Are High Oil Prices a Form of Exploitation

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No day passes without the news offering a neat economics lesson or two. No tuition fee is payable, only a little thought is needed to absorb the lesson.
It is in the nature of news that much or most of it is bad, for good news is no news and commands neither much air time nor many column inches. In democracies, where everything ultimately hinges on the popular vote and the polls report almost day by day which way the popular vote would go if it were cast then and there, governments need nerves of steel not to lean the way the polls go, and few governments have nerves of steel, especially when they have election dates to think about. Non-democracies have other reasons to be concerned about popular discontent.

One recurrent piece of news is about shamelessly high, and rising, oil company profits. Latest broker consensus estimates put the 2005 net earnings of the ten oil majors at over $100 billion. Exxon Mobil alone is expected to earn $31.6 billion, with Royal Dutch Shell, BP and Chevron each making over $20 billion. Such numbers make the lay public feel dizzy and furious, especially when the moment comes to fill the cars tank and paying painfully more than one did last time, or three months ago.

Governments find it imperative to be seen to be doing something to get the price down. In Western Europe, between two-thirds and three quarters of the retail price of gasoline is tax and the easiest way to reduce the price would be to cut the tax. Nearly every government has so far resisted the pressure to do this. Keeping the tax high is the main way to keep European consumption below the American level and put an obstacle in front of the triumphant advance of the “sports utility” behemoths. The remaining way to appease the angry public is to attack oil company profit margins. Though high profits curb consumption no less than do high taxes, cutting the former does not hurt government revenue while cutting the latter does.

Last month, both the Austrian and the French government threatened to put an excess profit tax on oil company profits unless they reduce gasoline prices at the pump. (They duly did so to a minor extent, though some of the reduction was due to an easing of crude prices after the International Energy Agency organised a 2 million barrels/day release from government stocks.) France in addition invited the companies to make greater efforts to develop renewable energy sources.

Wasting Resources On Renewable Energy
Renewable energy deserves a digression. Seven kilometres offshore from where I live on the Channel coast, the French powers-that-be have just given the go-ahead for a German company to build the countrys biggest wind farm, from which 21 windmills, tall as 40-storey skyscrapers, will deliver 105 megawatts of power into the national grid when the wind blows. To attract the investment, a price equal to 2.2 times the Western European average had to be guaranteed. 105 megawatts is about a tenth of the capacity of an average-sized thermal power station, but will have the same initial capital cost.

See Natural Gas Regulation by Robert J. Michaels in the Concise Encyclopedia of Economics for a discussion of government regulation of gas.

If oil companies have not so far put more money into renewable energy, it is because short of a technological miracle, they thought it would be a waste of money. Some miracle of an unexpected kind will very likely occur one day to make some renewable energy source economical, but until it does, responsible oil companies will make haste slowly toward biomass, solar or wind power beyond the research stage. They can hardly invest in anticipation of technological miracles, and to invest in existing technology is to waste two units of hydrocarbon energy to produce one unit of renewable”as is the case with hydrogen as a fuel and ethanol vegetable origin.

Will Oil Go To 100 Dollars A Barrel?
Hydrocarbon reserves are supposed to start running out around 2020-2030, and go to $100 a barrel or more before they do. These conjectures need to be put in perspective.

Crude oil reserves have been supposed to be running out for the last forty years, yet have remained remarkably constant as a multiple of annual production, rising as production rose. There is no guarantee that this will go on being the case indefinitely. But contrary to the somewhat simplistic argument that “like everything else, oil in the ground is a finite quantity”, there is no presumption of the reserves-to-production ratio falling in the foreseeable future. For all we know, it may rise. The headlong progress of seismic search and drilling technology is likely to permit exploration to depths undreamt-of a mere five years ago. After all, over 90 per cent of the worlds sea bottoms remain wholly unexplored. Deep drilling in very deep water used to be unthinkable, now it is just very expensive, but as the practice spreads, it will become less expensive.

