John McGowan Seeks a Guide for the Perplexed

He writes:

John McGowan: I also know that Professor DeLong is not running an Ann Landers service for the economically challenged. But I am encouraged by his having just today posted a request to the physicists of the world to help him in his perplexity about the attraction between negative and positive particles. So here’s my request...:

In its article on the energy bill last week, the Washington Post writes about “the oil and gas industry, which has seen record profits in recent months.” My question: how does the rising price of oil translate into more profits for Exxon?...

ExxonMobil owns a lot of the oil it sells. It doesn't have to buy it from anybody. Thus its costs go up by little when the price of oil goes up. But its revenues--that's a different story. The prices of the refined petroleum products it sells go way up when the price of oil goes up. And so the profits it reports go way up as well.

Furthermore, if the oil market is completely demand driven, why hasn’t the price gone up even further?... [T]he companies have got the consumer by the balls. Why not just squeeze harder?... But what keeps Exxon from maximizing what it charges for its product?...

Hard as it may to believe, the oil companies are scared enough of the antitrust authorities not to explicitly collude with each other to charge higher prices, and are inept at creating and maintaining market institutions that would support informal collusion. The only times when oil prices have been seriously and consistetly elevated well above marginal cost are (a) in the days of standard oil, (b) when the Texas Railroad Commission ruled the earth, and (c) in OPEC's heyday. What keeps Exxon from charging even more is its fear that its customers will buy their petroleum products from somebody else if it tries.

The final possibility is that the oil futures market is pricing oil way beyond its current actual cost of production. And if that’s the case, then high oil prices on that market are, at least in the short term, simply a bonanza for oil companies. Maybe that’s the case. I don’t know.

The cost of production of which oil? There is oil that costs $5 a barrel to extract. There is oil that costs $15 a barrel to extract. There is oil that costs $55 a barrel to extract. And then there are all those places with oil--oil shale, oil sands, et cetera, et cetera--where the oil would cost more than $60 a barrel to extract. The oil futures market is guessing (a) what level of demand for oil there will be in the future, and (b) how much it will cost to pump that last barrel of oil to satisfy that last little bit of demand. But for every barrel other than that last, most expensive barrel there is a wedge (and in many cases an enormous wedge) between the market price and that particular barrel's cost of production. It's an "economic rent."

I have an even larger question. Did the increased emphasis on “primary responsibility to the shareholders” since the mid-1980s bring about a marked change in what are considered acceptable profit margins for big American companies?... When I arrived in Rochester in 1984, Kodak employed 54,000 people in the Rochester area. In 1986 (or so), Kodak was the target of a hostile takeover bid because the company (an absolute model of a paternalistic employer and civic booster) was seen as “underperforming.” The company fought off that takeover bid, but within eighteen months the CEO had been fired, a new management team was brought in, and well before the recession of the early 1990s, Kodak had embarked on the downsizing that now has it employing less than 30,000 people in Rochester. Now, I know that Kodak’s transformation has many complex causes.... But Kodak’s first move toward cutting costs was not a response to direct competition or to the market’s resistance to its products. It was about increasing the profit margin. A once acceptable profit margin had now become unacceptable...

Ah. This is one of the great unresolved questions in the economic history of America in the twentieth century. There are, broadly speaking, three interpretations of what went on:

The first is the interpretation of a whole bunch of finance economists starting from Adolf Berle and Gardiner Means writing in the 1930s, and including my brother-in-law Paul Mahoney. It is that a whole bunch of changes in corporate law and financial practice in the early twentieth century culminating in the New Deal shifted a great deal of practical power away from "owners" and to "managers." Shareholders collected their dividends, yes. On those rare occasions where companies wanted to issue more stock managers were very solicitous of shareholder concerns, yes. But most of the time managers did what they wanted, chose their own successors, and set corporate policy with not that much attention to maximizing company stock prices either in the short run or the long run. And shareholders couldn't do much of anything about that: it was simply too costly and too hard to stage a successful proxy fight to throw out the incumbent managers at the company annual meeting.

Now this does not mean that shareholders were "exploited." Managers did care about the level of dividends and the price of the stock--it was a big loss of face at the country club to report poor financial numbers. But managers cared about other things as well--being pillars of their community, indulging in natural benevolence toward their subordinates, and avoiding nasty headlines in the local press, among others.

Now if you're a finance economist, you see this system as "inefficient": companies are wasting a lot of money by employing too many people in jobs that are cushier than they have to be, and while this is good for the workers of the company it also raises costs and prices, and so the gains to workers are outweighed by the losses to shareholders (who collect lower dividends) and consumers (who pay higher prices). If you're John Kenneth Galbraith, you see this technostructure--this technocratic corporate elite of managerial capitalism--as broadly a good thing, because managers are interested in the fundamentals of production and human relations rather than in prettying up their numbers for Wall Street road shows.

In any event, this system comes to an end in the 1980s as Wall Street figures out how to successfully undertake hostile takeovers, and as the threat of being subject to a hostile takeover pushes even those managers who would have been very happy under the old system to pay more attention to the bottom line as a way of boosting current stock prices and making the benefits to outsiders' undertaking a hostile takeover much less.

That's the first interpretation (in its two flavors).

The second interpretation is one that has been pushed by Larry Summers and Andrei Shleifer. It notes that organizations run on patterns of long-term trust and confidence, and that it is devastating to an organization's effectiveness for those at the top to break the established implicit long-run bargains that the organization runs on. Under this interpretation, the paternalistic-employer-and-civic-booster model of the American corporation that dominated the first post-WWII decades was an effective and efficient system of corporate organization. Come the hostile takeover, however, the corporate raiders can replace the old management that had made and kept the implicit long-run bargains with new managers who have no attachment to them, and are willing to do the bidding of the shareholders and the takeover artists. This "breach of trust" moves us to a system of corporate organization that is less efficient and effective for society as a whole--workers who don't trust their bosses won't spend time learning things that are important if you work for this particular company but not in the larger job market, firms won't invest in the community in an attempt to make it a place where workers would like to stay, et cetera. But this new form does expropriate a lot of the value of the firm that was shared with workers-as-stakeholders, and transfer the value to the bosses and the shareholders.

