Oil: Marginal vs. Average Cost
By Arnold Kling
The Washington Post‘s Steven Pearlstein needs to learn the difference between marginal cost and average cost.
Without some miracle breakthrough like controlled fusion, energy independence is unattainable, probably undesirable and discussion of it avoids the real question of why the world continues to let the price of a crucial commodity be set at artificially high levels by a notorious cartel.
Ironically, at this moment of $54-a-barrel oil, OPEC is no longer in control. Given the current realities of supply and demand — and the panic and speculation driving oil traders — it is the market that is setting prices…
The entire article is like that. On the one hand, he concedes that oil prices are determined in a market. On the other hand, he makes it sound as if the reason that prices are high is that OPEC and the oil companies have suddenly gotten greedier.
My assessment is that demand has increased, and some supplies have been disrupted. As a result, the cost of satisfying the last increment of demand, the marginal cost, is now over $50 a barrel. The marginal oil comes from low-yield wells or wells that produce high-sulfur oil that is costly to refine. That makes the marginal cost high.
Average cost of oil production remains low. That is, there is a lot of oil that can be pumped and refined inexpensively–but not enough such oil to satisfy demand. Owners of low-cost oil, like any suppliers in any market, can charge marginal cost and earn high profits.
With more oil exploration and drilling, oil companies could reduce the pressure on supply. They have an incentive to do this to the extent that they believe that prices will remain high. However, if they believe that prices are going to fall again, then they would lose money by investing in capacity.
I think we will see some new capacity come on stream. It seems to me that even if prices slip back in the short run, the overall trend in the oil market is for demand to increase, and for occasional supply disruptions to lead to price run-ups. So I would think that investments in new production capacity would be profitable.
See also the online discussion forum on Pearlstein’s article.
UPDATE: See also Jerry Taylor and Peter VanDoren, who write
the best remedy for high gasoline prices is…high gasoline prices, which provide all the incentives necessary for motorists to conserve, for oil companies to put more product into the marketplace, and for investors to look into alternatives fuel technologies.
For Discussion. Should we go back to a system of oil price controls in order to reduce the profits of greedy suppliers?