The Economics of Oil

My normal method of blogging involves typing a secret password into the Republican National Committee Mainframe, and plagiarizing whatever bit of propaganda that has already been developed for my particular issue. For this post, I decided to research facts on my own, which took like 3 weeks of hard work, confirming my worst suspicions. So, I hope you take the time to read this post, because I took the time to write it!

With consumers facing record prices at the pump, there is plenty of anger to be directed and misdirected at various sources. After doing some research, I am now marginally more prepared than I otherwise would have been to present you with the facts about the oil business, and which factors weigh the most on the price of gas and heating oil.

Ownership Of Oil Reserves

You all know the equation: big oil = Exxon Mobil = Beelzebub. But in the scheme of things, Exxon is small oil. The truly big oil are the nationally owned companies of many oil rich nations. (Note to readers: state ownership = communism). In fact, state-owned oil companies control 90% of the world's oil. Here is the list of the 20 largest oil companies by reserves (not production):

1. Saudi Arabian Oil Company**

2. National Iranian Oil Company**

3. Qatar Petroleum**

4. Abu Dabhi National Oil Company** (United Arab Emirates)

5. Iraq National Oil Company**

6. Gazprom (Russia)

7. Kuwait Petroleum Company**

8. PDVSA** (Venezuela)

9. Nigerian National Petroleum Corporation**

10. National Oil Corporation** (Libya)

11. Sonatrach** (Algeria)

12. Rosneft (Russia)

13. Petronas (Malaysia)

14. Exxon Mobil* (USA)

15. Lukoil* (Russia)

16. Pemex (Mexico)

17. Petrochina* (China)

18. BP* (England)

19. Chevron* (USA)

20. Petrobras (Brazil)

(*Public, ** OPEC)

The Supply Chain

Crude oil is pumped out of the ground, then shipped via tanker or pipeline. The world's largest consumers (North America, Europe, Asia) all import oil, and all other regions export it. The general rule is that it is cheapest to refine oil when it is close to its final source; therefore, oil is almost always shipped in the crudest form possible, and the biggest consumers are also the biggest refiners.

The only US port that can accommodate oil supertankers is in Louisiana, so often the supertankers divide their cargo onto smaller tankers that can go directly into any port, where it then goes to refineries. The Gulf region, specifically Texas and Louisiana, refine more oil than anywhere else in the country. No new refineries have been built since 1976, but refineries have seen significant technological advances. Most demand for refined oil is in the form of light products such as gasoline (think "light sweet crude"). Refineries in the US have focused on something called "downstream processing", which allows refineries to take crude oil and produce up to 60% gasoline, as opposed to the 20% produced by more rudimentary refineries. Many refineries without downstream capabilities were shut down, and the utilization of the remaining refineries remained high.

We use oil for a lot of things: gasoline, propane, food wax, motor oil, asphalt, petrochemicals, and more. Downstream refining allows refineries to quickly adapt to the particular demand profile of final products, and those products are sold to retailers.

The gasoline marketers are a particularly interesting case. Most gas stations that we are familiar with are supermajor brands, whereas a 'supermajor' or 'major' is an oil company that has reserves, refineries, and retail stations. There are 6 supermajors: Exxon, Shell, BP, Chevron, ConocoPhillips, and Total S.A. But all is not as it seems....over 95% of retail stations are independently owned--not owned by the supermajors. The retail stations may or may not be part of a regional distributor, but what they do have is a branding agreement with their respective supermajor to sell only that company's gas.

This brings us to the next item: how gas stations get their gas. When refined gasoline comes to port, it is up for sale. Distributors and branded stations may have some power to set prices--but not much. They have to buy gas from their supermajor's refinery, and cannot shop for the best price. Conversely, the generic gas stations are free to shop the best price, and can typically have some effect on the price they pay, resulting in lower prices at the pump. Consumers decide if they want the lowest price, or the consistency of a proprietary gas blend.

Supply

OPEC countries control about 40% of the world's oil production, with everyone else accounting for the rest. Mining oil supply consists of several steps, including finding the oil, drilling a test well to see if the total find is economically viable, then setting up a pumping operation.

As noted above, most of the world's oil supply is located in the Middle East.

Oil supply has typically fallen victim to a low success rate. Exploration of fields where oil has not already been found historically yields only a 20% chance for finding a supply that is economically viable to pump. Much like in refining, technology improvements have increased this success rate to as high as 50%--still a risky proposition considering the costs involved with finding oil.

The most important feature of the supply for oil is that it is not perfectly competitive. Markets work best when they are perfectly competitive: involving numerous or infinite participants, no restrictions on trade, and no barriers to entry. The supply market for oil has none of those features; rather, it is characterized by high fixed costs and relatively few participants (companies).