There is also a third interpretation: that the coming of the Volcker disinflation, the dominance of central bankers, and the elevation of price stability over full employment as a goal of governance was bound to weaken American workers' power enough to make the Kodak model clearly less profitable than the more "Hard Times" alternative.

I find that I'm 30% a finance economist, 20% a Galbraithian, 20% a follower of the Summers-Shleifer "breach of trust", and 30% a believer that the high unemployment of the Volcker disinflation was the key in its shift of power away from workers.

You will observe that I give 0% weight to the hypothesis that it was a shift in culture--a rise in the belief that managers had "primary responsibility to the shareholders"--that was responsible for the very real change that you ask about. This is a professional deformation: for 27 years I have been trained to look first at changes in technologies, resources, institutions, forms of organization, and incentives, and only after all of these have failed to give answers to throw up my hands and disappear in a "blaze of amateur sociology."

How much of a difference did this shift--whatever caused it--actually make? Here's a graph from the National Income and Product Accounts: net operating surplus of private enterprises as a share of net domestic income. It shows (a) a large and steep fall in the rate of profit at the end of the 1960s, (b) a partial jump back up in the 1980s. So figure that these changes in the 1980s, whatever caused them, look to have boosted profits by about three percent of total income.

Comments

[liberal]

Brad DeLong wrote, "The cost of production of which oil? There is oil that costs $5 a barrel to extract. There is oil that costs $15 a barrel to extract. There is oil that costs $55 a barrel to extract. And then there are all those places with oil--oil shale, oil sands, et cetera, et cetera--where the oil would cost more than $60 a barrel to extract. The oil futures market is guessing (a) what level of demand for oil there will be in the future, and (b) how much it will cost to pump that last barrel of oil to satisfy that last little bit of demand. But for every barrel other than that last, most expensive barrel there is a wedge (and in many cases an enormous wedge) between the market price and that particular barrel's cost of production. It's an 'economic rent.' "

Yes, Ricardo in a very modern setting.

BTW, it looks like the post is an email containing two voices. Very hard to read. Would be better with HTML blockquote tags.

[Jean-Philippe Stijns]

[...and 30% a believer that the high unemployment of the Volcker disinflation was the key in its shift of power away from workers]

I am wondering how much of the ECB's high interest rate policy can be directly or indirectly interpreted as an attempt to break the power of unions in the European Union. I also wonder if the end-product will be stagnation of real median wages...

[scorpio]

certainly the merger wave that started in the '80s has led to oligopolistic markets across many industries, allowing management and shareholders to extort rentier profits vs consumers and the labor force. "it's my way or the highway". and the highway leads to low-wage countries.

[anne]

Jean-Philippe

"I am wondering how much of the ECB's high interest rate policy can be directly or indirectly interpreted as an attempt to break the power of unions in the European Union."

Before trying to answer this question, ask whether the power of unions in Euro countries is waning. What is your opinion?

[kharris]

J-P S is scaring me. The implication is that, just by doing what we pay them to do, central bankers may be working persistently against the interest of workers. Since central bankers cannot target organized labor specifically, his question must suggest that the pursuit of low inflation, at some point, skews the economy toward benefiting owners at the expense of workers. Do we believe that is true?

[David Yaseen]

Is any of the increase in oil company profits due to an insistence on their part upon a specific return on investment for the oil they sell that they don't already own? If so, roughly how much of the increase in end-user prices can be attributable to this?

[Jake]

Email: "Furthermore, if the oil market is completely demand driven, why hasn’t the price gone up even further?... [T]he companies have got the consumer by the balls. Why not just squeeze harder?... But what keeps Exxon from maximizing what it charges for its product?..."

Prof. De Long: "Hard as it may to believe, the oil companies are scared enough of the antitrust authorities not to explicitly collude with each other to charge higher prices, and are inept at creating and maintaining market institutions that would support informal collusion...
What keeps Exxon from charging even more is its fear that its customers will buy their petroleum products from somebody else if it tries."

He nails it in the last sentence, despite his earlier attempts to pat big government on the head. Can you say SUPPLY and demand?

And collusion doesn't work unless you get about 75% of the market in one pocket. Otherwise, competitors will undercut you and they will become rich at the expense of collusion greed.

[anne]

KHarris

"J-P S is scaring me. The implication is that, just by doing what we pay them to do, central bankers may be working persistently against the interest of workers."

Agreed. I was struck by the remark, and would like to see this much discussed.

[anne]

The European central bank is charged not with balancing relative price stability against growth and employment as is the Federal Reserve. Rather the European bank is charged with limiting inflation. This charge makes the experiment of Alan Greenspan in persistantly lowering short term interest rates as the budget balance improved during the Clinton Presidency, even as unemployment fell dramatically, impossible.

[Julian Elson]

Your marginal extraction cost view of oil prices would make more sense if oil were a renewable resource. Since oil isn't renewable, though, intertemporal substitution effects also effect prices. The simple model of intertemporal substitution of exhaustible resources (with zero marginal extraction costs), as found in, say, Varian, is that oil prices rise at the interest rate, until, at the same moment, they are exhausted and oil prices reach the price of their nearest perfect substitute (say, liquefied coal). Of course, since we have an exhaustible resource AND costs of extraction that vary with quantity AND market manipulation from OPEC... I'm too tired to really think about it.

[dogfacegeorge]

"the pursuit of low inflation, at some point, skews the economy toward benefiting owners at the expense of workers. Do we believe that is true?"

Is there any doubt that this is true? I thought that was why we insulate the Fed (as best we can) from the political process.

[anne]

Then I ask again, are European unions losing influence because of the unemployment levels through the Euro countries? Can the European central bank be a limiting element on union influence?

[anne]

George

The answer seems less evident given the balance between inflation and employment the Federal Reserve is asked to maintain. For Europe, I agree. I have never carefully considered the relation however.

