Call for Energy Price Controls: Has the 1970s Experience Been Forgotten? (hidden perils of a $3.50/gallon federal price cap)

By Donald Hertzmark -- October 3, 2011

[Editor note: Tomorrow, economist Michael Giberson will critically assess government ‘price gouging’ laws.]

As an economist, whenever I hear the word “shortage” I wait for the other shoe to drop. That other shoe is usually “price control.”

– Thomas Sowell, “Electricity Shocks California,” January 11, 2001.

Like Bill Murray’s weatherman character in the movie Groundhog Day, the American public is obliged to relive certain bad ideas again and again (and again).

Like the movie the idea of price controls for energy keeps coming back, but will we, like Murray’s weatherman, reexamine what leads us to relive such unworkable concepts? The latest contestant in this march of folly was posted recently in the Atlantic Monthly’s business blog.

The idea–called a buffer fund–is to establish a target price for retail gasoline (diesel, too, though they seem to have forgotten that part of the fuel supply) and use taxes or subsidies to maintain the target price over time.

Price Controls – Back by Popular Demand

The response from the readership was immediate, never mind how any of this would work, whether it has everworked as planned elsewhere, or what would happen to the economy if it were implemented. This is a great idea!  Stick it to Big Oil!  Let somebody else pay for my gasoline!

A sample of some of the comments on the Atlantic article includes the following gems:

· Normal market operations concentrate too much money in the oil industry

· Oil companies never put their earnings back into the economy

· We consume too much oil and only rationing can cure the disease (at least this one acknowledges that price controls accomplish nothing)

· It all stems from allowing (!) people to live in single family houses

· Speculators are behind all the problems!

This time the justification for a buffer fund and price controls is that every time the economy gets rolling, energy prices rise and snuff out the recovery in the crib.

Really, I am not making this up.

How The Buffer Fund Might Work

In brief the mooted buffer fund for gasoline would establish a target price for gasoline – say $3.50/gallon. When market prices are lower than $3.50/gallon (where? for how long?) the government would levy taxes on gasoline equivalent to the differential between the current retail price and $3.50.

Conversely, when the retail price exceeds the target price, then the government would release funds from their gasoline account (maybe we can call it a Trust Fund) to retailers to ensure that the target price is maintained.

The elements of the buffer-fund price-control program are simple:

· A separate financial account for the gasoline fund;

· A price surveillance mechanism to determine the actual prices of gasoline at various market points around the country

· A staff to assess whether market conditions warrant the fund to take in or release monies to the gasoline market;

· An electronic financial transfer in or out of retailer’s accounts to build or deplete the fund.

Now, most of the movements of gasoline prices are out of the hands of the retailers. Others are involved in the market as well – crude producers, refiners, traders, shipping companies, gasoline blenders/jobbers – so the buffer fund will need a few additional staff and functions who will:

· Establish “appropriate” or allowable prices for each major function;

· Determine the mechanisms for transfers of funds between and among the different segments of the gasoline supply industry;

· Survey prices of substitute fuels – diesel, LPG, natural gas – to ensure that suppressed gasoline prices do not result in diesel prices that are “too high”

· Review the operations of oil refiners to ensure that refiners are not using their flexibility to produce too little gasoline when prices are low and too much when prices are high.

· Establish enforcement procedures, fines, adjudication for a, etc. to make sure that those contravening the new regulations are appropriately punished.

So we can be sure that a buffer funds maintaining level gasoline prices would provide stimulus for someparts of the economy – price surveillance “experts”, cost of supply “experts”, lawyers, process servers, administrative law judges – you get the idea.

Covering these costs will be accomplished by adding a simple regulatory fee to the price of gasoline at the pump ($0.001/gal. should suffice).

Problems Aplenty

The only problem is this: buffer funds or buffer stocks have neverworked.

Many countries have tried to operate buffer funds or stocks for commodities – rice, sugar, coffee, gasoline, diesel fuel, palm oil – intended to prevent “excessive” swings in local or international prices. And they all have one thing in common – losing money for their sponsors and providing only a temporary remedy, if that.

Simply put, these buffer stocks or buffer funds have not been large enough to hold out against market forces for a sustained period of time. Moreover, political leaders have often found it difficult to resist the use of such stocks for short-term gain rather than as a part of larger economic or financial strategy.

In fact, countries that enacted price controls and buffer funds in the 1970s in an attempt to shield their citizens from the market price of oil and gas still maintain such controls. Indonesia, which now spends more than $14 billion annually on oil price subsidies has been trying to eliminate them for 20 years. But the problem with subsidies and shielding consumers from the market is this: once consumers have a taste of cheap oil products the buffer fund idea goes out the door and the subsidies become a way of life.

According to Germany’s GTZ, which tracks retail gasoline and diesel prices around the world, many country still subsidize either diesel or gasoline. How does GTZ determine whether a country subsidizes fuel? Why by using the US retail average price as the benchmark – below the US level is a subsidy, higher is a revenue régime.

Gasoline is often heavily taxed, but only the higher-octane variety, what is needed to operate modern low emission engines (used by the “wealthy”). Diesel and kerosine are subsidized to varying degrees, leading to excess demand, import management, losses at domestic refineries – the whole complex of economic maladies that has given rise to the “unbalanced” oil demand barrel – too much diesel demand, more than chemistry wants to produce – courtesy of a misuse of the pricing system.

Where Did This Crazy Idea Come From?

In July of this year the U.S. Department of Energy and the International Energy Agency decided that oil prices were “too high”, and that owing to all of this year’s bad luck – kinetic military action in Libya, earthquakes in Japan, piracy on the high seas, dilution of our precious bodily fluids – and that releasing 2 mm b/d from strategic stockpiles for one month would make the markets see the light, lower the price of oil and get incumbents reelected.

Things did not really work out that way: the release was too small to make much difference; one month is not enough time to convince markets that the OECD countries were serious; and the buffer stocks of crude and products in the OECD countries were too small.

Further, no efforts to increase the production or movement of U.S. or other OECD oil and gas were initiated concurrently, efforts that would have added considerably to the credibility of such a release.

What could have been done to change psychology was to announce the approval of the a pipeline to move more Canadian oil to the U.S. Gulf, the issuance of more licenses to produce oil inside the U.S., and the approval of more shale gas exploration in Europe. None of these possible initiatives, all popular with private investors, was announced.

The overall result? Oil prices dropped for a couple of days, but supply and demand adjusted to the injection of storage oil. Who could have imagined that? But there was one clear result; we can erase the word “strategic” from the SPR and rename it the Petroleum Buffer Stock. (Perhaps public television can run a story about the new PBS.)

Final Thought

Price controls, ill-considered release of strategic oil stocks and dumb policy can give the U.S. the worst of all worlds – higher prices, inflexibility and investment paralysis. I am reminded of the simple wisdom of Milton Friedman on this point:

We economists don’t know much, but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers can’t sell tomatoes for more than two cents per pound. Instantly you’ll have a tomato shortage. It’s the same with oil or gas.” ^[1]

^[1] “Controls blamed for U.S. energy woes”, Los Angeles Times, February 13, 1977, Milton Friedman press conference in Los Angeles (cited here).