Currently, about 30 billion barrels of oil a year are taken out of proved reserves and about the same amount put back due to new discoveries and transfers from probable to proved reserves. At an average price of $50 a barrel, this oil will fetch $1.5 trillion, of which $500 billion accrues to OPEC countries and $1 trillion to non-OPEC producers. At a “ballpark” figure for finding costs of $12/barrel, it takes $360 billion to add back the same quantity of oil to the reserves. The difference between the finding cost and the selling price is accounted for by amortisation of production installations (in fiscally generous countries, by a depletion allowance as well) by lifting costs, royalties and taxes, and the upstream profits of the operating companies. Downstream profits are earned from much thinner refining margins. Raising the finding cost by, say, 50 per cent to replace reserves would raise the total cost of crude, and of refined products, by much less than 50 per cent. There seems to be no good reason for crude to cost $100 for any length of time. If it did, a glut of crude might well follow a few years later.

It is the upstream profit that acts as the tail that wags the dog. Its expected level determines the finding cost the oil company will be willing to incur to replace (or raise) reserves. Until two years ago, the French oil company Total had a policy of not undertaking an exploration-and-development project unless it could at least pay for itself at a world oil price of $10 a barrel. This severe cut off level would hardly allow spending more than $3 a barrel on finding costs. However, what determines the finding cost that an oil company will be willing to risk is not the expected price of oil, but the expected profit it can make at that price. If the price goes from $50 to $70 or even a $100 a barrel but the company is not allowed to make any more money at $100 a barrel than it did at $50, it will not be prepared to incur higher finding costs. The deep ocean bottoms will remain unexplored and known world oil reserves will start to run out. Then will biomass and wind farms come into their own, at a vastly higher cost than would have been necessary if oil company profits had not been threatened with excess profit taxes and publicly pilloried as shameless if not downright criminal.

But Ought Exploitation Not Be Stopped?
One lesson to be learnt from the high price of oil is that it acts as a lure, inducing oil companies, from Exxon down to the small wildcatter, to explore prospects that did not look economic before, thus to increase probable and proven reserves and”perhaps to their own dismay”get the oil price down again. We call this economics, and it takes cool heads to let it work itself out. Most of the voting public lacks cool heads, and poll-watching politicians cannot afford to stay cool if they want to keep their influence and their seats. They will feel a need to reject the workings of oil economics for being “exploitation of the defenceless consumer” that ought to be stopped. Hence the threat to confiscate “excess” profits,”a threat that will discourage some of the very investment that would in time raise oil reserves and deflate the “excess” profits that called it forth.

Behind this easy lesson looms a larger one about labour and capital, wages and profits. A self-correcting mechanism inherent in contractual freedom, helps push up low wages because low wages permit high profits and high profits lead to more rapid capital accumulation, hence higher demand for labour. The mechanism works in the opposite direction if high wages squeeze profits and curb capital accumulation.

In his Journeys to England and Ireland1 the sociologist and historian Alexis de Tocqueville was appalled by the miserable living conditions and low wages of workers in early 19th century English industry and noted that the mill owners were bringing starving men over from Ireland to have a large and docile labour supply and prevent wages from rising.

It is a fact that the Irish were made better off by being brought to work in the Lancashire mills, and it is a fact that the English were flocking to the mill towns because their life as farm labourers was more miserable still than as cotton spinners. Nevertheless, to observers like Marx and Engels, exploitation was flagrant. If it had been stopped by legislative fiat and regulation, capital accumulation would have stopped and the spectacular industrial expansion of England would not have taken place. It was thanks to this expansion that by the latter part of the 19th century, the English worker was arguably the best paid and generally best off in the world and that the Irish immigrant to Northwest England and West Scotland could share in this relative prosperity. Without “exploitation” and the corrective mechanism of capital accumulation that it sets off, much of the developing world would still be stuck in utter misery.


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