[Tom Cecere]

One part of the "implicit bargain" argument that Brad omitted is the issue of management compensation. In a steady state world, management would take its riches out over a 20-30 year period, with nice retirement bennies. In today's world, they have convinced themselves (and their ciphers on various Compensation Committees) that since they are subject to quick, arbitrary replacement, they need to gather the same riches in the short time they have, or, alternatively, get severance packages that effectively do the same thing.

This change has several intersting effects: 1) the firm winds up paying several managers each the amount that used to be paid to one over 20-30 years; 2) increased movement in the market allowed for the rise of professional negotiators, ratcheting up amounts with each change of control; thus, 3) the ratio of compensation between management and average worker went through the roof.

[David A Spitzley]

I note that there is reference to a graph at the end of this article, but there isn't one visible. Was this an oversight, or simply misleading language?

[chazbet]

As I was taught in my (incomplete) economics training, the question of what to do about the change in relative power of owners, workers, and managers and who benefits is a normative question outside the domain of economics. In theory, if we are unhappy about those outcomes we should pursue the regime that generates the greatest productive efficiency, then redistribute the economic rewards in a more desirable way, begging the question of whose desires matter most. In practice, redistribution is off the agenda in the U.S. and under attack in other polities.

[anne]

Ah :) But economics is quite about distribution of resources, though what reasons for distribution and conclusions drawn can range widely.

[Barry]

IIRC, even Krugman admitted that redistribution wouldn't work in the real world, because those who reaped the rewards would have the incentive and clout to prevent it.

[anne]

Redistribution is actually forever happening in the most or least balanced of economies. However could it not be so :) ?

[keypusher]

Thanks, Professor, for a very instructive post.

[keypusher]

Thanks, Professor, for a very instructive post.

[anne]

Agreed, this is a terrific post.

[j mcgowan]

Thanks so much. That helps me tremendously. And I promise not to make a habit of this kind of thing. I'm sure you had nothing better to do today than answer questions out of left field.

[John Emerson]

I hold to the mother of all cultural explanations, which is that Charles Reich's "Greening of America", with the help of Jerry Garcia and Alan Watts, convinced the managerial class to kick back, smell the flowers, work less, award themselves higher pay, loot their companies, and acquire new trophy brides.

All the other stuff is epiphenomenal.

[Aaron Gurwitz]

How about adding one more explanation to the sustained sea change in the shares of capital and labor: the fall of the Soviet Union? Say what you will about what a lousy place that was, the mere existence of a state run, if only in principle, in the interest of the proletariat may have kept the capitalists looking over their shoulders and afraid to let market forces immiserate the working class.

[bellumregio]

very helpful post. J-P S's question is interesting. Does anyone have insights? You could make a real thesis out of it.

[john c. halasz]

Why would an increase in the price of crude oil, as an imput, increase the profit margin on refined products? What's the transmission mechanism for that? Is it because a high crude oil price indicates a high level of demand for refined products, in which case refinery capacity is strained to the point of near complete utilization, and thus producers gain in market pricing power? But then what are the barriers to entry for competition from new refinery capacity? Is there something similar going here along the lines of the model Krugman sketched for the California electricity crisis of 2001, where it is precsiely the tight band of excess capacity that permits the manipulation of supply, if I recall correctly?

[zzi]

chazbet, your prof talked trash. First off, if anyone has any bargaining power at all then you can't be in a world of perfect competition so the determination of WHO owns what and who has market power becomes centrally important to the efficiency of the allocation. The oil market is a manipulated market (dominated by OPEC and a few very large companies that control a finite exhaustible resource). There is simply no way you can separate questions of ownership and distribution from questions of efficiency in that market, ever.

[vk]

Prof Delong,
Is the Shleifer Summers argument about trust and confidence anything along the lines of the time consistency of economic policy arguments of Kydland and Prescott? After all they also consider the consequences of inconsistent policy by Central Banks on confidence?
It also seems to me that maximizing *current* shareholder value is different from maximizing value over a period of time.

[anne]

John C. Halasz

Frank Wolak of Stanford and Paul Krugman analyzed the manipulated California energy crisis of 2001 beautifully. Krugman's New York Times columns are well worth another reading from the PKArchive.

This time there would appear no need to play with American production or refining capacity, but there is an issue Joseph Stiglitz has several times mentioned. Exploration by American oil companies has been surprising limited from his and my perspective. As though companies do not expect higher oil prices to last. Why should this be? The new energy bill among other gifts even includes a significant incentive for exploration, though why should such an incentive be needed? There is much to think about.

[kevin quinn]

This is off-topic, But Brad mentions Shleifer and Summers. He also wrote a piece in Harpers, snottily comparing a degree from a state college to one from MIT. Why can't you Ivy Leaguers say something true about Shleifer? Can you say ostracism? I knew you could. Look, Heidegger was much more brilliant than Shleifer could ever hope to be. Someone I admired. But in retrospect I see what the critics have said - his thought was not orthogonal to his praxis. Ditto, I'm afraid Scheifer. Trained in a discipline that teaches that promoting one's interest leads, as if by an invisible hand, to the betterment of the whole - he never made the distinction. I am disgusted for my profession; I am ashamed. What abpout the rest of you?

[anne]

Bellumregio

The inherent conflict is always evident. A high demand economy will tend to give producers pricing power, and will also tend to increase demand for labor possibly even allowing a bidding up of labor costs further pressuring prices. So a central bank will limit growth with a wish to limit inflation, and in so doing limit demand for labor. The question is where does the balance rest. I have thought the balance for the Euro countries rests too much on price stability which the Euro countries as a whole have.

[still working it out]

Great topic.

I personally very much of the Larry Summers and Andrei Shleifer school of thought. I work at the bottom of a large organisation and I see what they are talking about everyday.

A good employee with several years experience in my role AT THE SAME COMPANY can fix problems in minutes that would take another employee with the same amount of experince in the same role, but at several DIFFERENT companies hours or even days. The new employee is much slower as he has to obtain lots of new information that are specific to the company. Secondly they will not have relationships with other people in the company they need help from to fix their problem.

