Oil, the Dollar and Comparative Advantage

Thanks to oil prices that have reached record levels, proponents of increased exploration in the United States have gained an upper hand in the debate over whether to drill in previously untapped areas. While it would be hard to argue against more robust exploration in the States, it should be said that some of its adherents ignore the dollar’s outsized impact on the price of oil, along with basic economic laws regarding comparative advantage and trade.

Much has been made of expensive oil in recent years, while much less has been said about oil being expensive due to the dollar being weak. The oil discussion has for the most part centered on supply, but the simple truth is that since June of 2001 oil has risen 160 percent in euros versus over 380 percent in dollars.

The above number is important in many ways, but most notably it’s a reminder that even if future oil discoveries make the U.S. energy “independent,” U.S. consumers still won’t be free of monetary mistakes that make gasoline dear. Indeed, owing to discoveries in the North Sea in the mid-‘70s England was effectively energy independent, but this in no way shielded its citizenry from dollar and pound debasement that made fuel very expensive.

Furthermore, the law of comparative advantage states very clearly that as economic actors all, we should let others labor to make for us what doesn’t maximize our profitable talents so that we have time to pursue work that does.

Thanks to trade over the years that’s mostly been free, Americans have long done just that. While we could surely be “independent” when it comes to producing clothes, televisions and cars, we’ve often allowed foreigners to make those products so that we would have time to build the Googles and Microsofts of the world. A better, more enriching deal in terms of trade would be hard to fathom.

Where oil is considered, the simple wonders of comparative advantage have seemingly been ignored of late. Many politicians excitedly point to the economic nirvana that would surely result from a robust national energy policy. Thanks to increased exploration stateside, good jobs would be created in the oil space that would bless us twice for domestic petroleum purchases driving down our alleged trade deficit. On its face this sounds good, but basic economics suggests this would be an economic retardant.

Indeed, what’s been forgotten is that even in good times, the oil business is not a very good one. While oil companies presently enjoy returns of 8.3 cents in gross profit per dollar of sales, firms in the electronics and computer equipment sectors respectively make 14.5 cents and 13.7 cents per dollar. Former anti-trust miscreant Microsoft earns 27.5 cents per dollar of sales. In short, even if the rules regarding drilling were liberalized, it’s hard to imagine many Americans deserting the cushier margins earned in other industries for the relatively mundane returns offered from oil exploration.

Instead, it could credibly be said that we have an even better deal at present whereby we send weakened dollars overseas in return for oil. Some say this enervates our wealth position, but more realistically it enriches us. With all dollars eventually returning to these shores, the money we spend on a product offering low margins frequently comes back as investment in even higher-value ventures.

This isn’t to say that the unexciting returns earned in the oil sector should make the political class rethink whether enhanced exploration rights are wise. More drilling would be a positive. On the other hand, average returns in the energy sector are a certain reminder that liberalized drilling rights should include the right for foreign oil companies to bid for drilling access alongside our own oil companies. Let market forces prevail here, but be sure to let those not American into the tent.

Doing so would insure that just as we seek to apply comparative advantage to most other economic activity, so will we when it comes to oil exploration. If we ignore these economic realities, American human capital will be wasted on less profitable effort that will retard our economic advancement.

Some will naturally say that allowing foreigners to drill on our lands would be to this miss the point, that enhanced exploration should only benefit Americans. Forgotten there is the basic truth that it doesn’t matter where oil is discovered.

Whether oil is found in the Middle East, Canada or Alaska is immaterial. It’s only wealth if it’s sold, and once the oil reaches the marketplace there’s no accounting for its final destination. Americans will bid for oil alongside the rest of the world, and even if future discoveries make us “independent,” our demand will occur in concert with worldwide demand on the way to a world price.

To engage in talk about where oil originates is to make a distinction without a difference. And to implement a singularly American energy policy run by Americans would be to ignore simple economics on the way to sub-optimal use of what is limited human capital.