Floor Price, Round Two

A year ago, the Wall Street Journal carried an op-ed proposing that the US set a floor price for oil by means of a floating oil import tariff, as a way to reduce our reliance on the Middle East and to provide greater certainty for investors in alternative energy projects. My response to that idea later appeared in the letters section of the Journal. A week ago, in a column (Times Select required) addressing President Bush’s Iraq “surge” strategy, Tom Friedman of the New York Times proposed essentially the same concept, differing mainly in the price level involved, $45/barrel instead of $35. With all due respect to Mr. Friedman, whom I genuinely admire, this idea is just as ill-advised as it was a year ago, and in the meantime I’ve thought of a few more reasons why.

In addition to its inherent drawback of reducing the competitiveness of US manufacturers that sell into the global market, implementing such a tariff would be trickier than it might appear. If Mr. Friedman is talking about a $45 floor price for the West Texas Intermediate Crude (WTI) traded on the New York Mercantile Exchange, then what should be the floor prices of the various types of oil we actually import? Policy makers would have essentially three choices: they could impose the same floor price on all imported crude oil, set the tariff based on the price of WTI and apply it equally to all imported crudes, or vary it based on the quality of each individual crude type. Each option poses serious problems.

The first option just isn’t viable; setting an identical floor price for heavy sour crude from Venezuela and for light sweet crude from Nigeria would eliminate the incentive refiners require to invest in the costly hardware necessary to process the former. But applying a uniform tariff based on the difference of the legislated floor price and the price of domestic WTI wouldn’t work either, because once the tariff was triggered, the price of WTI would no longer be set by the market, but by the price of the imports that contribute to its supply, which in turn would be set by the tariff. This circular logic could only be avoided by basing the tariff on some foreign crude market. The only one sufficiently transparent and liquid to serve this purpose is the Brent contract on the ICE exchange in London. Thus if Brent were trading for $40/bbl, the tariff on all crude imported into the US would be set at $5/bbl, and WTI would be at $45. That could work, but applying that same $5 tariff to low quality heavy crudes would inflate their cost by a higher percentage and distort the crude selection process for refiners.

The ideal choice would be a tariff mechanism that explicitly recognized the inherent differences in quality, product yield, and market value of different crude oils, and preferably did so dynamically, rather than statically. Even something as simple as the sort of “gravity and sulfur bank” system used by domestic pipeline systems would be better than a flat tariff across all crude types. However, it would still be a poor substitute for the way a free market sets these differentials, because the value of each grade of crude oil is different for each refinery in which it might be run, and this shifts minute-by-minute as the value of the products that can be made from the oil changes. It’s just not the sort of thing that lends itself to a simple calculation and a scale that can be set once and for all, or even once a year. I’m not saying any of this is insurmountable, given our modern infotech capabilities, but it would introduce unwelcome complications into a process, the smooth functioning of which we all implicitly depend on when we pull up to the gas pump. It would also create a heck of an incentive for traders to try to outfox the system.

And all of this ignores the larger question of how to go about choosing a suitable price level at which to establish a floor. Should it change, year by year into the future, and should the trend go up or down? Up would make sense if we wanted to accelerate the process of weaning the US off of imported oil, but down has its own logic, as alternative energy technologies gradually matured and required less protection. And let’s be clear, protectionism is precisely what we’re talking about here.

What does $45/bbl mean at the gas pump? Well, depending on your state’s gasoline taxes and the level of refining margins at any point in time, this could translate into anywhere from $1.70 to $2.15 per gallon for unleaded regular. Given the national sense of relief that was apparent when prices fell back from $3.00/gallon to $2.25 this fall, it’s unlikely that a $45/bbl oil price floor would do much to promote conservation, though it might indeed foster more alternative energy by assuring investors that the projects they are supporting won’t be exposed to the risk of a future oil price collapse to the old norm of $25/bbl or less. (Domestic oil producers wouldn’t see much incentive for increasing their production, because any windfall they accrued from this measure would likely be taxed away, as demonstrated by the current royalty waiver flap.)

In contrast to a wide range of other options, including the much more politically challenging one of raising the federal tax on gasoline and diesel fuel, the floor price oil tariff is a deceptively simple-sounding, but actually quite complex bad idea. As a form of price controls, it is fraught with unintended consequences, many of which couldn’t be predicted in advance-- though I will suggest that increasing US emissions of greenhouse gases is a likely outcome. While I share Mr. Friedman’s concern that falling oil prices could slow down the development of necessary alternatives to oil, this is just the wrong way to support them.