Walter Molano | Shale and the law of diminishing returns
Published:Thursday | April 26, 2018 | 12:00 AM
One of the first concepts introduced in Econ 101 is the law of diminishing returns. It is classically presented as the decrease in marginal utility as a single factor of production is increased, assuming that all of the other factors of production remain constant.
Sound complicated? It is not.
Typically, a professor will use the example of a pizzeria. Assume that there is a pizzeria, with a single pizza oven. The factors of production in this case are the pizza makers, also known as labour, and a pizza oven, also known as capital. Of course, there are the inputs, such as dough, sauce and cheese, but the two main factors of production that determine output are labour and capital.
Imagine that it is the night of the big football match and the phone starts ringing off the wall. The managers see a big chance to increase output, so they hire another pizza maker. Output immediately doubles.
They then hire a third person, but the increase does not triple. It goes up by a smaller amount. The reason is that the pizza makers begin to jostle for counter and oven space, but the phone keeps on ringing. They then hires a fourth pizza maker, but the increase is even less because the four pizza makers are cramped into a small space and they begin to bump into each other.
Still, the phone is ringing off the wall and they hire a fifth pizza maker. Now, total output begins to fall because the pizza makers are so annoyed that they get into a fight and all production comes to a halt.
Does that mean that there is no way that the pizzeria can increase its output? No. The big constraint is capital. If the owners were to increase their capital by adding a new oven, and some more counter space, then they could easily increase output by adding more labour.
Unfortunately, this is a simple concept that is lost on many businesses. A trip to a local car dealership is a case in point. The minute you walk into a showroom, you are accosted by a half-dozen salespersons. Many furniture stores also have an excess number of salespeople. The concept is simple. After adding a certain amount of labour, the only way to increase output is by increasing capital.
A very interesting application of the concept currently exists in the United States shale industry.
Although shale formations are scattered around the planet, the US is the only country that has been able to fully exploit it. This is not because of Yankee ingenuity; it is because the US had the essential factors of production needed to fully take advantage of its shale deposits.
First, it had the capital stock. The US was the first oil superpower, and it had an enormous stockpile of unused drilling equipment scattered across the country.
Second, it had the labour. As home to the largest oil companies in the world, it had leagues of trained engineers, drillers and truck drivers that could be cheaply deployed to the shale fields of West Texas, Appalachia and the Dakotas.
Third, it had the transportation infrastructure needed to bring the shale oil to refineries and the global market. Although the US may not have the elegant bullet trains that grace Europe and China, it has an impressive freight network that allows its trains to haul bulk commodities to markets.
Built more than 150 years ago, these transcontinental networks allow mile-long behemoths, loaded with grains, iron ore and oil, to lumber along at low speeds - and more important, low costs. On top of that, vast networks of pipelines move oil and gas to the cardinal points of the compass, thus slashing operating costs.
These are the reasons why shale worked so well in the US, and why it will be almost impossible to replicate in many countries, such as Argentina. They do not have the capital, labour and infrastructure needed to bring the product to market at a competitive cost. They will need to invest hundreds of billions of dollars in infrastructure in order to be competitive, which makes no sense at current oil prices.
However, the fact that the US has been able to increase its output so dramatically does not mean that it will continue to do so going forward. This is where the law of diminishing returns kicks in. Many pundits are arguing that the US will be able to expand its shale production infinitely.
Yes, it is true that the US shale deposits are immense and that output could increase dramatically. However, we cannot forget capital constraints. In the case of the pizzeria, the constraint was the pizza oven. In the case of the shale industry, it is transportation. US railroad and pipeline companies are reporting that they are operating at full capacity.
Despite all of the noise that truck drivers will soon be obsolete, the reality is that there is an acute shortage. There is a shortage of 50,000 truck drivers in the US. General Mills recently reported a squeeze to its profits due to a lack of drivers.
Therefore, the US's ability to increase its shale output is not infinite. In reality, it is reaching its maximum level. This is due to the simple law of diminishing returns.
- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.