Size matters, at least in many economic sectors, if not in the personal attributes of GOP presidential candidates.
Candidate debate comparisons aside, there were three examples of this in the news last week: The effect of rising oil prices on North Dakota production, the decision to restart mining on Minnesota’s North Shore, and in the push for greater U.S. agricultural trade with Cuba.
And each provides a different example of why economists say size matters.
The first relates to how oil developers are reacting to the recent modest rise in crude prices: Once the price crosses $40 per barrel, some are willing to put their rigs back to work in North Dakota.
As I noted in a 2015 column, there is no single “breakeven cost” in shale oil or gas production below which every well shuts down and above which every well makes money. Rather, it depends on location, geology and whether one is drilling entirely new wells, re-fracking older ones or simply pumping existing ones in good shape.
The possibility that entirely new drilling could start at $40 per barrel however, would have surprised analysts only two years ago, considering costs that prevailed then. At that time, the necessary price to justify new drilling was deemed well above $40. If last week’s predictions of drilling take place, and some observers are skeptical, it indicates that North Dakota oil is an “increasing cost industry.”
This is where size matters. It is a situation where the average cost of production rises as the entire industry or sector gets larger and falls when the sector shrinks in size, as we’ve seen recently. This is different from “economies and diseconomies of scale” that involve how costs rise or fall as the size of one particular factory or company varies.
Drilling costs certainly rose over the past decade as oil in North Dakota and parts of Texas boomed. This is because rising demand drove up the lease rates on drilling rigs and trucking costs as well as the cost of fracking sand and other inputs, not to mention labor, especially skilled roughnecks.
So costs per well drilled in otherwise comparable conditions were higher in 2014 than in 2004, for example.
But as oil prices fell sharply, demand for rigs, supplies, services like trucking and wage rates also fell. As drilling and fracking activity shrank, costs came down, the classic indicator of an “increasing cost industry.” If oil prices were to rise now, eventually so would average costs.
Not all industries have such increasing costs. Minnesota iron ore, the second news item, differs from oil in this regard. This is a very mature sector. Most mines have been in operation for decades. The investment cost of steel mills and other infrastructure is already amortized. There are plenty of qualified workers when jobs come open. Such mining is important in Minnesota, but small enough compared with overall national use of explosives or mining trucks, that increases and decreases in output over recent decades don’t push the prices of these inputs up and down significantly.
So, as production fell, the per-unit costs of labor, supplies and other inputs didn’t fall, and variable costs per ton of pellets produced didn’t change much. The news Monday that Cliffs Natural Resources is bringing its Babbitt, Minn., operation back into production isn’t going to push the prices of supplies or labor up. Lake Superior-area iron mining is what economists call a “constant cost industry” in the sense that average or per-unit costs don’t increase or decrease as output for the whole industry rises or falls. So the way size matters here is almost in inverse to the case of the oil industry — the industry’s size provides a cushion to the investment risks of its participants.
The third example of “size matters” is different in that it involves the size of a market, or demand, for products rather than the size of a particular industry that supplies them.
The Obama administration continues to do whatever it can to improve economic relations with Cuba. Agriculture Secretary Tom Vilsack, interviewed in Lima, Peru, hailed opportunities for U.S. farmers if trade with Cuba increases. His department has released estimates that with normalized relations, U.S. producers could supply 50 percent of Cuba’s food imports given the short shipping distances as opposed to European or South American food sources.
U.S. farmers are among the strongest supporters of this rapprochement. Some Republican members of Congress are bucking their party’s general opposition to renewed relations precisely because farmers and agribusiness companies are so positive. But no one should get their hopes too high.
At this point, let me state that I strongly support the administration’s policy. I have worked with Latin America for 47 years and have made two trips to Cuba in the past 12 months. So I am rooting for this policy for the sake of the Cuban people and for U.S. farmers and businesses. There truly are win-win possibilities here.
But again, size matters. These “win-wins” are small, and Minnesota farmers should not expect big benefits. Cuba’s population is only 11.3 million, half that of Taiwan and only a fourth that of South Korea. Nigeria’s population is 14 times larger, Indonesia’s 20 times, India 100 times and China 120 times.
Moreover, the commodities mentioned, including soybeans, rice and poultry meat, already are traded in very efficient global markets. The U.S. may well sell these products to Cuba, and that nation may buy less from Brazil, Argentina, Thailand or Europe. But unless Cuban consumption increases enough to bump global demand for a world of 7.1 billion people, world prices are not going to increase.
The rice grown in Arkansas or soybeans from Minnesota that flow to Cuban ports and tables may displace rice and soybeans from Thailand or Brazil. But those Brazilian and Thai exports will be sold somewhere else in the world, substituting in the overall scheme of things for the U.S. rice and soy newly flowing to Cuba.
The world will be better off because fewer resources will be spent on transportation. Yes, U.S. producers will capture some of this reduction in “basis” between where the products are produced and used. But this will be a few cents per bushel or per pound on a small fraction of overall U.S. exports, and the effects back at the farm won’t even be measureable. (This is somewhat less true for U.S. poultry producers than for soy and rice.)
More importantly, as the communist regime in Cuba withers away, it will progressively import less foodstuffs and export more. Like Argentina, Cuba has a natural resource endowment and labor force that could make it a powerhouse food exporter, at least relative to size. Only the abysmal failure of its government makes it a food importer. A decade or two from now, Cuba may well displace Mexico as a source for U.S. consumption of fruits and vegetables. It would be a waste of land to grow soybeans or wheat in Cuba, but it could soon be self-sufficient in rice.
Cuba also has great potential in hogs, beef and poultry. If these industries do, in fact, develop, they may become an outlet for corn and soy from Minnesota, since Cuban land and labor have a competitive advantage in higher-value crops than feed grains. But the long-term outlook for Cuba is that it will export more agricultural products than it will import. And overall, it is a case where the re-establishment of economic relations will benefit both sides, but the effects on the United States as a whole will be small, because Cuba is small.