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John R. Lott, Jr.: High Gas Prices Are Not Something New

With oil prices closing above $125 a barrel of oil on Friday, angry politicians are blaming the higher prices on everything from speculators to greedy oil companies. Last week some Democratic Senators demanded “urgent action . . . to adequately investigate whether speculators are driving up prices.”

Democrats are proposing to protect the American people from “greedy oil traders who manipulate the market.” Senator Barack Obama wants price gouging by oil companies to be a federal crime.

Everyone wants lower prices, but many politicians seem unable to understand that speculators actually smooth out wild swings in prices. Speculators make profits by buying oil when the price is low and selling it when it is high, and doing that protects consumers. Tensions rose last week because of Venezuela financing Columbian terrorists. Columbia looked like it might retaliate and send troops into Venezuela, the world’s sixth largest oil exporter.

There was an obvious risk that Venezuela’s oil exports could be stopped. Oil prices increased immediately. They didn’t wait for the war to actually break out. By buying oil now in order to set it aside if supplies are interrupted if the conflict escalates, is good for consumers. Storing oil for then will prevent what would have been even higher prices. Politicians obviously thought speculators were unjustified to start bidding up prices. After all, war might never occur. Yet, if speculators didn’t do that and Venezuela's shipments are halted, the much bigger increase in oil prices would surely cause politicians to really call for the scalps of everyone in the oil business.

The speculators are taking a real risk with their own money. If no war occurs and prices fall, few in congress are going to shed tears over the money that the speculators would lose. If war breaks out and prices only rise a fraction of what they otherwise would have gone up, who is going to thank the speculators for a job well done?

Speculators are actually extremely accurate in predicting the future. But it is not just in oil prices.

Markets do a remarkably good job compared to polls and pundits in predicting election outcomes. In 2006, trading markets correctly predicted the outcome of every U.S. Senate race. In 2004, they correctly guessed the presidential vote in every state but Alaska. Similar accurate predictions have been seen in everything from how much money movies make to who will win sports league championships. Possibly all that isn’t too surprising when people put their own money at risk, but do politicians’ really want to compare the accuracy of their predictions with that?

Bidding up prices today also produces another benefit. Higher prices today reduce consumption and increase inventories and thus reduce how much prices will rise tomorrow. All this ensures that the overall increase in price will actually be less.

The possibility of higher prices when disasters strike also gives oil companies an incentive to put aside more oil to cover those emergencies. Storing oil is costly, and if we expect oil companies and speculators to bear those costs, you had better compensate them.

The irony is that letting the companies charge higher prices actually reduces customers total costs because there will be more gas available when the disaster strikes. Unfortunately, Venezuela’s risks are not the only production problems that have been occurring. Last week, Nigeria, the eighth larger oil exporter, faced rebel attacks on a major oil center. Over the longer run, the U.S. has refused to increase production of oil despite huge untapped reserves. While New York Sen. Charles Schumer and other Democrats lambast Saudi Arabia and other countries for not increasing oil production enough, these same politicians have consistently voted against any increase in U.S. oil production.

Senator Obama sees part of the solution in a massive windfall tax on American oil companies. Putting aside the fact that having politicians blame oil companies is a bit hypocritical — U.S. oil companies have paid more than three times in taxes to the government than they have earned in profits over the last 25 years — higher taxes on profits will reduce production and increase prices. A higher tax on profits will mean fewer investments in producing oil and that in turn will mean less production in the future.

Ironically, Democrats won the 2006 elections and took control of both the House and the Senate by promising they would reduce gas prices. Yet, with regular gas now selling above $3.67 a gallon, Americans can only longingly remember the average prices of about $2.20 a gallon that Democrats were complaining about in early November 2006. The Democrats’ bigger sin is that they seem to have no understanding of how markets work.

As Robert Samuelson recently pointed out, high gas prices have long been in the making. But punishing speculators and oil companies, while politically popular, will only hurt consumers.

John Lott is the author of Freedomnomics and a senior research scientist at the University of Maryland.