakers. That’s why we are currently enduring demagoguery regarding speculators and why it’s so important that citizens who are not familiar with the function of speculation in markets take a moment to read  Mark Perry’s primer on the economics of future trading:

In fact, speculators don’t determine market forces, they respond to market forces of supply and demand.

Therefore, speculators can’t be blamed for high oil prices, because high oil prices are ultimately caused by factors beyond the control of any speculator: rising global demand in places like India and China, and global supply in places like Saudi Arabia, Nigeria and Venezuela. No individual speculator, or any group of speculators has an iota of influence over the demand for gas or oil in Brazil, nor do they have one iota of influence over the amount of oil in Canada or ANWR, or any control over OPEC quotas. Think about it – Exxon Mobil, one of the largest oil producers and private oil companies in the world, has NO control over the world spot price of oil, so how could a small group of speculators?

Read the entire post. Part II is here and an additional post on the same topic is here.

Fueling food riots

food riot Peter Gordon observed the other day that "politicians are better at creating problems than addressing them. Schools, housing, health care, transportation and others suffer from too much political attention."

Echoing that idea, Clear Thinkers favorite James Hamilton writes about one of the underlying economic reasons for food riots that are occurring in developing nations in some parts of the world:

As a result of ethanol subsidies and mandates, the dollar value of what we ourselves throw away in order to produce fuel in this fashion could be 50% greater than the value of the fuel itself. In other words, we could have more food for the Haitians, more fuel for us, and still have something left over for your other favorite cause, if we were simply to use our existing resources more wisely.

We have adopted this policy not because we want to drive our cars, but because our elected officials perceive a greater reward from generating a windfall for American farmers.

But the food price increases are now biting ordinary Americans as well. That could make those political calculations change, and may present be an opportunity for a nimble politician to demonstrate a bit of real leadership. I notice, for example, that although Senator Barack Obama (D-IL) was among those who voted in favor of the monstrous 2005 Energy Bill that began these mandates, Hillary Clinton (D-NY) and John McCain (R-AZ) were among the 26 senators who bravely voted against it.

Wouldn’t it be refreshing if one of them actually tried to make this a campaign issue?

Sigh. Read the entire post.