The thing which makes this point interesting is that I work at the very bottom of the company in what is supposed to be a relatively simple role. If a long term relationship with my employer can improve my productivity so substantially it beggars belief that for the many many other very complicated roles that exist in increasingly complicated company environments there are not also enormous productivity gains to be made by having long term relationships between companies and their staff.

A second problem is that there is no long term accountability. If a measure saves money today, but leaves a mess 3 years down the road then no-one cares. The managers who make the short sighted decision will have moved on. This makes it very difficult for long term planning to happen at all. Everything is short term.

[bailey]

1. k.harris & anne, in the U.S. it's called CAPITALism.
2. My question on oil prices is, if demand warrants $60. oil wouldn't oil companies (responsible for creating evermore profits for their owners) increase exploring & drilling to the max.? Remember the argument they gave @$20., that it just wouldn't pay.
3. Brad, since you've raised the subject of Economic history, could you PLEASE provide a glimpse into the Supreme Court's (1868 defacto?) acceptance that corporations deserve the same rights as individuals? Or, if not, could you point me to a reference or two you like on this topic. I'm astounded that so many are ignoring our rapid move (last 20 years) toward becoming a corporate state. If there's one question I would ask of Court nominee Roberts, it would be: from a Constructionist perspective, should rulings accepting that corporations are dur the same rights as individuals be open to review? Thanks.

[still working it out]

In regards to actually answering this question I wonder if their have been any comparitive studies between Japanese and American companies. The Japanese corporate environment is pretty much the epitomy of the paternalistic company that used to be common in America. For me the comparitive success of Japanese companies makes very strong case for Larry Summers and Andrei Shleifer point of view. Higher productivity, higher wages.

A comparison of companies in the same indurstry might be very instructive. Perhaps GM and Toyota...

[anne]

Still Working,

Nicely done :)

[Bostoniangirl]

I think it's really ironic that Andrei Shleifer and Larry Summers are associated with a "breach of trust" model. The biggest issue facing Harvard right now is that the faculty don't feel that they can trust Harvard.

[zzi]

Here is one group of employees that has been gaining at the expense of shareholders:

The Financial Times today has an interesting comment by Frank Partnoy today entitled "A serious question for all the overpaid bankers" which points out that in the past four years securities firms paid out $7billion more in bonuses to their employees than they made in profits.

But he concludes by writing:

"Most bankers know they are not pillars of society with grand thoughts or profound answers. Their next best job, if any, would pay only a fraction of their current compensation.

Banks soon will face the constraints other industries have faced..."

Mr. Partnoy is described as a former banker at Morgan Stanley and now a Professor of law at UC San Diego.

[SamChevre]

Bailey--I'm not Dr Delong, but I'll take a stab at your question #1--why don't oil companies sell more oil at $60 than they are selling.

For any traded good, the price is set by the cheapest producer. In most cases, this means that only the cheapest producers stay in business. However, for natural resources, the cheapest producer can only produce a certain amount; he still sets the price, but he can set it at a level which give him extra profits (economic rents) and thus more expensive producers can also exist. The Saudis are the cheapest producers of oil; thus, they set the price.

So the question isn’t why Exxon doesn’t charge more; it’s why the Saudis don’t charge more. The reason is that they want to maintain fairly stable demand for oil, since they have large reserves to sell in the future. Higher oil prices lead to substitution away from oil; many of those substitutes are expensive and time-consuming to start using, but cheap to continue using (think nuclear power). So the Saudis want to keep prices high enough to make money, but low enough that the market will still be there 10 years from now.

[Ian Whitchurch]

Disclosure : I run a small unlisted Australian ooil company. We're looking to list late this year or early next.

The oil industry is, and always has been, very imperfect capitalism.

As far as the US goes, capitalism is broken. At the small end the best and most efficient mechanism for mobilisising capital for economic activities - the publicly traded joint-stock corporation - does not exist.

At the small end, there is no Houston Oil Exchange with about a zillion junior oilers in the $3-$30m dollar range ; the small American operators work in a way I can only call fourteenth century, as incorporated parterships funded through a combination of direct investment, retained earnings and bank finance.

For 95% of oilers in the US, if you want to drill a true wildcat, you need to go to a bank and put your house on the line.

In Australia, a Mariah Energy LLC would be a public company, listed on the ASX. If it runs out of money, it can do another share issue.

In the USA, Mariah Energy LLC has the Bank of Oklahoma breathing down their neck, and a bad string of wildcats sees the principals lose their houses (I know this because we were negotiating with them to buy several of their interests, in order to "get the bank off our backs").

To list a small oiler in the US, you need to go to Canada or Australia, and that just isnt the way business is done there, and in any case, it's a cultural shift to deal with quarterly reporting, exchange requirements and stockbrokers.

The cultural difference with the tech industry is notable.

This means small American companies dont wildcat. In Texas, a wildcat is half a mile from existing production, so it's little surprise they never find anything substantial.

The fact that the Lower 48 is comprehensively drilled out doesn't help - an important oil area like Pennsylvania or Ohio has had every possible formation drilled in every possible place, and it's gone.

Other structural factors like the abortion that is US Land Title laws (48 states, 48 types of law. And then Federal Lands are different), the fact that leases are split into zillions of small parcels (each of whom are expensive to verify title on) and that the names of rock formations can change every time you cross a cou nty line (guys, it's called the International Committee on Stratigraphy).

So, small oilers - $20m and below - keep plugging away in drilled-out counties, looking for twenty or fifty thousand barrels at a time. Good geologists who should be going after elephants are wasting their time in played out fields.

This is because the fields that arent played out are in places like Mali and Mauritania, Burma and Bangladesh. Max de Vieri helped start a company called Hardman ; Hardman, based in Perth, Australia, could play off Mauritania because their houses werent on the line if it didn't work, and because they could always raise a new $250k on the market for the expenses of doing the pre-exploration work of acquiring leases and so on. His new company, Baraka Petroleum (BKP on the ASX) has more dirt in Africa than Devon, Apache and Unocal put together.

