Saturday, March 3, 2012

Gas prices, elasticity, and Frank Guinta

William Tucker at Miscellany: Blue takes Congressman Frank Guinta to task for misjudging the economics of rising gas prices. But William isn't doing any better than Frank.

William writes:
The world market produces 87.5 million barrels of oil a day. Guinta’s favored solution, the Keystone XL Pipeline Project, would produce 830,000 barrels a day — a drop in the bucket of world supply that would have a negligible impact on prices.

It may be a drop in the bucket, but that doesn't imply it will have a negligible effect on prices. In order to determine the effect on gas prices, you also need to know the elasticity of gas supply and demand-- that is, how much the supply and demand for gas change in response to a change in price.

If the supply and demand are elastic, then the addition of more gas will look something like this:
This graph shows that, when the gas supply expands, and the red supply curve shifts to the right, a small price decrease is all that's needed to encourage gas buyers to buy more gas, and to encourage gas suppliers to supply less gas. (The equilibrium price and quantity are determined by the intersection of the supply and demand curves.) Thus, the market reaches its new equilibrium with only a small drop in the price. In this scenario, a 1% increase in the supply of gas will have a negligible effect.

This is the same graph with inelastic supply and demand:

In this scenario, when the supply of gas expands, and the red supply curve shifts to the right, the price rockets downward. For whatever reason, people just aren't interested in buying more gas, so it takes a huge price change to clear the market. Even a 1% increase in the supply of gas could have a noticeable effect on the price in this scenario.

As it so happens, in real life, the market for gas is closer to the second scenario, with an inelastic supply and demand. Most people aren't going to significantly change their gas consumption in response to a 10 cent change in the price. Thus, in order for the market to absorb a new supply, gas prices have to fall a lot.

Bizarrely, the article from the Center for American Progress which William cites begins by assuming the demand is elastic, then switches mid-article to assuming an inelastic demand.

First, they quote Ken Green:
“The world price is the world price. Even if we were producing 100 percent of our oil,” Green said, if prices increase because of a shortage in China or India, “our price would go up to the same thing…We probably couldn't produce enough to affect the world price of oil,” he added. “People don't understand that.” [See the first graph.]
They then discuss the Strategic Petroleum Reserves:
There are, however, two proven solutions that would reduce demand and prices. If oil and gasoline prices rise to unbearable levels—say $120 per barrel or $4 per gallon at the pump—the administration can reduce prices by selling oil from the Strategic Petroleum Reserve—currently at its full capacity of 727 million barrels of oil. Each 1 million barrels put on the world market per day would increase the oil supply by more than 1 percent, putting downward pressure on prices.

Previous emergency SPR sales had an immediate impact. President George W. Bush ordered the sale of SPR oil to keep prices down once they hit $69 per barrel after Hurricane Katrina. The SPR oil was on the market in 17 days, and prices dropped 12 percent in a month. [See the second graph.]
I don't know who Ken Green is. Maybe he does know what he's talking about, but he was quoted out of context. In any case, his quote here is misleading. If releasing some of the strategic petroleum reserves lowers gas prices, then obviously we can produce enough gas to affect gas prices. More specifically, if 1 million barrels per day released from the petroleum reserves knocks down gas prices, then 830,000 barrels per day from the Keystone Pipeline should knock down prices by nearly as much.

So, factually, Frank Guinta's op-ed is accurate. (Though it would take time to get that new gas to the market, so the lower prices would not be seen for a while.)

But, while I disagree with William Tucker's economics, I also oppose more drilling. People buy too much gas in America, because the bad side effects of gas-- global warming, sending money to mad dictators-- are not factored into the price. Why should we add to the problem? After we have a carbon tax, or a cap-and-trade system, so that our gas market works sensibly, then let's consider more drilling. If people need relief from high gas prices in the meantime, better to cut their taxes to make up for the loss, instead.

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