March 26th 2016

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Articles from this issue:

ROYAL COMMISSION INTO SEXUAL ABUSE: J'accuse...! A travesty of justice

CANBERRA OBSERVED Turnbull's grand plan coming apart it seems

EDITORIAL Defence White Paper: rhetoric outpaces action


DOMESTIC AND FAMILY VIOLENCE Is not family breakdown the real issue?

ECONOMICS Oil offers resistance to free market's operation

HISTORY OF TAIWAN Kaohsiung Incident opens road to democracy

LAW AND SOCIETY Section 18C may render all speech "inoffensive"

VICTORIAN PARLIAMENT Risk to democracy, rights in health complaints bill

RESEARCH Transgenderism: treat it as a mental illness

MUSIC In deliberate pursuit of accidental sounds: Arve Henriksen

CINEMA AND SOCIETY Hollywood writes in "hero" part for Trumbo

CINEMA Hailing the Golden Era: Hail Caesar!

BOOK REVIEW Diminished expectations

BOOK REVIEW 12 million refugees

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Oil offers resistance to free market's operation

by Colin Teese

News Weekly, March 26, 2016

In the late 1930s John Maynard Keynes’ general theory of economics turned orthodox economic thinking on its head. Orthodoxy proclaimed that price flexibility in a free market would ensure that all output of goods and services, including labour, would be fully utilised.

Although the price of crude

oil may drop, there is no

guarantee that the price of

petrol at the pump will

follow it down.

Accordingly, they insisted, unemployment was impossible.

Keynes disagreed. Economies, he argued, could settle into a permanent state of unemployment. Recovery was impossible without government intervention to stimulate demand. The 1930s Great Depression proved him right.

The collapse of the Bretton Woods agreement in 1971, and the oil price hikes brought on by Middle East producers in the later 1970s, shook the faith of governments in Keynesian economics and opened the way for a rebirth of orthodox economics.

The story of quite how this backward somersault was made possible is complicated, and unnecessary to explain fully here. Short-handing, orthodox economics was reborn by redefining full employment.

Orthodox economists asserted that genuine full employment resulted in very high levels of inflation. If inflation was to be avoided, an unemployment rate of 4 to 6 per cent was necessary. Accepting their assertion took us back to the depression years of the 1930s, where unemployment was the accepted method of stabilising economies.

There was good reason why orthodox economics so eagerly embraced the idea of a link between inflation and full employment. That link made it possible to ignore the uncomfortable fact that in the real world price flexibility was a myth. In reality, in capitalist economies, for a variety of reasons, prices for both labor and commodities (labour is not a commodity) are infinitely flexible on the way up and stubbornly sticky on the way down. Business obviously doesn’t resist price increases; labour has the same attitude towards wage rises. Falling prices and wages are another matter.

The reality-modified free market

Without price flexibility, the ability of so-called “free markets” always to deliver the best possible economic outcomes must be heavily qualified.

In economist speak, free markets are not actually in play without “perfect competition”. That particular state is only satisfied in a market where large numbers of buyers and sellers are confronting each other and no individual buyer or seller has the capacity to influence price.

Unfortunately, in the real world of our time, no such state is ever present.

Since the 1980s there have been numerous examples of the failure of “free markets”; the most recent headline event relating to oil is but one of many.

Interestingly, the current federal Minister for Resources, Josh Frydenberg, in the February 29 issue of The Australian Financial Review, bought into oil prices. The main conclusion he drew was that the market would eventually find some equilibrium level.

Good luck to him. If that happens it will be the first time. All commodity markets, free or otherwise, are subject to constant re-adjustment – not least because they are subject to constant manipulation.

Oil prices have disrupted the world economy before. As already mentioned, back in the 1970s they surged; this time they have collapsed.

Defenders of economic orthodoxy will argue that back in the 1970s the market was corrupted by price fixing. And so it was. Then again, markets are never perfect.

Oil is not the only disturbed commodity market at this time. Iron ore and coal, vitally important to Australia, are similar. Prices have tumbled for both these commodities. True, they share certain similarities with oil, but there are interesting differences. This article will concentrate on the latter.

Many commentators express surprise at the extent of the fall in oil prices. How can this be?, they ask. We are supposed to be running out of oil. How can the commodity be in such surplus that prices fall by 80 per cent?