And CNPC and Woodside are putting up the actual cash to get it explored.

At the big end, the worlds biggest companies are not Chevron, BP and Shell, but are companies like CNPC, Aramco, Gazprom and Statoil - State Owned National Oil Companies.

And despite propaganda from wingnuts, they are pretty damn good at what they do. CNPC made the Tarim work, and thats a very tough area (like East Siberia, only geologically more complex and geographically worse), Statoil are the best guys in the world at deepwater and Aramco's management of the Saudi fields has been exemplary (they also found Naysirah, which is a billion-barrel field in the middle of the country in a totally different petroleum system from Ghawar et al).

The capitalist Supermajors are hidebound and bureaucratic. They lost a shitload of money last time oil spiked in the early 80s and then fell back, and they arent spending anything close to their new profits on finding new fields.

It costs call it $20m a throw for a new wildcat off Greenland or the Falklands. Call it $20m of seismic and six wells back-to-back to verify if the field's there. Only $200m, but it's not happening. At all.

This is because of the capital destruction - financial and then human - that accompanied the crash of the late 80s.

All the companies stopped hiring, and started laying off staff 20 years ago. That means you can't get a bright young 45 year old petroleum geologist - they couldnt get hired when they left college, and went to work in tech or something. So now, when you need to put a team together, they arent there. Just old guys (average age in the AAPG is now 58) and young guys ... btw, Brad, does UCal have a Petroleum Engineering program ?

Thus, you dont have a team to assess a new area (say, the old Cambrian and older basins in central Australia), and in any case the money guys, who remember what happened to profits in the late 80s, are telling you to ustify the project at $20 oil with a need for a 15% annual rate of return ... and you just can't do it.

Let alone put together the team of 50 people to do it right.

Thus, the smaller companies - most definitely including CNOOC, but also AGIP and Woodside - are eating the big guys lunch.

The response of the big guys - buy reserves, and let someone else find them.

The NOCs play mostly in their own countries, and they are also under pressure to make definite returns, and that means fewer wildcats and more development work. The real story in Russia isnt the nationalisation of Yukos, but the fact that Russians have stopped wildcatting in East Siberia. Thats where there production crunch has come from - old fields get old, and new fields need to be discovered to replace them. And you can't do that if you dont drill wildcats.

Ian Whitchurch
Northern Territory Oil
ianw@acceleratedfarmins.com.au

[Ralph]

Still working it out: That is exactly the context in which I was thinking of the Summers-Shleifer theses. I recall reading a story a number of years ago about Ford thinking of replacing the top seller Taurus with a similar model but running into trouble because the initial team had left the company and not left much of an institutional memory behind. Having worked in Silicon Valley which is full of companies with constantly changing employees I can vouch for the difficulties they face. On the other hand, at places that are based on "reinventing the wheel" sometimes not have institutional memory can be an advantage.

[Ian Whitchurch]

BTW, in Texas, the Railroad Commission regulates oil and gas.

My understanding is that if you want to complain about the lateness of the Houston to San Antonio train, you go to the Petroleum Division of the Bureau of Minerals.

Ian Whitchurch

[Mike S.]

I think John McGowan's observation about the "culture change" and increased focus on delivering value to shareholders is important, but it just has the cause and effect backwards.

One of the points Prof DeLong makes in his discussion of the "finance economist's" theory is that in the 80s, Wall Street "figured out how to execute hostile takeovers." The raiders in those deals adopted the banner of "shareholders rights" as a PR strategy that allowed them to claim that they were on the side of the angels -- and helped them deflect criticisms growing out of their deals' negative impacts on workers.

History is written by the victors -- the successful raiders and their PR mouthpieces were able to claim their wins as victories that were inevitable beause of the power of their core ideal of shareholder rights.

Today, a generation or two of managers later, few companies feel a direct threat of a hostile takeover. But that's at least in part because the concept of "shareholder value" has been elevated to a place in the canon of managerial thought. The raiders' PR strategies were so successful, they put themselves out of business!

[john c. halasz]

Anne:

Sorry, after turning it over while at work, I'm still a bit puzzled by the explanation of the problem. In the normal case, if a raw imput increases in price due to demand constraints, the cost of production increases and that results in an proportional increase in the price of the product. Depending on the demand elasticity of the product, that results in an fractional decrease in profits, both because profit is a rate and the cost denominator has increased and because increased prices reduce sales. Somewhat longer-run, decreased investment reduces supply to restore the "equilibrium" rate of profit in accordance with that prevailing in other economic sectors. Is that correct? On the other hand, if increased production capacity is tightly constrained, when demand is high both for the raw and the processed product, producers of the final product will soon begin to reap rents well in excess of the cost of production, just as the raw product producers do. In the case of oil refineries, it is a highly capital intensive process, which entails steep up front costs to expand capacity, which must be amortized against long-run prospects, whereas, while at the upper end of the demand curve demand is highly inelastic, the historical experience of fluctuations of both supply and demand increases risk, especially when crude oil supplies are high and thus demand is low, barriers to entry are lowered, necessitating the trimming of profit margins. Is that correct? Hence the incentive is to keep refinery production capacity close to crude oil supply and demand levels, within a tight band. Is that correct? If oil companies are not investing their heightened profits into further exploration that could be because they "know" that further finds are not really out there, a la Hubbert's peak, or because an increased supply of crude would knock them off their current sweet spot and result in diminished rates of profit, or because, with permanently higher crude prices, the profits from refining would diminish, as per the first standard microeconomic account above, in which case they would be better off seeking to invest their money elsewhere. What have I missed?

[jim brady]

Brad,
I think you have missed something (Sorry if somebody else has brought this up - I didn't read all the posts) DEMOGRAPHY. See the June Scientific American (baby boom). The Postwar period had an unusual combination of circumstances that lead to labour shortages and a series of paternalistic deals by big companies in an attempt to bind employees for the long term. While this was beneficial at the time to both parties, it has broken down on both sides. The demographics will move back in favour of labour next decade so we may see a revival especially if rising transport costs act to dampen international trade.

