What Sanders and the Saudis Don't Understand

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I sometimes marvel at how deeply people misunderstand capitalism. It seems pretty obvious to me that people work harder when they are incentivized with the prospect of making more money. And when people work harder, they are usually more productive.

The ability to own a business (the means of production) is the cornerstone of capitalism. There is nothing to prevent any American from starting a business. And that's why these shores are the chosen destination for immigrants from around the world.

In recent years, it sometimes seems that the business landscape gets skewed by mega-corporations that can steamroll local businesses with lower prices, driving them out of business. I'm thinking of you, Wal-Mart, and you, Starbucks.

The fact is, larger companies do have the ability to take market share and crush weaker businesses solely on their ability to charge lower prices. But oftentimes there is a backlash — lower prices can only take a company so far.

Take Wal-Mart, for instance. Labor is usually the biggest cost for a company. And Wal-Mart recently had to raise wages. After all, if people won't work for you because you don't pay enough, well, your business will suffer.

But sometimes the mechanism of capitalism works in more mysterious ways...

Free College?

Bernie Sanders thinks that free college for every American is a realistic idea. The desire to make college available to everyone is a noble idea, no doubt. But how would this actually work?

The federal government has already tried to make student loans available to anyone who wants them. Again, sounds good on paper. But the reality has worked out differently. For one, many 18- and 19-year-old kids do not take student loan debt seriously. That's why there's over a trillion in outstanding student loans right now.

Many college graduates don't buy homes and cars because they can't afford it. So they continue to live at home with their parents while they pay off the loans.

What's worse, though, and largely unanticipated, was what colleges did in response to the endless flow of government tuition money: they raised prices.

In 2015, the average cost of tuition and fees at a private, four-year university was $31,231. Tuition prices have risen six times faster than inflation. In 1971, Harvard's tuition amounted to 13 weeks' worth of the median household's annual income. Today, it's about a year's worth of the median annual income.

The reason is very simple: Federally guaranteed loans meant there was too much money available. And when there's too much money in the system, you get price inflation. We've seen the same thing with health care. Prices have risen much faster than inflation.

I shudder to think what would happen if Sanders was able to make college free for everyone. The federal deficit would go through roof. And the quality of education would probably decline, too, as there would be less incentive for colleges to compete with each other and offer a better experience.

The Saudis Don't Get It, Either

By far, though, I love the irony of how Saudi Arabia's attempts to attack U.S. oil production are working out. They thought that by crushing prices, they could crush indebted U.S. oil companies.

I guess it seemed reasonable. After all, U.S. oil companies had costs per barrel up around $60 and $70, while the Saudis costs are closer to $10 or $20. Push U.S. oil companies to the point where they are losing money and they'll just stop producing, right?

Well, it's certainly not working out as they hoped. Because as it turns out, U.S. oil production costs are far more flexible than the Saudis thought.

U.S. oil companies have been aggressively cutting costs. Drilling rig costs have fallen by at least 30% over the last couple of years. And drillers have gotten more efficient, too. In October 2014, there were 1,309 rigs working U.S. oil fields. In December 2015, there were just 475. But the fewer number of rigs only caused an 8% drop in production.

Infrastructure is another area where oil companies can cut costs. They used to have to build roads and water lines and such when they wanted to develop an oil field. Just recently, Lockheed Martin debuted a huge blimp that can carry much of the needed equipment to the oil field, giving oil companies another way to cut costs.

Now, even at $35 a barrel, many U.S. oil companies are still profitable because of their ability to cut costs. That's what capitalism does: it makes operations more efficient. The Saudis definitely didn't see that coming...

And it gets even better, because as it turns out, it's the Saudis who have the more inflexible oil costs. Because they rely on oil revenue for government spending.

Saudi Arabia's revenue losses from lower oil prices will be around $40 billion this year.

Saudi Arabia has already had to tap its own foreign reserves by $65 billion in 2015 (around 10% of its total) to meet its spending requirements. It will likely run a budget deficit of ~$165 billion this year.

Plus, the Saudis have announced a $4 billion bond sale to raise cash — the first since 2007.

Funny thing, it's the Saudis that are going into debt. And while we have seen a few U.S. oil companies fail, they were the weak ones anyway.

The biggest irony may be yet to come. The Saudis want to sell part of their national oil company Aramco to international investors via an IPO. They say they want to raise money in order to diversify the Saudi economy. It should be obvious that Aramco will be worth more to investors if the company is making more money from higher oil prices. So will they bend to capitalism and push oil prices higher before the IPO?

Logic would say yes. But trying to undermine the forces of capitalism is most illogical.

Until next time,

Briton Ryle

@BritonRyle on Twitter

An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.