Who’s Afraid of Oil and Wheat Prices?

Logistics put the “Global” in “Global Markets.”

A guest essay by the Naïve Economist

A lot of economic theory is about relative prices or relative costs.  So, if someone perceived an expensive way of doing something or a cheap way of doing the very exact same thing, then that someone should go cheap.  Why pay more when you can pay less?  That would be the prediction that proceeds from the theory.  Profound stuff.

The Germans had figured out how to synthesize oil from coal or, in lay person’s terms, to “liquefy coal.”  It was an expensive way to procure oil… relative to the available options.  The available options included procuring oil from people who extract it directly from the ground.  Just go out and buy it; trade in markets.  And, so, the Naïve Economist asks, why bother bearing the heavy cost of synthesizing oil rather than just procuring the real thing at much lower cost?

The answer would be that you develop the capacity to synthesize oil when, for whatever reason, you expect to lose access to cheaper options.  That’s what the Germans had in mind in the 1930’s.  They were contemplating the prospect of setting their “war machine” off on conquering the world, and they anticipated (correctly) the prospect of being cut off from regular sources of oil.  They might not be able to procure oil on markets or to just take it themselves.  But they could expect to procure lots of coal in the market, because they were already sitting on top of a lot of it.  They could then anticipate falling back on their capacity to synthesize that coal into oil.  In a pinch, they could keep their tanks rolling, their planes flying, and their u-boats hiding under the waves.

By the middle of the 1930’s the German conglomerate I.G. Farben had built up robust capacity to synthesize oil from coal by a process of hydrogenation.  The Americans took notice.  The Germans had been organizing international cartels governing the conduct of munitions-relevant industries, and, just like that, the Antitrust Division of the U.S. Department of Justice (the competition authorities) had a new anti-cartel mission.  That was 1937.

The Division was created in 1933, the same year that the new administration of Franklin D. Roosevelt managed to shepherd through the National Industrial Recovery Act.  The Act amounted to “Build Back Better,” 1930’s style.  The purported successes of the Soviets’ First Five-Year Plan (1928-1932) and of Mussolini’s policy of encouraging cooperation between government and private enterprise inspired the Act.  The economy was stuck in the nadir of the Great Depression.  “Capitalism” seemed to be doing a poor job of marshalling society’s resources and solving problems.  Was it not the problem, and would concentrating control of the economy in the central government not be a big part of the solution?  Was not competition in markets the source of much ruin and waste?  Could the central authorities not do a better job of coordinating economy activity?

It is not obvious what the Antitrust Division was up to in the years 1933-1937, and, indeed, it is hard to find commentaries that talk about these years.  Suffice to say, the emerging panic over international cartels did seem to restore some purpose to the Division and some vague sense that maybe “cooperation” in markets did have a dark side.  Maybe free market competition was not always a bad thing.

It is no accident that the Germans made a point of seizing the oil fields of Baku on the Caspian Sea after they had opened their war with the Soviet Union, but, by and large, the Germans’ war effort was fueled by expensive, synthetic oil.  Not the allied war effort.  The allies surfed to ultimate victory on a wave of cheap American oil.

Before the war was even over, the United States started to lay the foundations for a globalized oil market.  Standard Oil of Southern California (the original incarnation of Chevron) had secured from the Saudis a contract to find and develop its oil resources.[1]  In the post-war, the American navy would secure free navigation of the seas.  Everyone would have the option of procuring oil in a global market.  Everyone might realize different costs of transporting oil from the source to their preferred destination, but everyone would be paying very similar prices for the oil itself.  That’s why we speak of the price of oil.  Admittedly, there is some variation in the quality of oil that comes out of the ground.  Some has higher sulfur content, for example, and these variations can affect the yields of products that come out the process of refining oil.  But, the basic principle holds: absent transportation costs, the prices of homogeneous products should not vary that much no matter where the stuff comes from.

The Naïve Economist observes that the phrase “global market” glosses over a lot of important detail.  Specifically, the idea that prices for homogenous products—for certain grades of oil, of coal, of wheat, of bauxite (aluminum ore), or soybeans, of whatever—should not exhibit systematic variation may derive from the fact that the people in the business of shipping these things around the world may have invested enormous resources in doing just that: shipping it around the world.  Logistics rule.  Logistics enable markets to become globalized in the first place. 

And logistics can break down.  Indeed, the Germans anticipated that going to war would induce other parties to shut down logistical networks.  They would have to be ready to do something about that.  Hence the liquification of coal.