[anne]

Ian Whitchurch

"The response of the big guys - buy reserves, and let someone else find them."

Agreed. Thank you so much. I always look forward to your incisive comments.

[Jussi]

Anne,

"I have thought the balance for the Euro countries rests too much on price stability which the Euro countries as a whole have."

Many people say this, but without price stability being the Bank's primary objective, we would never have had a single currency in the first place: the Germans (and others) would never have bought it.

It's a deliberate trade-off.

[Jussi]

Jean-Philippe,

"I am wondering how much of the ECB's high interest rate policy can be directly or indirectly interpreted as an attempt to break the power of unions in the European Union."

Now how could that be - we live in a 'socialist paradise', don't we? Things like that don't happen here :-)

But humor aside, that's a very extraordinary question. Firstly, because ECB is a 'technical' and not a political body.

Secondly, because 'worker representation' is compulsory under EU labor law, at least for larger corporations. Nothing I've heard of discourages workers' movements, either (though I admit I'm not as up-to-date as I used to be).

And thirdly, what do you mean by 'high'? Surely 2% is very low, by anyone's standards.

Or were you, by any chance, being tongue-in-cheek? :-)

[anne]

Jussi, nicely answered. Still, there remains the sluggish growth that has been a problem for western Europe since 1990. Asking the European Central Bank to lower short term interest rates may prove too difficult for some while and there is little chance for any fiscal stimulus. Consumer spending is not likely to rise much, though encouraging home buying with simpler financing in Germany and the Nordic countries may help. A difficult problem. How does Europe create work?

[Pierre Azoulay]

Brad forgets to mention research by Mullainathan and Bertrand that precisely attempts to discriminate between the "financial economist view" and the Shleifer-Summers view. Using variation in the timing passage of state-takeover laws, they show -- pretty convincingly in my view -- that when managers become more entrenched (protected from takeover threats), wages go up but TFP does not. ie, rather than building empires, managers prefer to enjoy what they call "the quiet life." As usual with empirical work, there are caveats, but talking about this without mentioning their contribution seems a bit strange. The paper was published in the JPE a few years ago.

[Jussi]

Anne,

"How does Europe create work?"

Very slowly or not at all, at the moment, although some are doing better than others. Do you have any suggestions for us?

[anne]

Suppose the problem western Europe has found is not related to conservative monetary or fiscal policy, nor to structural employment limits from employer perspectives. Rather the employment problem might be a demand problem and the demand problem might be related to the declining birth rates and population growth. Similarly for Japan. Limited population growth may limit demand indefinitely, so resolutions to the employment problems in Europe might call for finding ways to compensate for demographics.

[anne]

Immigration will help create demand in western Europe, but immigration has seemingly been too little accompanied by social and economic integration from Britain to Germany and on. France is actively looking to improve cultural integration, which is essential. Finland seems to have fewer limits on retaining workers, but more active programs to take workers who lose jobs to other employment. The Netherlands was able to use part time employment effectively. The question of employment in Europe is most employment, and from a demographic perspective possibly allows for more borrowed and creative resolutions.

[glenn hefner]

bailey - the reason the major oil companies are not spending hundreds of billions more on Exploration and Production even though oil prices are at high historical levels is that most of them realize that oil is still a commodity and they believe that laws of commodities still exist. Seeing that demand for oil over the short term is rather inelastic, but somewhat elastic over the medium and long term, high oil prices tnd to raise marginal supply but tend to kill marginal demand, which eventually lowers the price for oil.
In addition, the capital and expenses involved in these projects are multi-years, so the companies aren't willing to spend billions now, hoping that prices atay high. For the record, nearly all oil projects make great returns at $60 oil. Most make great returns at $40 oil, it's just the industry isn't willing to bet these prices are here forever.

What's amazing to me is why these companies are not hedging all their production at $60 prices. There's a futures market, and even if they can't hedge all production FAR in the future, these companies just aren't hedging must, and THAT makes no sense to me.

[glenn hefner]

As for JPS's assertion, I've lived in Italy for the past 5 years (for my sins), and I'll throw in my two cents:

One, I really don't think that 2% interest rates - outside of Japan, the lowest in the world - can be considered a "high interest rate policy."

Secondly, clearly there's very little political will on an individual country basis to make the hard decisions necessary to improve eocnomies. Germany is, finally, taking the lead, but this road, to be trite, will be long and hard.

Politics on a european parliament is both toothless and spineless (it is, thus, perhaps very mollusk-like) and that institution has NO capability to enact anything of value.

Thirdly, the ECB's sole duty, I believe, is to keep a check on inflation. Therefore, they do not change policy based on growth or unemployment. Should it? Does it? I guess that's another question, but at interest rates of only 2% - less than half that of the UK and nearly half of the USA - it's dubious to suggest the ECB is doing anything of the sort.

[anne]

Ian Whitchurch's company and other international wild-catters were evidently willing to explore when oil prices were below 40 dollars a barrel. The profitability of large oil has been astounding, but the American giants prefer to buy reserves rather than explore are possibly reduce profit margins. So much for competition.

[Bob Dobalina]

anne-- Krugman's spin on Enron is tainted by his politics.

I'd suggest reading the source that he has habitually misrepresented, linked in my name.

"Staff concludes that supply-demand imbalance, flawed market design and inconsistent rules made possible significant market manipulation as delineated in final investigation report. Without underlying market dysfunction, attempts to manipulate the market would not be successful."

[Mr. Econotarian]

"The only times when oil prices have been seriously and consistetly elevated well above marginal cost are (a) in the days of standard oil"

This is a false legened. Standard Oil did engage in some hard-ball business strategies to become a monopoly in many places, but it did not convert its monopoly power into substantial oil price increases. Infact, it used its massive economy of scale to reduce or keep prices the same.

