Should Canada be restricting oil exports?

Canada is now the largest foreign supplier of oil to the US, to the tune of some two million barrels of oil a day. Should we be? Shouldn't the Canadian government be trying to keep that oil here in order to satisfy our own energy needs? A non-economist might be inclined to respond in the affirmative: the prospect of running out of fuel seems the sort of thing that a government should be trying to prevent - especially in a country as cold as ours!

But that's not how an economist would look at the problem.

The fundamental resource allocation problem is to decide how much oil should be extracted now, and how much should be left in the ground for the future. Economists know that it's usually pretty hard to improve on the outcomes generated by properly-functioning markets, so the first question to be asked when contemplating government intervention would be: is the market functioning properly? Or, in the jargon of economics, what market failure needs to be corrected? In the case of oil, there's the obvious negative externality of the pollution generated during its production and consumption. The solution to this is of course to determine the appropriate mix of taxes and regulations so that the private costs correspond to the social costs.

But once that's done, there doesn't appear to be any other market failure that would justify much in the way of further government intervention:

• The markets are pretty competitive: no-one - not even OPEC - has enough market power to systematically move prices one way or the other.
• There's little reason to think that there are any important informational asymmetries that would distort agents' decisions.
• The oil market's infrastructure is - for the industrialised countries, anyway - remarkably well-developed.

So there's little reason to believe that government intervention would improve on what the market decides. The price should (more or less) reflect the benefits of current production and the costs of depleting oil reserves. But there's lots of reason to believe that it can make things worse. For those of you who aren't familiar with the techniques used in welfare analysis that follows, here's a good power-point introduction.

Here's a graph summarising the situation under free trade:

Since Canada isn't large enough to affect either the world supply or world demand for oil, it takes the world price as given. Consumption will be characterised by the point x₀, and production by x₁. The difference between the quantity produced (Q₁) and consumed (Q₀) is exported. (An oil-importing country would be one in which the intersection of the domestic supply and demand curves occurs above the world price.)

Consumer surplus is the region A, the area between the demand curve and the price, while the producer surplus is the sum of the regions B + C. It should be noted that although producer surplus is larger than consumer surplus in this graph, there's little reason to believe that this is in fact so; it's not hard to re-draw the graph with (possibly more plausible) supply and demand curves so that consumer surplus is larger.

What would happen if exports were forbidden? Prices and quantities would be determined by the intersection of the domestic supply and demand curves at x₂ in the following graph:

The domestic price would fall to P₂, and output would fall to Q₂. The region B₁ would be transferred from producers to consumers, and the producer surplus would be reduced to the region B₂. Note that the region C is now neither producer or consumer surplus - the 'deadweight loss'.

Another option is the 'National Energy Program' (NEP) model, introduced by the federal Liberal government in 1980, which essentially set domestic prices according to the autarky case, but also allowed suppliers to export 'excess' production at the world price:

Production goes back to free-trade levels (i.e, x₁), and domestic prices and consumption are the same as in the autarky cases. Compared to the free trade case, the welfare effects of the NEP were to transfer B₁ from producers to consumers, leaving a producer surplus of B₂ + C₂, with a deadweight loss of C₁.

Len Waverman and Robert McRae presented some estimates for the effects of the NEP in this study. Their estimates probably shouldn't be taken as definitive, but they provide a good idea of the order of magnitude of the distributional effects of the NEP (amounts are in 2006 CAD):

• Residents of Alberta lost roughly $46 000 per capita.
• Canadians outside Alberta gained $7 500 per capita.
• The deadweight loss amounted to around $40 000 per Albertan.

So it's not really a surprise that Albertans have a very bad memory of the NEP.

It should be noted that this analysis is based on the short-run supply curves, conditional on the productive capacity that was in place during free trade. But in cases 2 and 3, the price that oil producers receive will be less than the initial world price. The resulting loss in profits will lead to reductions in investment, shifting to supply curve to the left. This shrinkage will stop when the price they receive yields the same rate of profit that they had before - that is, the world price:

In the long run, consumer surplus returns back to its original level A, and producer surplus is reduced further to B_1a; the regions B_1b, B₂ and C are all deadweight loss. The only long-run effect of the NEP or similar attempts to discourage exports would be to fritter away much of the gains from producing oil, with no corresponding gain for consumers.

