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“Let’s Try a Free Market in Energy” (Letter from Charles Koch to FORTUNE Magazine in 1977 in Response to ARCO’s Thornton Bradshaw’s ‘My Case for National Planning’)

[Editor Note: This letter by Koch Industries's CEO Charles G. Koch, addressed to Fortune Editor-in-Chief Hedley Donovan, provides a pro-free market rebuttal to ARCO's CEO Thornton Bradshaw's "My Case for National Planning" (Fortune, February 1977).

Koch's scholarly effort is reproduced below as a historically important document in the energy debate. It is authored by a rarity of rarities, a principled free-market capitalist. The context and timeliness of the rebuttal was stated in the Libertarian Review at the time:

While this essay was only the latest in a series of attacks on a free market economy and defenses of National Economic Planning to appear over the past few years by intellectuals, businessmen and labor leaders alike, Bradshaw's piece deserves special scrutiny. For it comes to us from a man who both is a leading representative of American major oil companies, and was a member of Jimmy Carter's task force on energy during the 1976 presidential campaign. Moreover, it has been published at a time when both oil and government energy policy are getting widespread public attention.

"Let's Try a Free Market in Energy" by Charles Koch

This article is a reply to Thornton Bradshaw's provocative "My Case for National Planning" which appeared in the February, 1977 issue of Fortune. In that essay, Bradshaw asserted that a free market has never worked efficiently in crude oil, that it never could work efficiently in oil (or in the more exotic energy sources that must be developed), and that the only solution to our present crisis is to adopt governmental planning and pricing in certain energy raw materials. I will maintain, in rebuttal, that most of Thornton Bradshaw's major contentions are wrong-headed and blatantly self-serving, and that his proposal for planning and pricing can only make matters far worse than they already are.

There are certainly some limited areas of agreement that ought to be pointed out at the start. I would agree that government price fixing in natural gas has been an unmitigated disaster and that we should move to restore immediately free market pricing to wellhead sales. I would also agree that proposals to divest the major oil companies are counter-productive and would only lead to higher energy costs and less efficiency (as well as--dare I say it?--highly immoral). But while Bradshaw appears to recognize easily the economic harm associated with such measures, he proceeds to recommend a massive "new" experiment in governmental planning of energy outputs and prices. Such a position is curious (at best) and deserves to be explored in some depth.

Free Market in Crude Oil?

The major contention of the Bradshaw article is that governmental planning is necessary because the "free market mechanism never has worked for oil". According to Bradshaw there has always been "too much oil or too little" with a consequent "disorderly" market of gluts and scarcities. Further, the market "fails even more completely when it comes to promoting development of fuels now considered exotic". Such developments, Bradshaw maintains, are far beyond the means of private companies and will likely require massive governmental subsidies and loans.

What is curious about this criticism, particularly for someone in the oil industry, is that it has gotten the matter almost completely backwards. The free market mechanism has at times worked inadequately for oil because the government and the courts have failed in their duty: they have never defined and enforced property rights in underground oil. Surely Bradshaw realizes that the market "mechanism cannot work without property rights, without the right to own--that is control--the resources to be traded in free markets. Yet such a system has never existed in crude oil.

Historically crude oil has been in a kind of "no man's land" as far as property rights were concerned. Under the so-called "rule of capture", the only oil that could be "owned" and, thus, fully controlled, was oil that had been pumped to the surface. Producers owned whatever they could "lift". Unfortunately, such a system created perverse incentives to pump newly discovered oil as quickly as possible, since any oil not pumped by one producer might be pumped by another. Thus, the "gluts" that Bradshaw complains about resulted from the absence of property rights and not from any market "failure".

Pumping wells at very high rates can be, of course, wasteful and inefficient, resulting in substantially less oil being recovered than would be the case if the underground oil could be controlled and recovered more slowly. In addition, the most economical manner to inventory oil for future production is to leave it in the ground and not lift it to the surface. Yet, again, the perverse incentives set into motion by the court's "rule of capture" required that the wells be promptly pumped in order to establish "rights" to the oil. Thus, it is government (and the courts) that must take the blame for past waste and inefficiency in oil production.

A number of alternatives were attempted as a substitute for property rights control to underground oil. For instance, oil producers frequently sought to band together to limit production. If adjacent producers could draw up an agreement restricting production, and if the agreement could be enforced, then the "chaos" of the nonmarket oil might be alleviated or prevented altogether. Bradshaw tells us that such "voluntary restrictions failed", but he never quite tells us why they failed.

The facts are that voluntary restriction failed because of government. State governments made restriction agreements illegal per se under their own anti-trust laws and the courts refused to enforce these early unitization efforts. So voluntary attempts to cure the property rights defects of the "rule of capture" were undercut by government and there was no "restriction". Thus, government regulation came to crude oil production in the 1930's--the prorationing system--not as the result of "market failure", but as a direct result of the absence of property and contract rights--and thus the absence of a true "market"--in oil.

OPEC and a Free Market

Another important contention in the Bradshaw article is that the existence of OPEC makes a free market in crude oil impossible since that organization "controls the price" of oil. On the other hand, Bradshaw asserts, if there were a free market including OPEC oil, the newly posted price of crude would fall to $3 or $4.

Neither of these claims is accurate, however. In the first place, our own domestic price fixing of crude oil and natural gas prices has tended to reduce domestic production, stimulate consumption and increase our reliance on foreign crude. It is entirely possible that OPEC would not long be setting world oil prices if America deregulated domestic oil and gas and created a free market in crude oil. Our own irrational price fixing policies prop up the OPEC cartel price.