If you look at this graph:

http://www.wtrg.com/oil_graphs/crudeoilprice1869.gif

You will see that from 1869 until the 1880s, the price of oil decreased substantially. After that, there were no significant oil price increases until AFTER the breakup of Standard Oil in 1911...

Standard Oil also brought substantial reductions in the price of distilled products as well. For example, kerosene dropped in price from 58 to 26 cents between 1865 and 1870.

[anne]

http://www.pkarchive.org/

Frank (Wolak) Thoughts On The California Crisis
By Paul Krugman

We're approaching the first anniversary of the sudden, unexpected end of California's energy crisis. I went way out on a limb, at least by journalistic standards, by saying that market manipulation was a key feature of that crisis. I have since been vindicated: arguments that people called leftist nonsense a year ago are now conventional wisdom.

But of course I wasn't a brilliant investigative reporter; I just knew enough to talk to the right people, and to understand what they were saying. Paul Joskow and Severin Borenstein were very helpful. But my most helpful source of all was Frank Wolak, the Stanford professor who also heads the CAISO market surveillance committee. (CAISO is the "system operator").

In a recent paper Wolak offers a very nifty model to explain what was going on. However, as they say in the journalistic trade, he buries his lede: the model is in passing, amid a dense discussion of institutions and their reform. So I thought I would lay it out here, to give you an idea of how I think about the whole thing.

Wolak's model starts with a simplified demand curve. We assume that the demand for electricity is totally inelastic at some given quantity - say 900 megawatt-hours - until the price reaches a ceiling, say $1000 per mwh. It doesn't matter for current purposes whether that's a legal ceiling or the price at which utilities simply refuse to buy.

On the supply side, we assume that there are a smallish number of generators, each with limited capacity - let's say 5 generators with a capacity of 200 mwh each. Each generator has a marginal cost of, say, $20 per mwh actually produced....

[bailey]

Sam C. I agree, in truth I've been doing a little looking into buying a small p.v. outfit.
Glen H., THANKS, That's GREAT info to think about.

[Mark Gardiner]

As an institutional investor (board member of a multi-billion $ pension fund), I believe more attention should be paid to the community of interest among CEO's, board members, advisors, investment bankers, private-equity investors and related enablers as a driving force in the concentration of economic power (and individual wealth) away from workers / citizens and into corporations and their managers. I don't have time to absorb all the economic theories, but would posit that any theory that attempts to explain the trend to wealth concentration in the US without dealing with the practical impact of the corporate decision-making structure (and its very effective purchase of political and legal power) is likely to miss the mark. The effect of this concentration of power among literally a few thousand like-minded individuals - and the very self-interested approach they've been allowed to pursue - explains much of the difference in economic policies between the US and other developed economies. Only in the last few years have US institutional investors (who, after all are investing the pooled assets of regular folks) attempted to put the brakes on the ratchets created by the corporate power elite.

[Russil Wvong]

Last week's Economist has a fourth explanation for the increase in profits as a share of GDP, from Richard Freeman:
http://www.economist.com/printedition/displayStory.cfm?Story_ID=4221685

"China's impact on the world economy can best be understood as what economists call a 'positive supply-side shock'. Richard Freeman, an economist at Harvard University, reckons that the entry into the world economy of China, India and the former Soviet Union has, in effect, doubled the global labour force (China accounts for more than half of this increase). This has increased the world's potential growth rate, helped to hold down inflation and triggered changes in the relative prices of labour, capital, goods and assets.

"The new entrants to the global economy brought with them little capital of economic value. So, with twice as many workers and little change in the size of the global capital stock, the ratio of global capital to labour has fallen by almost half in a matter of years: probably the biggest such shift in history. And, since this ratio determines the relative returns to labour and capital, it goes a long way to explain recent trends in wages and profits."

[Jussi]

Anne,

"Rather the employment problem might be a demand problem and the demand problem might be related to the declining birth rates and population growth"

No doubt demographics are a factor, but I believe the demand problem is made worse by sheer unwillingness to spend money, or at least unwillingness to spend 'a lot' of money. I know this affects me, at any rate.

[anne]

Jussi

Fine, since we are simply suggesting. Then there may well be something to looking for ways in which to dramatically increase home ownership through western Europe. Ireland and Spain have been helped by this. Mortgage instruments may need to be structured more competitively, for financial instruments in general are not competitive in Europe. Home owning is the ultimate incentive in spending.

[guest]

McGowen's question seems to be so obvious, why bother to answer them?

[nate]

is there some sort of tax break or government grant for hybrid economists?

one may need to consider globalization too. cannon makes really good camera stuff. this may have contributed to kodak situation.

[Randall]

Fine questions deserve fine answers, so think a little about the thread and learn.

[wkwillis]

Glenn Hefner
The corporate executives make more money as a nonlinear function of the company making money because they get stock options out of the money.
They value one chance in two of very high prices and very high profits and very high stock prices much more than a certainty of medium oil prices and medium profits and medium stock prices.
Mr. Econotarian
That (1865 to 1911) was a period of deflation so you need to adjust for the substitution of the Civil War inflated greenback dollar with the gold backed dollar. Otherwise I can't argue.
Even the discovery of Spindletop and the collapse of crude oil prices from foreign (outside Pennsylvania) supply areas like Ohio didn't destroy Standard Oil because Standard Oil was a refining and not an exploration and development company.

[rjw]

can I just echo the plaudits for the post - fascinating to see all these strands of different literatures tied together like that

[Pancho Villa]

Brad, as usual: Go, go, Brad go!

[Ian Whitchurch]

Standard Oil was actually involved in preventing crashes in oil prices several times, by taking the lead in organising producer cutbacks until stocks of oil declined to more reasonable levels.

BTW, the Texas state government also did this in the 1930s, sending in Texas Rangers with guns to enforce limits on how many days a week producers were allowed to produce.

Free market capitalism in Texas ? Never has happened, never goanna happen.

Ian Whitchurch

[liberal]

Jussi wrote, " 'How does Europe create work?' Very slowly or not at all, at the moment, although some are doing better than others. Do you have any suggestions for us?"

