Article published Monday, June 25, 2007, at Tech Central Station.

Pumping Out Bad Policies

By John R. Lott, Jr.

With gas prices around $3 a gallon, the Senate last week passed new energy legislation. It will ultimately go to conference with the House to work out differences between the Senate and House bills. But any bill that gets agreed upon seems certain to increase the swings in gas prices and leave the average American worse off.

Senator Charles Schumer (D-NY) claims that oil companies are colluding to drive up the price, "they wink at each other and do the same thing." Likewise, Senator Hillary Clinton (D-NY) blames the companies for taking advantage of Hurricane Katrina to raise prices: "You have a hurricane, and all of a sudden you see prices going up like that. That has... everything to do with people trying to make money off the backs of this tragedy."

With such reactions, it is not too surprising that a new Bloomberg/Los Angeles Times poll shows that 38 percent of Americans view the U.S. oil industry's "gouging, greed, profits" as the main reason for higher gas prices. The second reason is "the Bush Administration" at 21 percent.

Another statement by Senator Clinton claims that "I want to go after the oil companies and the oil speculators and the manipulators of the money, because they're the ones who I think are really behind [the price increases]." The bill approved by the House places severe criminal penalties for companies found guilty of price-gouging and "unconscionably excessive" raising prices. Companies face fines of up to $150 million, individuals $2 million and 10 years in prison.

Yet, these responses misunderstand what speculators and companies do. Speculators and companies make money by smoothing out price swings. Consider what many seem to regard as the most difficult puzzle - why gas prices rose before Hurricane Katrina had actually caused any physical damage. How could this be explained by anything other than greed?

Before the hurricane hit, it was evident to many that refineries and would be damaged and that supplies of gas to consumers would be reduced. The prudent (as well as profitable) action in such a situation is to take some of the gas that is relatively plentiful before the storm and store it for when the gas is scare after the storm hits. Reducing gas for sale before the storm means that prices will rise, just as more supplies after the storm meant that prices will rise much less than they otherwise would have. That is all speculation is: trying to buy low and sell high, but in doing so they smooth out price differences: raising the low price and lowering the high price.

Sometimes speculators get it wrong. The anticipated hurricane may veer off course and miss land or it may fade. If it ends up not doing much damage, speculators lose money.

Vague, undefined rules such as "unconscionably excessive" prices, give firms little guidance on what is allowed. This is actually a form of price control, but without telling anyone what the controlled price is. Is a 5 percent increase in price OK? What about a 25 percent increase? The whole concept is similar to refusing to set an official speed limit on roads and then letting the courts judge whether you are guilty of speeding. Would you like to wait for the judge to tell you whether you had violated the speed limit?

Naturally, everyone wants to pay lower prices. But there is a reason prices are as "high" as they are: people want more gas than is available. And other nations, such as China, are developing fast, increasing the demand for gas. You can't get something for free.

Stopping prices from rising with price controls simply means that people will compete for gas in other ways. Just like in the 1970s, whatever gas is sold is going to be competed for fiercely among consumers, with perhaps long waits at the pump.

If you want to help people buy gas, help them - donate money or if necessary, have the government help. But forcing companies to pay for others' altruism is a recipe for disaster. It eliminates energy companies' incentives to store gas and smooth out price swings or get gas supply quickly to disaster areas.

The other parts of the energy regulations make little more sense. Replacing oil, which is currently trading at $65 a barrel, with ethanol costing over $100 a barrel, is like throwing away about $40 for each barrel of ethanol used. If claims that prices will come down are true, the investments will pay for themselves. No subsidies are needed. Companies would develop the alternative energy sources - whether it is wind, solar, new hydropower, geothermal, or landfill gases - on their own.

Bashing companies may be profitable short-term political behavior, but the discomfort will be over far sooner and less severe if markets are left to their own devices.

*John Lott is the author of Freedomnomics and will soon be a Senior Research Scientist at the University of Maryland.

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