Jewish World Review May 24, 2006 / 22 Iyar, 5766
The high price of economic ignorance
"The indignation shown by many people today at the mention of the very word profits indicates how little understanding there is of the vital function that profits play in our economy." Henry Hazlitt, "Economics in One Lesson," Chapter XXII: The Function of Profits
It was a futile effort, but a game try. The other day, the president of Murphy Oil, whose worldwide headquarters are located at El Dorado, Ark., tried to explain why the oil companies shouldn't be blamed for seeking a "reasonable return on capital."
It was like waving a red flag in front of very angry bull. You could almost hear the hoots from drivers paying almost $3 a gallon for gas here in Arkansas. Hey, we'd heard about Exxon Mobil's first-quarter profit this year: $8 billion! How justify that ?
Consumers are mad as hell and we aren't going to take it anymore. What's all this about a reasonable return on capital? What we want is a scapegoat, and Big Oil is made for the role.
When Claiborne Deming, Murphy Oil's president, claims that oil companies are just asking for a "reasonable return" on their investment, just what does he mean?
If you'll forgive me for sounding like your textbook in Economics 101:
When a company makes an investment, it does so in the expectation that it will earn a reasonable return, and this reasonable return is determined not just by the cost of the capital which is what the company is required to pay bond holders and banks in interest, and shareholders in dividends but the need to compensate the company for the risk on that investment. Because there's no such thing as a free lunch or a risk-free investment.
When oil execs like Mr. Deming try to explain all this, they're drowned out by all the anger out there.
Maybe that's because news about rising gas prices and oil companies' billions in profits tends to make the front page. The risks those companies take don't.
A small news story might help put things in perspective. ("Energy firms unlikely to see/ compensation, Morales says" Page 7A, Arkansas Democrat-Gazette, May 12, 2006)
The Morales in question is South America's newest Castro clone, and he's staying true to a pattern that has reduced Cuba, the Pearl of the Antilles, once one of the most prosperous countries in Latin America, to another grubby, desperate socialist paradise.
Comrade Morales, too, is seizing the property of foreign investors without the inconvenience of having to pay for it.
The size of Evo Morales' haul in Bolivia was buried in the last paragraph of this buried story:
"Foreign energy companies have invested more than $3.5 billion in Bolivia since 1996, including more than $1.5 billion from Petrobras (Brazil's government-owned oil company)."
It looks as though all of that could now be lost and the loss will have to be made up by a reasonable return on remaining investment. Which translates into higher prices at the pump.
Nor are dictators the only risk oil companies face. Some of those risks come with the territory like Alaskan oil spills.
Other risks are democratically elected like the Congress of the United States. Every time there's a spike in the price of gas, Congress decides to investigate those Gas Gougers. This has been going on since at least the 1920s, and no vast conspiracy has ever been found, but these public hearings/inquisitions do let the politicians act as if they can actually do something about the high price of gas.
Congress is now contemplating another tax on the oil companies' profits. How taxing the production of a commodity is supposed to reduce its price is another of those mysteries that has always eluded me, but never mind. Because a "windfall profits" tax isn't really an economic measure but a political one.
Meanwhile, Big Oil, like any big (or small or medium-sized) business, still has to make a high enough profit the return on capital to reap a reasonable return on its investment.
In this case, the companies that invested in those Bolivian oil fields may need to earn a return big enough to compensate them for the loss of $3.5 billion.
Windfall-profits taxes, gas-gouging investigations, fury at Big Oil . . . they make good politics but bad economics. They may even provide some emotional relief. What they won't provide is more fuel at lower prices. No wonder they call economics the dismal science.
What this latest uproar over the high price of fuel demonstrates most convincingly is not the villainy of the oil companies, but the need for more education about economics.
So good luck, Mr. Deming, at explaining all this. You're not up against an economic argument but an emotional reaction. And it's never easy trying to reason folks out of what they didn't reason themselves into.
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