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Oil subsidies subvert free market functions

The United States consumes roughly 18 million barrels of oil per day, of which 51 percent is imported. The magnitude of our imports has led many to believe that we must subsidize oil companies to increase domestic production.

This belief gains popular support when respected news sources report that the dollars spent on imported oil often end up in the hands of terrorist groups.

For decades, our reliance on imported oil has provided the oil industry with a ready excuse to ask for tax preferences to enhance domestic exploration and production. But in a market system, the revenue generated from sales should provide a competitive profit; if not, there are too many firms and some should exit the industry. It is certainly not an indication that a government subsidy is needed.

U.S. policy has been to give preferential treatment to domestic oil companies. This has been accomplished through tax breaks that encourage exploration and extraction at a more rapid rate than a free market would support. Just recently, on May 17, Congress extended a $20 billion package of oil industry subsidies that will deplete U.S. oil resources at a rate faster than would otherwise occur in a free market.

A non-renewable resource

It seems logical to conclude that the greater the quantity of oil that the United States buys from foreign countries, the more power that those countries have. For at least three reasons, this logic does not apply to oil. First, the market for oil is global, and if one hostile nation decided to deny America oil, the United States would merely buy it somewhere else. Second, oil is a non-renewable resource. Once it is used, it is gone forever. Unlike a bushel of wheat, oil cannot be replaced in next year's harvest. Exploration can increase the known quantity of oil and advancing technology can make it easier to extract; but when a barrel of oil is gone, it is gone. Third, again unlike a bushel of wheat, oil does not spoil. Known reserves of oil can remain in the ground, stored there for future use.

In a market system, it is the price that signals when to extract oil stored in the ground. This price, determined by buyers and sellers worldwide and influenced greatly by the large Middle Eastern suppliers, determines the total quantity available at any moment and how much is produced in each country. When prices rise to surpass costs, or costs fall due to technological change, this stored oil will be extracted because it is then profitable to do so. Until then, it is economically efficient to leave it in the ground. Subsidies speed up production, depleting this non-renewable resource faster than in the unregulated market.

Stateside drilling and national security

Spending large sums to subsidize the opening of new domestic fields to extract oil at an artificially low cost weakens our national security. Because oil is non-renewable, every barrel taken from the ground in the United States is one less barrel that would be readily available in a national emergency. Thus, excessive depletion of domestic reserves would make the United States more, not less, dependent on foreign oil.

In turn, artificially low prices have changed oil consumption patterns and the production of alternatives to oil. On the demand side, for example, these artificially low prices encourage residential and commercial land use patterns that rely on the continued use of oil in transportation. Instead of transportation networks that increase the population per acre, oil-intensive street, road, and freeway networks decrease population per acre. Such patterns are very expensive to reverse. On the supply side, these artificially low oil prices discourage the production of alternatives to oil and stifle technological innovations of energy alternatives.

Now that the strong demand for oil by China and India has driven up the world price of oil, we can see the result of this long history of subsidized depletion: greater dependence, not less. The question is: Do we continue this pattern of excessive depletion and dependence on oil, or do we end the subsidies and let the market re-direct our efforts toward conservation and the development of alternative fuels such as natural gas, hydro, wind and solar, relying on oil as a transition fuel?

Charles O. Kroncke is associate dean in the University of South Florida College of Business. William L. Holahan chairs the department of economics at the University of Wisconsin-Milwaukee.

Oil subsidies subvert free market functions 06/12/11 [Last modified: Sunday, June 12, 2011 4:30am]
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