The only reason American international sanctions work is that they are enforced by the American government against Americans and American companies. I should say it’s “the main reason” because American sanctions are also enforced, although more indirectly, against people and companies in friendly countries. Sanctions are analogous to protectionism even if they can be invoked for other (good or bad) reasons than supporting the prices and profits or wages of American producers—reasons such as national security or countering foreign tyranny. Like sanctions, a tariff against “China,” for example, works because it is enforced by the American government against Americans who want to buy Chinese stuff. (See my previous post “American Sanctions: Why Foreigners Obey,” October 1, 2019.)
Another example of that is provided by the Wall Street Journal (“Chevron Faces Tough Job Restarting Venezuela’s Damaged Oil Fields,” October 6, 2022):
Chevron in 2020 wrote down its Venezuelan assets, taking a charge of $2.6 billion, just months after the Trump administration stepped up sanctions that barred U.S. companies from drilling, transporting or selling Venezuelan crude.
This logic is not well understood by the general public. Governments and special interests don’t go out of their way to explain it.
Speaking of Chevron itself, the story suggests that the company may have, all in all, benefited from pandering to the Venezuelan tyrannical state: “Chevron has been operating in Venezuela for about a century and built a close relationship with the leftist government that has ruled there for more than two decades.” But note that other American producers with an interest in Venezuelan oil, including Chevron’s competitors, were harmed.
Incidentally (second fact), the dire state of oil production in Venezuela also provides a good and useful, even if extreme, example of industrial policy.
But in an otherwise instructive report, the caption of an accompanying picture in the same WSJ story does not exactly contribute to increasing economic literacy:
Oil companies are no longer motivated to drill more as oil prices rise.
Perhaps they are not motivated to drill for new, more expensive oil because of other factors that compensate for the benefit of a higher price. But ceteris paribus, they are certainly not less motivated, and the price may not have risen enough yet. Ceteris paribus, higher prices are the only factor that can effectively motivate them to drill more.
READER COMMENTS
steve
Oct 10 2022 at 4:48pm
Shouldn’t it actually be higher prices that you think likely to be sustained? So much of the price increase is related to the Russia/Ukraine crisis. Some of it due to inflation. If you think it likely inflation is somewhat controlled in the next year and all it takes is for Ukraine and Russia to reach an agreement to drop prices, do you take that risk? A lot of capital costs in a new well or even re opening an old one.
Steve
Pierre Lemieux
Oct 12 2022 at 11:05am
Steve: Quantity supplied (in the short run) is a function of spot prices (through increase in capacity, hiring more workers, pumping more from existing well, and such). Supply (which includes new investment) is a function of expected prices, not spot prices; in that sense, you are right. Here again, the distinction between supply and quantity supplied, the long-run and the short run, is important.
As for inflation, be careful. If all prices and wages rise in the same proportion, the allocation of resources will not change (except if inflation generates expectations of a future economic crash). Now, if inflation is 10% and gas prices increase by 50%, the relative price of gas has increased by 40%. The relative price increase is the only factor that changes the allocation of resources–in this case, increased production of gas and lower production of other stuff.
Thomas Lee Hutcheson
Oct 10 2022 at 7:47pm
I’ve zero love for the Maduro Chavez regime in Venezuela (although Colombia has benefitted from the immigration) but how does the decline in oil production there say anything about “industrial policy” as opposed to old fashioned state owned enterprises?
Pierre Lemieux
Oct 11 2022 at 11:14am
Thomas: The basic idea of industrial policy is that the state decide what will be produced in higher quantity and what in lower quantity. Butter or cannons? More heating oil or more iPhones? The more these decisions are made by the state (see the case of new industries in Rexford Guy Tugwell), the closer you are to the ideal of industrial policy. One may say it’s a matter of degree, but isn’t or wasn’t the goal of “socialism for the 21st century” to have the perfect industrial policy, including with the help of state ownership of the means of production? And where (and how!) do you stop the advance of industrial policy when you need it to correct the consequences of previous industrial policy?
Thomas Lee Hutcheson
Oct 11 2022 at 1:12pm
Actually, I thought the point of Socialism was to produce a fairer share of the fruits of modern technology and the way to do it was for the state to own the means of productions and so capture all the benefits. In principle what was produced could still be determined by consumer demand which profit making state owned firms would still be guided by. The idea of the state determining which goods should be produced I though of as the quirky Soviet version of Socialism which could not work for standard Hayekian reasons as turned out to be the case. In principle one could have “industrial policy” without Socialism or Socialism without “industrial policy.”
