Saturday, June 7, 2008

Enron redux


Value, Price and Economic Controls

Why is the price of oil so high and what will happen as a result? Compare this with information, which we have rendered essentially free because it has a value which extends the value of other things. Oil is dependent on other things to have value beyond the cost of production to add value. A medium sized commercial jet has a design that takes oil into consideration. The jet can be operated cost effectively at an oil cost up to about $40.00 per barrel of oil. Anything over that threshold produces losses, airlines fail, and people look for alternative transportation. People use information to rearrange travel plans to get the best bargain and if the best bargain is not economically sound, people will not travel. Oil makes the airport possible from the aircraft to all the other support vehicles. This industry consumes lots of oil. It also runs on information to coordinate flights and control air traffic. We have air traffic controls so the jets don’t crash into each other killing passengers and destroying equipment and facilities. We must have economic controls to do the same thing. When the price of oil threatens stability, we must slow it down to prevent it from destroying the machinery we all depend on.

As an academic exercise, take a look at the academic world. The value of an education is great. It’s structured information presented in a personal manner that makes it expensive. You could learn at your own pace and structure your mind any way that you want. Instead most people choose to be structured in a uniform manner, in a university by a professor bought and paid for just so there are no questions. At the end you receive a degree and find a job or you don’t. The university prepares you; it just can’t prepare you for anything that you may encounter in the business world. Education is great; it is also limited and expensive. Education is designed to eliminate risks or at least manage them. There’s no doubt to the value of education, which like oil keeps things running by exacting a price. Students are all speculators, so are university administrators and the investments being made today could go either way. Oil prices are manipulated by speculation as well as demand. When a university buys more oil than it can use, it raises demand and that demand may look good on paper by showing gains as the oil goes up. There is good reason to separate out speculative demand from true demand for statistical as well as practical reasons. The university that creates demand for oil only to profit on the upside of price is much different than the air line that creates demand to provide transportation services at the airport.

The economic controls are only possible on the supply side. Demand will follow price to some logical conclusion. Supply side controls that measure demand, speculation, and actual consumption serve the market by separating statistically true demand from speculation thus eliminating demand produced by speculation. Speculation is running up oil prices to artificial new highs because universities as well as other institutional investors are guessing that oil will reach higher prices and speculation ensures that they will. This is why the speculators are always right at the expense of the market for true demand. Accounting for speculation is not difficult and serves to control runaway prices created as a result of speculation that captures value without returning anything of lasting value. Speculation can’t be eliminated, it can only be measured reported and factored into judgments about price.

The economic controls are accounting controls, that allow for market corrections to be made in order to prevent a complete breakdown as a result of speculation that creates a false snapshot of the specific commodity market. An extreme example of the damage caused by the lack of this sort of control in energy markets is Enron, which engaged in energy speculation and then collapsed as a result of the illusions it created by believing it could ride out any storms caused by a false market it was developing. Since that collapse, it appears that speculation has only increased and the institutions are now engaged in the same sort of market making to raise funds, with no long term strategy to deal with the downside of such behaviors. The immediate downside is in the aviation, trucking and consumer fuel business. Higher costs slow down economic growth, while making food cost soar to higher levels. Speculation that concludes that food will cost more produces food that will cost more as a result of higher perceived energy demand. The higher food costs have no long term benefit, unlike education which has a great long term benefit. The irony is that by speculating on oil price futures, universities are contributing to higher food costs as a result of increased energy prices that aren’t the result of demand for energy. If we didn’t learn the lesson with Enron, the lesson is being repeated by our universities.

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