What this official is saying is a version of the classic freshman mistake: an increase in demand leads to higher prices, and higher prices make people buy less, so an increase in demand leads to lower sales. Amazing stuff, and further evidence of the Dark Age of economics now descending.
Um … er … an increase in demand for a good – say crude oil – causes customers to bid up its price in a market. This increase in price renders it unaffordable to some market participants which results in them not bidding. This reduction in demand results in what, exactly? “Lower sales” in what sense?
Without being specific it is hard to tell what Krugman means other than his ‘argument’ rests on sneering arrogance rather than specifics.
In the case of crude oil whatever is produced is consumed. This is done almost instantly after being put to market. The relationship of crude supply to finished product demand is inelastic. While there is some crude oil and finished products in storage both in tankers and in ‘strategic reserves’ there is no large amount of ‘vintage’ oil anywhere awaiting marketing. Reserves tend to be left in the ground rather than produced then stored. With oil, the distance between worthless – in the ground – and worthless – in the atmosphere – is very short.
In the case of volume of consumption remaining unchanged relative to the volume of production regardless of price Krugman’s argument is correct. If “lower sales” means instead lower prices he needs to consider this remark from another well- placed public intellectual:
As drawn, the supply curve from the general public is flatter than the demand from HLIs (banks); this is the case in which equilibrium is locally stable, because a rise (fall) in q will lead to an excess supply (demand), pushing the price back to its original level.
‘q’ is price, BTW. Of course this is from one of Krugman’s own papers so the worst economist in the world noted in the title of the first piece must be Krugman, himself.
Because of the close relationship between oil production and consumption it is very difficult to gauge demand as it shows up in price figures alone rather than in changes in inventories. If a gadget maker’s prices are too high he will wind up with a warehouse full of gadgets. If oil prices are too high demand will fall off but so will production as there are no warehouses for anything more than a small fraction of daily production @ a whopping 75+ million barrels every single day.
It’s a big challenge for the industry to balance inventory with supply.
Too little inventory and the marginal demand causes a spike in price as was seen in 2008. Too much and the pressure on price shuts in production of marginal wells.
It nevertheless is suggestive: periods where consumption appears to exceed production are those when price is set by the most expensive marginal fuels that are not marketable without some sort of subsidy. When demand bids price levels high enough the subsidy becomes unnecessary – becoming profits to the marginal producer, instead.
- Production includes conventional crude, natural gas liquids, condensate and ‘other’ but NOT refinery gains. Other does not specify and may not include bitumen (tar sands) or biofuel/ethanol.
- Consumption includes all refinery products so some double counting refinery gains may take place.
- Periods when consumption appears to have exceeded conventional supply can be seen as periods of rising prices with the 2006 – 2008 period leading to the spike in the latter year.
- Price is Brent spot price and is annual.
It is an assumption that oil prices must continue to rise as production becomes more constrained. There is an obvious supply/demand relationship that must be acknowledged; the assumption is that demand will always be able to fund itself. This is based to a large degree on prejudice – China’s appearance of economic ‘success’ or the intransigent character of ‘car culture’ in the USA. Prejudice suggests that fuel demand is sticky. While it may be that some sectors can effectively enforce claims on funds it in not necessarily true in other sectors. At bottom, all sectors must fund themselves from returns on the consumption of fuel.
Analysts suggest that returns on production investment is what sets final delivery price.
The return on investment approach has funds as a proxy of energy and the statement is EROEI or ‘Energy Return On Energy Invested’ standing for Energy Return on (money) Investment (EROI). As EROEI declines because of harder to reach reserves and conventional fuel substitutes the added energy cost must be recaptured as higher fuel production costs, These costs must in turn must be met by the end users or else fuel is not made available.
Here is a way to look @ it from the estimable Nate Hagens:
The corn ethanol and even the cellulosic ethanol debates typically miss a larger point. Much mental effort is spent debating whether the energy balance is slightly positive or slightly negative while society runs on an energy gain significantly higher than any liquid fuel alternative. When we hit $150 oil, there won’t be too many parents buying their kids a new GI Joe with the Kung Fu grip toy. At the same time, energy companies will need more and more employees to man wildcats and oil rigs and install solar panels. Though we might not be thinking in these terms at the time, the lack of energy gain (or lower net energy) will be manifesting itself in resources taken away from marginal areas of society (toy companies, hot tubs, hemorrhoid cream, Snausages, poker chips, etc) into energy producing and distributing sectors.
Since all the marginal areas of society contribute to GDP their loss of resources represents in turn a loss of final demand. The claims these sectors make on funds cannot be enforced. The businesses shed workers before completely shutting down. Without the businesses and workers with cash in their pockets the $150 price cannot be supported.
If fuel prices rises too high returns vanish and the fuel user becomes a ‘non- fuel- user’. There is a credit distortion to this process. Up until 2009 bids could be supported by credit as a substitute for- or addition to returns. Fuel users could use credit to bid for fuel that their returns would not ordinarily allow. That this was unsustainable is self- evident. The cost of credit added to the cost of fuel rendered both fuel prices and credit unsupportable.
Under the current debt- overhang there is insufficient credit to support 2008 spike prices or even the annual 2008 price of $97 a barrel. Fuel markets count on end users – as well as speculators – having access to cheap loans to push prices higher. Not any longer. Cut off from new credit or unwilling to borrow the number of end users able or willing to support high fuel prices is shrinking.
Paul Krugman is not alone here in thinking that a higher demand by itself will result in high prices. Rather it is demand coupled with funds that sets price. In the land of the broke there are few who can afford luxuries which are rapidly becoming the accoutrements of middle- class life such as houses and cars – or heating oil and gasoline.
The same condition is taking place in residential real estate. While the population of the US expands, real estate prices are declining. It isn’t the overall demand represented by population that sets the price but demand with funds. Returns depend on fuel price levels that allow them.