Stoke a housing bubble to get your economy roaring. Working for us Americans...for now...

[Jussi]

Liberal,

"Stoke a housing bubble to get your economy roaring"

Excuse me, but putting house prices beyond the reach of modest-wage earners is one of the most anti-social acts I can imagine.

(as if manipulating electricity prices wasn't bad enough!)

[anne]

Jussi and Liberal

The discussion on affordability of housing should go on. While affordability lessens when housing prices increase faster than wages, for most of the century housing prices increased at about the rate of inflation which was generally below the rate of wage increases. The question was whether initial financing could be had to afford a house. What helped drive the middle class housing boom after World War II was the GI Bill which provided for widely available financing and remarkably low mortgage rates for GIs. Housing prices rose, but the GI Bill for housing was wonderful for middle class America.

[Jussi]

Anne, we're talking about Europe :-)

[anne]

Jussi

I have always been puzzled by the lack of effective competition among financial service companies in Europe. Is a European emphasis on financing avaliability for housing possible? Evidently there is more of an emphasis in Ireland and Spain, but I wonder at the limited mortgage options even in Ireland.

[anne]

Jussi, how about midnight golf?

http://travel2.nytimes.com/2005/08/07/travel/07norway.html

Golf in the Land of the Midnight Tee Time
By JEFF Z. KLEIN

IT was going to be a tough chip shot: 50 yards onto a tiny green with the ocean right behind, the sun hanging just above the horizon and casting a bright gold glow on the water. One o'clock in the morning, and the sun is in my eyes.

I should have been asleep. I was at Lofoten Golf Links in Norway, the fourth or fifth northernmost golf course in the world, during the summer solstice last June. I'd just traveled for 26 hours straight: the flight from Newark to Oslo, then another to the northern city of Bodo, a quick dash to catch the coastal steamer for the six-hour passage to Svolvaer, the port town in the breathtakingly beautiful Lofoten islands, then a 45-minute drive to Hov, a farmstead on a single-lane road surrounded by ocean and snow-capped peaks. I was 95 miles above the Arctic Circle and exhausted. But the midnight sun was out, the temperature was a soothing 60 degrees, and a lush golf course was at my disposal, so why sleep?

"This time of year, you get spectacular bursts of energy," said Frode J. Hov, the course's founder and managing director, who grew up in this place. "At 2 a.m. you suddenly decide you want to paint the walls, so you do, then three hours later you realize that you have to finish the whole room, and you wonder, 'What was I thinking?' " ...

[anne]

Now that is what I mean about being creative. Midnight golf about Oslo or Helsinki? Yes :)

[anne]

Also, if financial companies are too little price and product competitive in Europe that are quite a bit less competitive in Japan. Europe could benefit significantly from the equivalent of GNMA mortgages, and organization of companies that parallel Fannie Mae and Freddie Mac. These finance sources have significantly helped increase American home owndership, and though the advantages of Fannie Mae and Freddie Mac in offering relatively lower cost financing have been criticized, I have no such criticism.

[anne]

Where is the equivalent of a GNMA or Fannie Mae mortgage in Germany, where the task of finding mortgage coverage without a guide is not a task I would take on. Why is home building so difficult in Germany?

[Jim S]

But in fact they have colluded by limiting refining capacity in the United States. The Kansas City Star had an extensive front page article on it about a month ago. Among other items was a refinery in Western Kansas that was closed down and the company that closed it refused to sell it to another company even when presented with an offer. There's no NIMBY effect in the community that lost those jobs. They'd love to still have them and wouldn't mind if someone would re-open it. Anyone care to do a bit of research on it instead of swallowing the common wisdom on the subject? Professor DeLong, do you read these posts?

[Jussi]

Anne,

"Is a European emphasis on financing avaliability for housing possible?"

I don't know the differences between all the countries, and so can't answer your quesion, unfortunately.

But I disapprove very strongly of housing 'bubbles', and don't want to see them where I live. It is an exceptionally anti-social condition, imho.

[nate]

spelling correction of an earlier post by me: "canon" not "cannon"

[Jussi]

Anne,

"Why is home building so difficult in Germany?"

Because it's expensive, and intensely frustrating.

Germans build houses to last for at least 200 years ('Stein auf Stein'), so they cost a lot in materials. Building is slow and expensive. Bureaucracy is rabid.

Ancillary costs, electricity, water, oil, gas, garbage collection etc, are very high; and German houses generally have awful insulation, which just makes it worse.

Without wishing to alienate myself from that country or to offend anyone, it really is the last place on earth where I have lived, that I would build a house.

[nate]

"Why is home building so difficult in Germany?"

i do not know but have some questions.

...are homes more likley to be built by unions with better benefits in Germany than in the US?
...are there more regulations on homes in Germany?
...are homes in Germany on average built with higher quality than in U.S.?
...do people live in homes longer and tend to move less in Germany than in the U.S.?

[Jussi]

Nate,

"...do people live in homes longer and tend to move less in Germany than in the U.S.?"

If you buy a house in Germany, it's a sign that 'you've made it'. Fewer than 40% of Germans ever own their own homes (if my numbers are up-to-date, which I believe they are) and a first-time buyer under the age of 40 is an exception.

Mobility does exist in Germany, but it's a fraction of the US scale.

Germans don't buy houses to speculate, they buy them to live in, and to pass down.

(mostly, anyway)

[anne]

Jussi

Thank you so much for the stark answers. I am not pointing to a bubble of any kind as a solution for a partial malaise in western Europe, but you have shown in dramatic fashion what might be done in adding percentage points to home ownership in Germany. I do not care to be critical of German economic structure, but there is a ministerial wish to increase home ownership in Germany and we can imagine what a decade long program designed to add 10 percentage points to ownership might do in generating demand.

[nate]

i remember reading somewhere that cultures in japan and germany tend to be collectivist, whereas the U.S. tends to be more individualistic. is this true? if so, does this show up in housing?