Capitalism is a matter of incentives, on management, politicians, investment managers, financiers and oil company executives. Sometimes they run in the same direction as rational free market theory would indicate. More often, in this increasingly complex world of big government, globalization, fast computers and dangerous projects, they don’t. To get the global economy to work properly, we need to fix this problem, and it’s often not obvious how to do so.
The Deepwater Horizon disaster has revolutionized the incentives in the energy industry. Before it, there was every incentive for major oil companies to develop deep sea drilling oil fields. The danger of major environmental problems appeared remote, while the alternatives, of Arctic drilling and oil shale/shale oil/tar sands all appeared environmentally harmful, in ways that could be clearly perceived by the local populace.
What’s more while the up-front costs of deep sea exploration and drilling were considerable, with oil prices above $50-60 these could easily be absorbed by the profits from production that was relatively low in cost. Even if oil prices dropped temporarily, production was still profitable on a marginal cost basis, so operations could continue, with the high up-front costs being amortized when oil prices were high. Conversely, while tar sands were viable at about $50 per barrel, the variable costs of production from sands and shale were high enough that if oil prices dropped they became uneconomic, producing ongoing losses for their owners. Thus in the winter of 2008-09, when oil prices briefly fell to around $30 per barrel, tar sands and oil shale production were almost completely shut down, while existing exploration and production operations from deep sea wells continued without interruption.
However after Deepwater Horizon the incentives have changed. For the largest oil companies, the probability of being forced into bankruptcy or forced takeover after a deep-sea disaster is substantial. In this respect, oil drilling is like nuclear power. After the 1979 Three Mile Island disaster, no further power stations were built in the United States, even though the casualty rate from nuclear power was less than a tenth of that of coal fired power stations, or even gas-powered or hydroelectric power stations, once casualties during construction were included.
Instead unconventional onshore oil sources become relatively more attractive. Although their production cost may be higher than offshore oil and their expected environmental damage greater, their environmental costs are well established in advance, provided reasonable care is taken with groundwater. Furthermore, the largest oil companies have sufficient reserves to survive a period of low oil prices, when production from sands or shale may be unprofitable. Thus it is rational in the new market environment for Shell/ExxonMobil/BP to concentrate their oil operations in unconventional onshore sources, rather than in deep sea offshore drilling.
However, that does not mean that deep sea drilling is completely unattractive for all possible operators. For one thing, emerging market deep sea fields may be less environmentally sensitive than the U.S. For the oil majors, this does not help much. If a disaster occurs, local emerging market governments will seize the opportunity to loot the oil majors, making a disaster offshore Brazil every bit as expensive as one in the Gulf. However, for local oil companies, the position is very different. There’s no point in the Brazilian government looting Petrobras; it owns 51% of it. Hence emerging market deep sea oilfields will be developed primarily by local companies.
As for US offshore oil, it is still accessible, but by fly-by-night operators with thin capitalization. For such oil companies, the risks of bankruptcy may economically be minor compared with the potential profitability of deep sea oil operations. Thinly capitalized companies can finance themselves by junk bonds, and ensure that equity capital is owned by retail shareholders, difficult for government and the trial lawyers to attack.
As I have discussed here in the past, similar perverse incentives exist in the financial services area. Banks are regulated primarily by forcing them to keep certain amounts of capital against their assets and other exposures. Even under the original Basel accords, this produced perverse incentives, because not all assets were treated the same. Government debts of OECD governments were treated as being risk free, and mortgages were treated as having a fraction of the risk of equivalent loans. Moreover, risk weightings were altered according to the credit rating of the asset.
Apart from the question of incentives mismatch between bank incentives and the banks themselves, the incentive for the bank is obvious: to buy as many assets per unit of capital as possible, since in good years returns could be maximized by this means. As is notorious, all three of the favored areas have now caused trouble. Banks loaded up on subprime mortgages, because under the risk allocation formulae, they were less risky than corporate loans. Banks also loaded up on securitized assets that had been mis-rated by the credit rating agencies — even if such assets appeared to be risky their high credit ratings meant that more of them could be bought per unit of capital. Finally, as has now become apparent, banks loaded up on government and government-guaranteed debt, particularly of the less well-run governments, which tended to issue more debt and to provide a higher yield.
An additional problem arose under the Basel II rules, in which large banks could use their own risk management formulae to determine the amounts of capital that should be allocated against particular positions. This gave the banks the incentive to use formulae that were insufficiently conservative. It also gave them the incentive to invest in assets such as collateralized default operations and credit default swaps, for which the risk management formulae were not merely too conservative but altogether misleading.
For the banks themselves of course, there was a theoretical incentive to prevent bankruptcy (although the state bailouts mitigated this greatly in practice.) However for their top executives there was no such incentive. A recent study has shown that the top executives of Bear Stearns and Lehman brothers earned over $1 billion each in cash bonuses in 2000-07, thus dwarfing their losses on stock holdings when those institutions went bankrupt or (in the case of Bear Stearns) effectively so.
Incentives can also play a perverse role in politics. It is generally agreed, presumably even among the Japanese political class, that the country’s budget deficits need to be brought down as a matter of urgency. The IMF has calculated that Japan’s public debt will reach 249% of GDP on its present trajectory by the end of 2012. That matches the highest levels from which countries have ever recovered; those of the United Kingdom at the end of two wars, in 1815 and 1945. Those reductions required in the first case a truly draconian approach to public spending that would be impossible in a modern democracy and in the second case an investor class full of “money illusion” – prepared to accept yields on government bonds that were in most cases below the rate of inflation. Neither of these remedies is likely in Japan – in spite of the legendary savings level and patriotism of Japanese retail investors they are currently getting a full 3.3% real yield on long term government bonds (when the current deflation is taken into account) indicating that there are no suckers to be found.
Hence it is essential for Japan to reduce the budget deficit, currently around 9% of GDP, before the end of 2012, when the country’s debt reaches the tipping point at which recovery is no longer possible. In their more rational moments, that need must be obvious even to Japanese politicians.
However consider the incentives involved. Japan has now had five changes of prime minister in less then four years; even during the 55-year one party rule of the Liberal Democrat Party prime ministerial terms of more than two years were uncommon. Hence the new prime minister Naoto Kan knows that he has no more than a year in office, or at most two. In those circumstances, why would he take more than cosmetic steps to improving Japan’s budget position? The current Democratic Party of Japan government has many unfilled spending promises, which it will be excoriated for ignoring.
Conversely sharp budget tightening will be met with dire warnings by the Keynesians that infest politics of the inevitable deep recession the cuts are likely to cause. Without any significant possibility of Kan lasting long enough to be recognized for his bravery as the Japanese fiscal position totters back towards balance and growth resumes, there is no incentive whatever for him to do anything other than “go with the flow” and introduce at least the less costly of the DPJ’s unmet spending promises.
In all three cases, the oil industry, finance and Japan, incentives to the participants will produce results that are clearly economically sub-optimal. The free market is essential to maximizing prosperity; state control has been proved time and time again not to work, if only because of the perverse incentives faced by those in positions of power. Yet the wise analyst and policymaker must recognize the economy as it is, not as the theoreticians would like it to be, and adjust his analysis and policies accordingly.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)