An unconventional market based solution with immediate benefits

Dear Web Guest:

Let me start by apologizing- as always. I am over three months late. We are involved in a very intensive project to renovate our JFK property and I was hoping that I will be able to write something relating to this project. Unfortunately it is not over yet and it will have to be the subject of the next “refection” submission from me, few months from now.

In the mean time I want to declare that I am a staunch believer and supporter of market forces, I believe that together with the basic need and wish that we all have to be free, different and better from the other it is the forces of the market and the economy that make our world go around. However strong a supporter of market forces one is, one has to admit that some things can not be left to market forces alone. For instance national security is one on which there will be a consensus amongst the most market driven people around (and I am one of them).

It is my contention that the market price for oil is too cheap and does not price in the environmental cost of oil (I am far from being a “Green”. I am very concerned about the environment but understand that any solution must be market driven) and certainly does not price in the national security costs related to our dependence on this resource which is owned by others.

In a perverse sort of way I would like to suggest herein that the best way to solve the Oil problem (dependency, price etc) is for the government to levy a substantial tax on oil. My theory is that done the right way such tax will cost a little, will have great benefits and will actually probably drive the price of oil DOWN in the short term and for sure in the long term!!!

So how can that be? Are there free lunches?

The Tax

The administration should immediately propose and Congress should pass a law to levy a $20 per barrel tax spread over the next 5 years starting from $4 with immediate effect and additional $4 every year thereafter until 2010.

In order to keep things in prospective this equates for example to about 16 cents increase in the costs of a gallon of gasoline for each of the next 5 years. The President should have the authority to suspend all or part of this tax whenever there are actual (not speculative as there are now) supply interruptions caused by geopolitical issues. IE – whenever there is not enough oil, not only should he have the right to release oil from the strategic petroleum reserve as he already has but also to suspend the tax. That applies only when the supply shortage is caused by geopolitical reasons. It does not apply when the supply shortages are due to demand exceeding supply. The President should also have the right to accelerate the rate at which the tax is being levied if the price per barrel is below $60.

Geopolitical Concerns

The current price of oil reflects a substantial element of geopolitical concerns. Those concerns reflect the situation in places like Nigeria and Venezuela but ultimately the most serious concern is Iran. My proposal will not make these concerns worse. Whatever happens in the geopolitical front will occur with or without the tax. The ability of the President to suspend the tax if any of these concerns materializes should isolate the effects of the tax on any price movements resulting from any of these concerns coming true.

The Effect on The Price of Oil

Other than the above mentioned concerns the price of oil should have been affected only by normal supply and demand but it is not. The fact is that oil stocks are very high, at or close to the highest they ever been. That should have pushed the price of oil down significantly. However the price stays very high, why is that? The answer lies in the huge quantities of extra liquidity generated in today’s booming world which is seeking an investment outlet. Like many other financial and investment markets, all driven by the “tsunami” of liquidity looking for a “safe” place the price of oil is a bubble. The fact is that every time that there is a small increase in stocks, especially if it results from a smaller rate of usages (draw down) than expected, the price reacts violently down, why?

The oil market is a very efficient and huge market. There are not many financial/investment markets that equal it for liquidity and size. The result is that a lot of liquidity that is looking for investment is channeled to it. That liquidity is generally on the side of demand- IE driving the price higher and higher due to the geopolitical issues but more so, due to the inexorable belief, the consensus that exists amongst most experts, that the demand for oil resulting from the continued economic growth in the world will continue to increase and that supply will not keep up with demand.

This consensus needs to be shuttered. The announcement by the US administration of a plan to add $20 per barrel to the price of oil (over 5 years) by way of tax will immediately cause a serious rupture in that consensus belief. The concern for the speculators who are currently pushing the price up based on the “consensus” will be that such a tax will cause a substantial increase in the cost of oil, which will result in a significant reduction in demand activating a sharp downward correction in the price of oil.

This will cause a significant part of this speculative liquidity to want to come out of oil. It is enough to create a measure of uncertainty in the consensus belief to cause enough of the extra liquidity to leave. There is hardly any doubt that such an announcement in itself will immediately cause a reduction of $4 per barrel in oil. The price has come down by $5 in the last three days due to a slightly more than excepted increase in stocks. The announcement of the tax could actually cause a much bigger drop in price of oil thus causing the actual price for the consumer to stay the same in spite of the addition of the tax. It does not take much of that speculative money to change direction for the price of oil to move down significantly.

Thus the entire increase in the effective price generated by the tax will most probably be naturalized by the drop in the price of oil generated by the announcement of such tax.

Cost-Benefit Analysis

Like anything else in our world such a tax will have costs and benefits. The balance is very much weighted on the side of the benefits.

If, as I predict, the ultimate price of oil to the consumer (not only gasoline, all oil users, industrial, commercial, consumer) will actually not change by much as the market price will reduce by similar or more than the tax, then the benefits will be limited to:

– a massive reduction in the budget deficit
– another incentive to market forces (oil companies, alternative fuel companies, auto manufacturers) to seek alternatives to oil or additional supplies or ways to achieve reduced demand. With the price being as volatile as it is there is a fear that it will go down to a level that will not justify alternative fuels or the costs of investment necessary for reduced consumption. The tax provides a floor below which the cost of oil will not go and thus supports market forces in their efforts to seek these alternatives.
– The long term reduction in dependency on oil and its suppliers resulting from the above could actually be the most important feature of this tax.
If my analysis is wrong (and I strongly believe it is not) and the price of oil to the consumer does go up materially as a result of this tax the benefits mentioned above will be magnified. The pressure to find alternatives to oil will grow and results will come in faster. This is by the way why the price of oil will reduce once the announcement of such tax is made.

And what about the costs? Well, if I am correct and the ultimate price to the consumer will not change or will actually even reduce then there are no downsides. The economy will continue to grow and will just enjoy the benefits of the upsides enumerated above.

What if I am wrong?

To hear some politician the costs of adding $4 a barrel with immediate effect and the prospect of adding $20 over the next 5 years will be “devastating”. How could they say it with a straight face eludes me? Did we not just go through a period of three years wherein the price of a barrel increased from about $20 a barrel to $70 a barrel?? $50 a barrel in 3-4 years? 350% increase in the price in 3-4 years? Are these politicians living in the same world as we are?

What has happened during that period of time? Well, the economy grew at an average rate of above 3% per annum which only about 10 years ago was considered above the long term sustainable growth rate for the economy, unemployment is at record lows so much so that the Fed is concerned about inflation. What is the matter with these politicians?

An increase of $4 a barrel or about 6% a year for the next 5 years for a total of $20 a barrel or less than 30% will have a minimal effect on the economy. Current thinking amongst economist is that long term (as opposed to sudden) increases in oil have very little effect, some quantify this effect at about .25% of GDP growth for each $10 of increase in oil price. That assumes a static economy. We saw a $50 increase and no reduction in the rate of growth as the economy adjusts itself. The economy is very strong, oil is not a huge element of it anymore and the effect it will have is minute.

Every decision that we make has risks and rewards, costs and benefits. Here is one where the balance between the two in the short term is clearly positive, the effect of it in the long term will be to resolve one of the largest problems facing the world- the dependency on a finite resource and one which generally gives dictators the power to hold the world hostage.

What in the world can stop people from acting on it? Is it that politicians are not people? Maybe it is about time for the real people to tell the politicians what to do.

This is it until next time……

Ronnie Ben-Zur, CEO
May 10, 2006.