Pierre Lemieux
Oct 12 2022 at 11:21am
Thomas: You are right that there are many definitions of socialism, from Marx to the idea that “a fairer share of the fruits of modern technology” does not require the collective ownership of the means of production. Now, if one accepts that “market socialism” is impossible, as you seem to do, you cannot have socialism without an industrial policy with a vengeance. I don’t understand why you would not agree with that. (I discuss market socialism in my review of Schumpeter’s Capitalism, Socialism, and Democracy.)
diz
Oct 11 2022 at 2:35pm
Oil companies are no longer motivated to drill more as oil prices rise.
Yes, this is definitely false. As a career energy project investment professional I’d say we are in uncharted territory. Returns on individual projects are very high. You can drill a new well in parts of the US and earn returns north of 100%. I have seen them in the 200-300% range when oil was $100+. All other things being equal, these returns would provide strong motivation to drill. And any one company is a “price taker” in that their incremental drilling is unlikely to impact price.
What is different in this cycle is the reaction of the capital markets. Public Companies believe they will be punished for drilling. I am somewhat skeptical this is true, but it seems to be the conventional wisdom. Private companies have been more aggressive about drilling in part because the game of selling their projects to publics is no longer a winning one. To the extent they have drilling capital, and to the extent there is takeaway infrastructure they have been drilling. But private equity capital is beginning to run dry as well, in large part due to the effects of the impacts of “ESG” (an umbrella term for anti-oil and gas sentiment as used here) on capital fundraising.
It’s an interesting case study for an economics text book. What happens when capital markets do not allocate capital to high return projects due to social considerations? Something will give. The returns are high because the products are necessary for the foreseeable future.
Pierre Lemieux
Oct 12 2022 at 10:44am
Diz: Your points and questions are good, but they don’t change my argument. Remember: ceteris paribus. If you wonder whether A causes B, you change A while maintaining all other factors equal and see if B changes.
diz
Oct 12 2022 at 11:57am
I wasn’t intending to disagree with your point, just add some color. I think the following statement is true:
But ceteris paribus, they are certainly not less motivated, and the price may not have risen enough yet. Ceteris paribus, higher prices are the only factor that can effectively motivate them to drill more.
Higher prices do motivate producers to drill more, but there are other factors impeding them. To be sure there are labor shortages, supply chain issues etc but in past “booms” these were solved by paying more for labor, equipment, etc. There are parts of the country like the Appalachian basin that are pipeline constrained, but again in the past this was solved by building more pipelines.
Where I perhaps differ a bit is I think the friction point is in the capital markets. So as you might have put it: Higher prices mean higher returns, but maybe returns have not risen enough yet to draw more capital into the sector.
Though already you’re seeing some pushback on the ESG mindset and more interest in “energy security”, to some extent the capital we have available today is a function of what the markets valued over the last 2-4 years. When I said “something will give” I suspect what will happen is (at least some) investors will reduce their marginal appetite for ESG feelgoods and increase their marginal appetite for high return projects as commodity prices remain high. There is also a political overlay which may cause this new equilibrium point to occur at a higher or lower price.
Craig
Oct 12 2022 at 12:05pm
Just overheard ‘my good buddy’ George Gammon {he likes to use that phrase to describe guests on his show} that we have entered a golden age of political stupidity.
FogCity
Oct 13 2022 at 5:19pm
“Oil companies are no longer motivated to drill more as oil prices rise.”
I think this may be backwards. As Oil companies are less motivated to drill and “drilling” falls below reserve replacement levels, oil prices will tend to rise. Next thing you know, we have extreme contango.
Pierre Lemieux
Oct 14 2022 at 10:44am
FogCity: I think you are confusing quantity supplied and supply, a movement along the supply curve (which is what I was speaking about, ceteris paribus) and a change in supply (which, in case of a reduction of supply, has the effect you mention). The question was, does an increase in price leads producers to increase quantity supplied? See my post “A Frequent Confusion and the Yo-Yo Economic Model,” which explains the standard supply-demand model.
diz
Oct 14 2022 at 12:13pm
The industry has a saying “the cure for low prices is…low prices”. Or vice versa with high prices. This is largely a description of movement along the supply curve with the standard supply-demand model functioning, I think, with a lag effect given the time it takes for investment decisions to result in new oil and gas supply.