Logistics also impinged conduct in the Pacific Theater of the Second World War.  The Japanese did more than just strike the American Pacific fleet at Pearl Harbor on December 7, 1941.  They also launched a campaign to seize the oil fields in the Dutch East Indies (the islands of modern Indonesia).  Everything it seized, such as the Philippines and Singapore, was about setting up a security perimeter around Japan and around these far flung places that would supply commodities like oil.  Setting up that perimeter might induce the Americans and the British to acquiesce to Japan’s plans and give up on the idea of fighting back.  Things didn’t unfold that way, but it was an inspired idea.

These days we hear a lot about oil prices and even wheat prices.  The United States and Ukraine are both important producers of wheat such that a poor harvest in one country or the other in a given season will discernably affect global prices for wheat—prices will increase.  Logistics networks are highly developed.  Private parties in the United States, for example, have dedicated physical assets for procuring wheat from wheat growers in the middle of the country and shipping it in “bulk” to countries around the world.  Mile-long trains full of wheat go from Montana to facilities on the Columbia River dedicated to processing those mile-long trains and pouring that wheat straight into ships dedicated to shipping wheat, and only wheat, to East Asia.  See this image of a ship, its great maw open and receiving streams of wheat, at the EGT facility in Longview, Washington on the Columbia River.  EGT is an international consortium of entities dedicated to shipping wheat in bulk from America to Asia.

But, back to oil prices.  Various parties talk about giving up importing oil from Russia.  The idea, presumably, is that giving up on Russian oil will disrupt an important source of export revenue for Russia.  Russia might find continuing its war with Ukraine financially untenable. 

All well and good, except that it’s not obvious that the determination of some cluster of countries to stop buying Russian oil will have much effect on Russian oil revenues.  Getting all countries in the world to boycott Russian oil would be one thing.  A global boycott would deny Russia revenues from exports.  But a partial embargo might amount to little more than political theater.  One country stops buying oil from Russia; it turns around and starts buying more oil from alternative sources like Nigeria or Ghana.  Other buyers find themselves buying less from these other sources… and buying more Russian oil.  So, imposing artificial constraints on the sourcing of oil induces a reshuffling of the market-wide sourcing of oil.  The main effect, ultimately, of very partial boycotts is to induce marginally higher costs in the delivered cost of oil.  Presumably, buyers were working hard to procure oil at least delivered-cost pre-boycott.  Imposing a boycott amounts to forcing themselves to procure oil from sources that can yield second-to-least delivered cost.  The entire global logistics network ends up operating at slightly higher cost, but it is not obvious that, but for some hiccups in making adjustments, the effects on “the price of oil” are more than second-order.  If even that.  So, says the Naïve Economist.

Is the Naïve Economist right?  Approximately so?

We can observe that oil prices are higher than they’ve been since 2008 or so.  These things have a lot more to do with the mysterious effects of “weak dollar policies.”  Basically, the more the American government prints dollars, the more we get inflation.  That inflation shows up markedly in prices of commodities, not just in oil prices.  The Naïve Economist should dedicate a separate essay to that.

Things may be different for wheat prices.  If the war disrupts Ukraine capacity to either harvest or ship its wheat, then global supplies go down and, other things equal, global prices go up.

Before, closing, let’s consider what the Naïve Economist might have to say about logistics and globalized markets more generally.  First, we have this idea of “energy independence.”  If, say, the United States procures no oil from other countries, then it has achieved an important degree of energy independence.  But, get this: Suppose OPEC or Russia were to reduce oil production.  What would happen to prices in global oil markets?  They would go up.  Even the prices paid by American buyers would go up.  So, if prices paid domestically are affected by production decisions made half-a-world away involving oil that domestic buyers were not going to buy, anyway, then is the country actually “independent”?  (Answer: No.)  Global supply goes down; global price goes up. 

Second: Global markets are not global for no reason.  They’re global, because people invested real resources in logistical networks, the stuff that gets commodities at least-cost from producers to buyers.  That’s not something to be taken for granted.  Logistical networks can be destroyed.  Just ask the Germans in 1937 or the Japanese in 1941.  Just look to the example of any famine induced by war.  War disrupts logistics, which is a more sophisticated way of saying something that sounds prosaic: War raises the costs of shipping, even going so far as to make shipping prohibitively costly.  That is a very bad thing.

So, appreciate your truckers, railroad engineers and pipeline engineers, the people who make logistics work seamlessly.  When they do their jobs, no one notices.  Oil flows; natural gas flows; homes stay warm in winter; grocery store shelves remain stocked with toilet paper.  When these people are prevented from doing their jobs, very bad things happen. 

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[1] Discovery! The Search for Arabian Oil (2007[1971]) by Wallace Stegner is a very nice account of Chevron’s experience.  Stegner had been the director of the creative writing program at Stanford.  Alumnae of the program included Ken Kesey (One Flew Over the Cuckoo’s Nest, Sometimes a Great Notion) and Larry McMurtry (The Last Picture Show, Lonesome Dove).