So should Canada be restricting oil exports? No.

Comments

[happyjuggler0]

Keeping in mind the political desire by some to restrict oil exports in the name of saving them for the day they start to "run out", I have some thoughts.

Just because prices are high now, compared to the recent past anyway, does not mean the world is running out of oil. The price is high because demand has been rising inexorably, while supply hasn't kept up. Basically the reason supply hasn't kept up is the major oil companies (and others) went with the philosophy "won't be fooled again" and chose not to engage in new major exploration due to the "temporary" run up in oil prices. It still may be temporary in the long run, but most people seem to think pries will remain high for some time. Thus high exploration is going on again.

In other words, a typical commodity bust/boom/bust cycle looks to be happening in oil. No "Peak Oil" yet Virginia.

In the absence of Peak Oil, the most likely scenario under the "let's save our oil now for when we need it later" crowd will be that Canada blocks oil exports, causing the world price to rise yet higher in the short to medium term. This helps along the demand side conservation and search for alternatives to oil as well. Eventually enough new oil will be found, in conjunction with reduced demand on a continuing basis regardless of price due to new efficencies (ubiquitous hybrids and other high mpg cars) and oil replacements (electric cars anyone?) and the price of oil will tank.

When the price of oil tanks, those people who were thinking in terms of oil running out soon will realize they were wrong, or at least highly premature. The export ban will be ended, and Canada's oil reserves will be sold at extremely low prices instead of extremely high prices as would have occurred under a relatively free market regime.

True, in the meantime Canadians would receive lower prices for oil products domestically. But the beggar thy neighbor attitude sets a precedent that can be used against other provinces as well. No exports for x for similar reasons for what occurred in oil, and everyone Canadian benefits at the expense of the poor saps who invested in x and who were employed making x. Eventually no one gains if everyone is getting rent seeking export bans, and everyone loses. It also has the deleterious effect of radically discouraging investment in Canada.

Ecuador just recently effectively nationalized the oil in its country. Guess how many people will invest in Ecuador now instead of elsewhere? Guess what happens to Ecuador when the oil price eventually comes down again? Kaput, just like after the 70's boom and 80's bust.

One other scenario is even uglier for Canada, assuming you like a united Canada that is. A ban on oil exports that clearly hurts Alberta would have a really good chance at increasing seperatist prssures from Alberta, and they would encourage the same in Quebec as well of course. If such seperatism succeeded (peacefully or otherwise, most likely peacefully, Canadians being what they are, eh?) then oil exports would flow again of course, thus negating the whole idea in the first place.

But if one thinks Canada would be better off in three or more pieces, then this is a good stealth way to go about it.

[Stephen Gordon]

That's a good point. Perhaps a better title for the post would have been 'Should Alberta be restricting oil exports?'

[Valuethinker]

happyjuggler0 is right. If any Ottawa government went anywhere near Alberta's oil again, Alberta would separate.

I believe also the Supreme Court would now find the NEP unconstitutional-- whereas in 1980 the constitution had yet to be repatriated. Natural resources are a provincial matter.

NAFTA in any case prevents Canada from favouring Canada over the US and Mexico in energy supply, I believe. It is one, level, playing field. And Ontario in particular cannot leave NAFTA, it would devastate the economy.

For better or for worse, we are now in the same boat. Given the looming natural gas supply shortages in North America due to declining production, I for one am glad that we are building LNG terminals in New Brunswick (although that gas will flow south to the US, not West to Ontario).

Quebec has Hydro, but Ontario is in one, sweet mess when it comes to electric power supply (and also home heating). I am glad the government is emphasising conservation: if California can achieve no per capita gain in electricity consumption since 1980 (the rest of the US growth is about 40% in that time) then Ontario, too, can probably do a lot. (in California this is known as 'the Arthur Rosenfeld effect' after the energy commissioner who drove it through).