Floor Price Pitfalls

A friend asked my opinion of a proposal in yesterday's Wall Street Journal to create an artificial floor price for oil by imposing a floating tariff, setting a minimum US oil price of $35/barrel. In his op-ed (subscription required) Mr. Marc Summerlin laid out a persuasive case for the benefits of such a tax. It would promote conservation and the development of alternative energy, while capturing revenue that might otherwise have gone to OPEC. Unfortunately, this idea has been around in various forms for decades, and it has many undesirable consequences beyond the energy markets.

The underlying concept has merit. In the absence of sufficiently liquid and affordable means for private firms to hedge against lower oil prices that would cripple alternative energy projects, the government could guarantee a floor price for oil, ensuring that alternative energy would be more competitive. The mechanism Mr. Summerlin suggests is a variable tariff that would kick in to keep the price of oil in the US above $35. If global conditions drove the price to $50 or $100, the full impact of those increases would be passed on to buyers. But a drop below $35 would be absorbed by the federal government in a dollar-for-dollar rise in the tariff.

A tariff on imported oil is another alternative to higher fuel taxes within the US. Both raise fuel prices and deter consumption, but they have very different effects on the economy and on the competitiveness of US products in the global marketplace. While a gas tax is imposed at the retail level, affecting consumers at the gas pump and raising the cost of all goods with a road-transport component, the proposed tariff would act at the producer level, driving up the cost of oil for refiners--thus raising the cost of gasoline, diesel and jet fuel--as well as for any businesses using oil or its derivatives in their manufacturing processes. That would make their products more expensive in the world market, relative to those of countries that don't impose such tariffs. As high as European fuel taxes are, they don't penalize their industries this way.

Another problem arises from the effect on domestically produced oil. Whenever the world price would fall below the level set by the tariff, US producers would begin to benefit from the artificially high price here. Unless taxed away in a manner matching the tariff, the US oil industry would receive a windfall. If this sounds familiar, that's because we tried something similar to this during the oil crises of the 1970s. The result was bureaucracy and market manipulation that rivaled anything seen with Enron. I started trading oil after the era of "Old Oil", "New Oil" and import certificates had ended, but I knew traders who lived in very nice houses and drove very impressive cars, as a result of exploiting those rules.

I also suspect Mr. Summerlin hasn't thought through the impact on the very futures market he's trying to help guide. The New York Mercantile Exchange's contract for West Texas Intermediate crude oil acts as the world marker price for oil, with a sizeable fraction of the physical crude delivered globally priced at a differential above or below it. The proposed tariff would terminate that role and truncate the market. Most of the volume would shift to the unconstrained London Brent contract, and the liquidity and influence of the US market on world prices would diminish.

It's possible that a narrower alternative to the tariff might achieve most of what the author intended. We could directly subsidize alternative energy projects for which the price of oil is a key factor. We might guarantee that oil sands projects, biofuels plants, and similar ventures always saw an effective oil price of $35 or more, without subjecting the whole economy to the distortions a tariff would create. Unfortunately, we tried that before, too, when the federal Synfuels Corporation guaranteed the market price for shale oil. The result was a set of billion-dollar boondoggles, none of which delivered meaningful benefits to the country. Similar mechanisms have perpetuated inefficient grain ethanol, at a high cost to taxpayers and with negligible energy benefits.

My regular readers know I have distinctly mixed feelings about higher fuel taxes, but I wouldn't hesitate to recommend them over either a tariff on imported oil or a price guarantee for alternative energy. Fuel taxes could raise at least as much revenue as a tariff and give a real boost to alternative energy and energy efficiency, while protecting the competitiveness of US exports and keeping the government out of the iffy business of picking technology winners and losers. The proposed tariff is just too similar to the failed energy policies of the 1970s.

An abbreviated version of this posting was published in the Wall St. Journal's Letters section on January 24.