Secondly, in the absence of domestic price-fixing, OPEC's "power" to control oil prices has been greatly exaggerated. World oil prices prior to October, 1973, were held down artificially despite massive world-wide inflationary pressures caused by the expansionary monetary policies of the United States and other governments. When the surplus capacity of regulated domestic oil and gas ran out in the early 1970's, the demand for OPEC oil began to soar. This enabled OPEC to belatedly and, therefore, drastically raise prices on their artificially underpriced oil.

And, finally, it is extremely unlikely that a free world market for crude oil would result in prices of $3 or $4 a barrel as Bradshaw speculates. As already noted, years of inflationary pressures have all but destroyed cheap energy. In addition, government regulations, restrictions and taxes in the U.S. and virtually every other oil producing country have added enormously to the costs of finding and producing oil. Certainly there is little need to worry about prices so low that "every drilling rig in the world would be stacked". Such fears are totally unfounded.

The Development of Future Energy Sources

Most of the other problems that Bradshaw associates with the market mechanism can also be traced to governmental mismanagement. Secondary and tertiary recovery techniques have been delayed because of price controls on crude oil. Market signals will bring forth coal and shale oil when and if the government gets out of the way and when and if the development of such oil is competitive with conventional techniques. Certainly the market cannot be faulted for leaving very expensive crude oil in shale or in coal; at the moment, that is precisely where most of it belongs.

Indeed, there is no sound economic reason why future energy sources cannot be developed and innovated totally within a free market framework. It is wrong to assert that future developments are simply beyond the financial capacity of private corporations and the private market. In fact, such assertions always attempt to prove too much. Governments have no "resources" of their own by which the private market might be "subsidized". If there are to be massive subsidies to develop exotic fuels, such funds will have to be borrowed or taxed away from the very same private market that cannot, allegedly, effect sufficient private commitments in energy research and development. Nor is there any reason to expect governmental time horizons to be longer than those in a free capital market.

In fact, the evidence is to the contrary. When expenditures are made through the political process, long term projects tend to be avoided since voters feel that they will benefit only in the distant future, if at all. On the other hand, owners of a business have every incentive to make long term investments, as the present value of their shares rises with expectations of future earnings enabling them to sell and realize the benefits now. There is every reason to expect that the private market, if unhampered, can finance and sustain future energy sources. For example, the now approximately $9 billion Trans Alaskan pipeline system (in which Bradshaw's Arco is, strange to say, a participant) has been financed privately in spite of the landmark governmental roadblocks and delays. Also, numerous billion dollar plus offshore development projects have been and are being financed without government subsidies.

The free market is an efficient regulator of future technological developments. When existing supplies are reduced, prices tend to rise and alternative sources are developed and innovated. The market process--when it is allowed to operate within a framework of assured property rights--has always tended to ensure a steady stream of innovations to replace, at lower costs and prices, existing depleting alternatives. The industrial world has yet to "run out" of any resource traded on the market, although there are dozens of cases of resource exhaustion, depletion, and even extinction with resources not protected by property rights. Innovation delays and artificial scarcities are the province of governmental planning, not of the free market.

Uncertainty and Planning

If there is an obstacle to future improvements, it is the incredible uncertainty associated with future governmental energy interventionism. Which exotic fuels will the government subsidize and what will be the total commitment? Will the prices of oil and gas continue to be regulated? Will the Congress decide to divest the major oil companies? Certainly energy companies are foolish to plan long-term when they have little or no idea what future policy and law will be, or, even whether they will be allowed to develop "competing" sources of energy. The government's energy shortage has become a self-fulfilling prophecy. Its irrational controls and meddling have dried up existing supplies of oil and gas and all but paralyzed future investment commitments. To assert that more government is required because the private capital market is inadequate to the task is to add insult to injury.

Bradshaw would likely respond that permanent government output controls and pricing, combined with "incentives" to private industry will substantially decrease the uncertainty and lead us out of the crisis. This is incorrect. Future government plans will be no more "certain" than its existing rules and regulations. What will crude oil outputs be in 1979 or in 1981? What prices will elicit that supply? What are our "national needs" in oil (or coal and gas) and who is to determine this and by what means? What new taxes are to be devised to reduce demand and consumption? And why should we assume that the political leaders that make these decisions are any more informed or any more wise than free men in competitive markets? The only "certainty" to be associated with governmental planning is that it will not work, will tend to produce results opposite to those intended, and will doom any substantial private long-range planning in energy development.

Economic theory and history demonstrate that a political bureaucracy cannot intelligently make such decisions, that the determination of some all-embracing national goal is illusory, and that the only sound alternative to the present regulatory arrangement is the prompt ending of all government regulation. In short, we must create a free market in oil. We must institute a system of full property rights in underground oil. We must abolish all federal and state controls over price and output in the petroleum industry. We must end the state prorationing system and abolish the Connally "Hot Oil" Act of 1937. We should, we must, establish a free market system in the energy industry. It is the only practical solution to the problems that face us.

[Part II Tomorrow: "Planning, Politics and Power"]

3 comments

1 Steve C. { 10.07.10 at 11:48 am }

Pretty much nothing has changed. Even with the evidence of the failure of Soviet style technocratic master planning, there are many people who still insist we need a national energy policy guided by the enlightened benevolence of the smartest guys in Washington.

2 Ed Reid { 10.07.10 at 1:25 pm }

Steve C. { 10.07.10 at 11:48 am }

How do we determine who are “the smartest guys in Washington”? Or, do we simply permit them to self-determine?

3 kuhnkat { 10.07.10 at 10:41 pm }

The smartest guys in Washington LEAVE!!

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