Distorting the Energy Market, a Bill by Devin Nunes.

Bloomberg.com has this item by Kevin Hassett.

A Modest Proposal to Revolutionize Oil Market

He sets the story with much gushing about Nunes.

Nunes, a third-generation farmer from the heavily agricultural San Joaquin Valley, has proposed a pilot futures market project that is a financial economist's dream come true. Clearly, he has put his graduate degree in agriculture to good use, since well-trained farmers are old hands working with futures markets.

He connects the story to a famous economist with no actual supporting evidence.

Here's the back story. Nobel Prize-winning economist Joseph Stiglitz studied situations where the nonexistence of markets can cause economic systems to end up in strange places. Nunes's fascinating insight is that energy markets might be a case study in the kind of market failure that Stiglitz had in mind.

"Fascinating."

Nunes's specific application is in alternative energy. Imagine you are deciding whether to sink a billion dollars into a plant that makes an oil substitute. If you eyeball the history of the oil market, you will immediately see a problem. The price goes up and down over time, frequently falling to levels so low that factories producing alternative fuels would be uneconomical.

He states the problem.

Nunes's specific application is in alternative energy. Imagine you are deciding whether to sink a billion dollars into a plant that makes an oil substitute. If you eyeball the history of the oil market, you will immediately see a problem. The price goes up and down over time, frequently falling to levels so low that factories producing alternative fuels would be uneconomical.

You could drop your money into a costly plant, then watch the price of oil drop and lose your entire investment.

This type of uncertainty is a big deal for financiers. If a new plant has a working life measured in decades, then uncertainty over the future price of oil is a significant impediment.

He then goes on to provide support for a terrible solution!

The Nunes solution is to have the government create a market for long-run put options for alternative fuels. This would give those who have constructed qualifying facilities the right to sell (or ``put'') their product at a minimum price to the government should the actual price drop below that.

If you are planning to invest a couple of billion dollars in a coal-to-liquid plant, then you could purchase a U.S. government-backed option that would guarantee you a minimum price of, say, $70 a barrel. If the actual price is above that, you can sell your product for more than that. If the price drops below $70, the government pays you the difference between the market price and $70.

The price of these futures contracts would, under the Nunes bill, be set at auction. Accordingly, the policy would probably raise revenue in near-term forecasts. In the long run, taxpayers would be taking on a risk that oil prices will drop, but that risk is a natural one for them take.

More on this soon. First he follows with a package of rosy outcomes, even in a worst-case scenario as far as the taxpayers are concerned.

Booming Economy

If oil prices fall so low that the government must pay lots of money to alternative fuel providers who have purchased these options, then that would mean the economy will be booming because of the low energy prices. In addition, tax revenue will be flowing in, and the Treasury's coffers will be full.

...

If it becomes law, then my guess is the project will be highly successful and will rapidly apply to any alternative to imported oil. And when government creates this missing futures market, the flood of capital into alternative energy will make all the silly targeted subsidies unnecessary.

And then he subtly inserts a demonstration of the flaw.

Nunes's bill proposes using coal-to-liquid plants as a pilot project.


Disclosure: I'm not a supporter of Liquid Coal Technology. Note: It appears likely that Mr. Hassett is an unabashed Liquid Coal supporter.

Note: When I say "Liquid Coal," I mean "Liquid Coal." I am a supporter of Clean Sequestered Coal as an important bridge in our transition to Carbon Neutrality, and I have no problem with reasoned Government Support in making Sequestered Coal a reality. Liquid Coal, however, has no capacity for Carbon Neutrality, and so is a bad long-term bet.


Back to this Bill.

So, the Government creates this new "market." Well, he says it's a market, and he inserts market terminology like "put*," but it's obviously not really a market at all. It's a Taxpayer funded price control in support of Oil** / Liquid Coal products, in fact, it's an entitlement. Why is this? Because, for one, it's set specifically in the favor of existing oil / coal interests as these interests control the vast majority of the money with which to buy "puts" at auction, and so as the price of energy decreases, they will be the primary beneficiaries of the Government Payouts irrespective of their contribution to the solution of the original problem.

Even if Liquid Coal (or whatever technology) falls out of favor in the market compared to better technologies, the taxpayer will support its continued production, even if there isn't a single private buyer interested in paying for the product. Since the Government has guaranteed future prices based on an auction process, the very concept of Capitalist Competition in which the best products thrive, and the worst products fail, falls by the wayside.

Risk is a natural component of Investment, and any story that suggests that Risk can be eliminated is one that is making bad assumptions. In this case, the risk is borne by the taxpayer, and a double-whammy is quite possible where not only are the taxpayers paying an exorbitant price for energy through taxation to pay for puts, but it's also likely that taxpayers will be subsidizing the very product that an efficient market would correctly put out of business.

In other industries, I'll wager that Mr. Hassett is not in support of Government intervention in the market, but it appears that he's been fooled by the co-option of market terminology by supporters of Big Government Coal and Oil Entitlements in the creation of this unbalanced marketlike Government Program.



* "This would give those who have constructed qualifying facilities the right to sell (or ``put'') their product at a minimum price to the government"

** Like Shale Oil, and Oil Sands.

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