Whatever we think about so-called peak oil, and of any other environmental factors said to be impacting on oil, the fact is that right now more is being produced than the market wants. (An important reason may be that Iran, now sanctions have been lifted, is back in the race for market share.)

Remember, oil is not something consumers buy. Refining is needed to turn it into an end product which private motorists and commercial users need. Importantly, neither group is tempted to buy more petrol simply because petrol is cheaper; they buy as much as they need, regardless of price. Economists call this “demand and price inelasticity”.

Refinement of the topic

Refiners of oil know all about inelasticity. They know competing with each other on price is not in their interest, both when buying oil and selling end products. They have price setting power at both ends of the chain.

Oil producers confront different problems. Some of the biggest produce with the benefit of cheaper extraction costs. They can gain market share by offering oil at cheaper prices than their competitors. Their higher-cost competitors lose out. The big winners are buyers of oil.

Would oil producers as a whole be better off cooperating on price? There was a time when they thought so. Hence OPEC, the Organisation of Petrol Exporting Countries.

It turned out that OPEC would never be able to resolve the basic conflict between oil producers. There is no such thing as “oil producers as a whole”. The fact that the oil market works against some oil producers’ interests reflects the realities of oil production.

Producers will never be able to manage demand and control price. Price will be determined by what, effectively, is a buying cartel of refiners.

OPEC was never going to work because, from the start, its aim was to sell more oil at a higher price. Except, perhaps, in the very short term, and under special circumstances such as the 1970s, that is an economic impossibility.

What about the selling of end products of oil? Distributors of oil-based products know, and so should our government’s pricing watchdog, the Australian Competition and Consumer Commission, all about the price inelasticity of oil-based products. This fact has profound implications for prices that commercial and private end-users pay to fill up at the petrol pump.

The pricing policy of distributors reflects the reality of oil and petrol marketing. Petrol product distributors mostly can buy oil at the lowest price. Because of price and demand inelasticities, we also know that they can always recover the cost of their raw material (oil), plus refining costs, plus profit. More importantly still, we know that it is against their interest to compete with other refiners on price for the end product. For oil refiners, competition, for whatever purpose, would result in nothing more than a mutually destructive race to the bottom on price.

It is not colluding to maintain a price. It is more a case that normal business competition makes no commercial sense. But collectively they do determine prices.

Price watchdog won’t bark

Suppose, because of shortages of supply, oil prices rise. The price of the refined products will follow in lockstep. Price competition makes that inevitable. But what happens if oil prices fall, and substantially, from something like $100 a barrel to around $30? In the same way, we might expect end-product prices to reflect the change.

However, price and demand inelasticity ensures that they don’t. Even when the fall in price becomes as large as it is now, given the timidity of our price watchdog, we should not be surprised if distributors of petrol products retain most of their windfall gain as extra profit.

They will claim, in justification, that oil is only one element in the cost of producing petrol. True, but irrelevant. Though it seems enough to satisfy our price watchdogs. What the latter should be pointing out is, just because the price of oil falls, none of the fixed costs associated with converting it to petrol should change. Most, if not all, the fall in oil prices should be passed on to consumers.

The real reason falls in oil prices are not passed on to the consumers of end products is because the distributors don’t have to pass it on. Competitive pressures are not at work. No less important, as all economists know, is that real-world prices are flexible on the way up and sticky on the down.

Certainly, as far as oil is concerned, the “free market” needed to deliver the competition to the benefit of consumers has gone missing.

This is bad news for ordinary moto­rists, but there are more important implications. Road and other forms of transport for the goods and services we use are big users of petrol and associated products. The fact that they are denied the advantage of the flow-on from cheaper oil prices, imposes a cost burden on our economy. We are all paying more than we should for the goods and services we need.

Worse than that: our entire economy is being denied the important advantage of lower transport costs.

It might be that our price watchdog is indifferent to the plight of ordinary motorists, but surely, in the interests of the wider economy, more pressure should be put on petrol distributors to bring petrol prices into line with the fall in oil prices.

In the same context Mr Frydenberg’s comment that ultimately prices will return to equilibrium, also seems less than helpful. They won’t.

It would be more helpful if he were to acknowledge the reality of market failure in the case of petrol prices and press the ACCC to take more robust action against price gouging by the distributors of oil products.

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