This cycle it really isn’t working that way. At least not as much as in the past. The industry response has been far more muted. There are people who have run correlation charts between operating drilling rigs and commodity prices and come up with estimates that as many as twice as many rigs would be running if historical relationships held.
Economists tend to caveat a discussion like this with “all other things being equal” but I think this is one of those cases where they are not. The “ESG effect” and to some extent domestic politics has greatly reduced the capital available to drill and caused caused a leftward shift in the supply curve. On this new curve, however, higher price does still incent more drilling.
Also, it’s probably worth noting in the oil and gas world this applies only in those markets where development is undertaken by profit seeking private entities whose individual actions are not reasonably expected to influence price. In much of the world oil is in the hands of national governments who explicitly attempt to influence price.
Pierre Lemieux
Oct 15 2022 at 12:49am
Diz: I understand better what you are saying. I agree with your penultimate paragraph. And your last paragraph certainly raises a good question: To which extent is oil and gas a private market? Do you know estimates of the annual world production that comes from state corporations?
diz
Oct 19 2022 at 3:53pm
Apologies had not checked the thread in a while. Quick search says 50% of oil production is in the hands of National Oil Companies. Didn’t take the time to vet whether they include Russia, as they have nominally private companies but many are skeptical the private owners don’t subvert themselves to the government. Perhaps more importantly NOCs control a vast majority of the export barrels, and thru OPEC work to keep prices at what they feel is a long term profit maximizing level. High, but not so high as to encourage other sources of energy overmuch.
Pierre Lemieux
Oct 21 2022 at 12:36am
Diz: Interesting estimate. I would be interested in your sources. Can you give them here? Or write to me through the contact section on pierrelemieux.com?
Craig
Oct 15 2022 at 5:05pm
“The “ESG effect” and to some extent domestic politics has greatly reduced the capital available to drill and caused caused a leftward shift in the supply curve.”
Read a Goldman Sachs called this the revenge of the old carbon economy.
On this new curve, however, higher price does still incent more drilling.”
But, but, wait a minute, I just think I heard Elizabeth Warren call for windfall taxes, no? 😉
I agree, but perhaps the supply curve is shifting to the left AND the SLOPE of that line is changing to make supply less elastic — less responsive to higher prices, not completely unresponsive to higher prices?
Pierre Lemieux
Oct 15 2022 at 8:49pm
Craig: This is not impossible. It’s an empirical question, I think.
Craig
Oct 16 2022 at 11:14am
It is but naturally an individual actor has difficulty knowing what the empiricism actually shows! The ESG effect, anecdotally? To me? Its real: https://news.yahoo.com/rent-revolution-coming-140920419.html
Different business, but at the moment there is no circumstance where I personally would want to be a landlord in this country.
So when Diz says: “You can drill a new well in parts of the US and earn returns north of 100%. I have seen them in the 200-300% range when oil was $100+. ”
He writes like he absolutely knows what he’s talking about and he very well could be correct, I would still be personally reluctant to invest in an industry of that nature because I can foresee windfall taxes in the near future and I can see future civil litigation where they come back in time and disgourge the ‘unjust enrichment’ to cover the costs of the externalities!
Don’t think that is coming? Trust me, I’m a lawyer (that’s the oxymoron of the day!), ITS COMING.
Pierre Lemieux
Oct 16 2022 at 4:12pm
Craig: My “empirical” comment was only about the elasticity issue. If investors expect costs to be higher or returns lower, there is a theoretical reason, by construction of the supply curve, for the latter to move to the left. (Expectations of optimistic and pessimistic investors are consolidated by trade on the market.) But it’s not clear in my mind why, theoretically, the supply curve should become less elastic.
Craig
Oct 16 2022 at 4:43pm
Well my theory is that additional quantity supplied might become less elastic, ie even though it might be more lucrative to do an activity, the producers might be less apt to produce that item. My hypothesis is based on anecdotal experience only, but that’s why its an hypothesis. Pre-pandemic, I was perfectly happy to continue to be a landlord. Now, to be honest I made up my personal mind in the face of the eviction moratorium and the fact the ruling striking it down was simply based on the CDC not having sufficient statutory authority. However, since then there is a situation where inflation erodes the value of the fixed rate debt payments while inflation makes the rental payments increase. My monthly expected rent could have increased by 30% while my debt carrying costs remained the same and of course, well below inflation. Its not enough to make me want to continue to supply a pre-existing unit and I have absolutely no interest in building rental units elsewhere.
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