Let's consider why. If you want to start a handyman business, all you have to do is buy a hammer and convince your mother that your father hung a painting crooked, and you have your first job. If you want to start a company to pump oil, you need infinity government permits and like a hundred billion dollars.

A market in which suppliers are relatively few, and each relatively large, is called an oligopoly, and the oil market is indeed oligopolistic. And the think about oligopolies is, they usually band together to form a cartel. OPEC is the biggest cartel the world has ever known, and they can basically exert their will over the supply market. In a competitive market, individual suppliers have no control over the price they can charge. If you charge $30 per hour to be a handyman, and there are 10 other guys on your street who do the same job as you for $25 an hour, you will be out of work--you have no choice but to charge the market rate. But for OPEC, they control such a large share of the supply that they can control the price through their decision of how much oil to bring to market. Since there are not enough other suppliers with excess capacity to steal business from OPEC, refiners must buy OPEC oil and bid the price up or down based on scarcity.

It is important to note the price elasticity of oil supply, which means how sensitive oil supply is to price. The more sensitive supply is to price, the more elastic supply is said to be. The more the price of a good goes up, the more of that good suppliers want to produce, as would be expected. If everyone in the country wanted handyman services and the going rate for handymen jumped to $500 an hour, you would cancel your engagements, dump your girlfriend, and try and perform your handyman duties all day long--the supply for handyman services is relatively elastic.

Oil suppliers, on the other hand, cannot respond so quickly. Just because the price of a barrel of crude goes from $100 to $130 overnight doesn't necessarily mean that oil suppliers can capitalize on the higher price by producing more. This is because oil exploration is a lengthy process, and because there are no close substitutes to oil production--oil producers cannot change their oil rigs to produce natural gas if the price of oil drops and gas rises. An elasticity of 0 means total dependence on price, and an elasticity of 1 means total independence of price--oil supply elasticity has been estimated at .1, which is relatively inelastic.

So, how much supply do we still have? Well, nobody really knows because there is still oil that we don't know about plus OPEC countries are shady with their reports of how much they already have. As recently as 2 days ago, The Economist reports that the world has enough oil to accommodate current consumption levels for 42 years. Of note, it also states this is slightly more than last year, implying that we are currently discovering oil slightly faster than we are using it.

The USA has proven reserves to supply ourselves with oil for 3 years given our current usage and without dependence on foreign oil.

Oil supply is a shaky thing. There is always a risk of a supply shock, which refers to an immediate and significant drop in production. I must say that there are reasons to be pessimistic about future supply. First and foremost, oil is not a renewable resource and will eventually run out if we keep using it. Short-term supply is maxed out. Some people think that Saudi Arabia could pump a couple more million barrels a day but that's about it. Long-term supply doesn't look much better. Politicians in the United States are gallivanting around failing to pump or build refineries. Politicians in China need all the oil they make (for the first time), and Russia's oil industry is suffering at a time when demand is peaking.

Demand

First things first: consumption = demand. Now then, industrialized countries consume much more oil than less industrialized companies, and the US and Canada consume the most. Canada and the US consume 3 gallons of oil per person per day, whereas the rest of the developed world averages about 1.4, the undeveloped world .2. The difference is attributed to transportation sectors, where in the US and Canada private vehicles are heavily utilized to travel relatively long distances.

Gasoline is by far the most important refined oil product, accounting for 45% of total oil consumption. But there are certainly other products, and other uses besides oil for transportation.

The most important demand issue is probably the trends in world demand. The developed countries are feeling the sting of higher prices, and demand for oil in the OECD countries is predicted to decline by 240,000 barrels in 2008. Developing countries, however, are still seeing growth in oil demand. China and its 400 ka-billion people have seen average annual growth in oil demand of 9% since 1990, and predictions are for another 5.5% increase this year! China is consuming about 7.4 million barrels per day of oil.

Now back to Russia...despite the misfortune of its oil producing industries, many of its other industries are starting to hit their stride. Russian oil demand in the 1990's fell off as the economy struggled to reorganize after the fall of communism. As luck would have it, one of the industries to recover in this decade is the auto industry, and as we know, autos need gas. Russian automobile sales have tripled in the past 5 years, and forecasts predict that Russia will account for more auto sales than any other European country by 2010.

(Column Intermission: If any of you are still reading this, I'm quite sure you are tired of words. I just found a great power point presentation that has a lot of this info in short blurbs, with pretty colors. So look at it if you want!)

The United States is the biggest consumer of oil in the world, using nearly 3 times as much total oil as the next largest user (China). The US consumes between 20 and 21 million barrels per day of oil, which is actually at or below what is has been this decade.

For economists and other general nerds, the price elasticity of demand is a fascinating study. By how much do gas prices have to increase for people to car pool? By how much do they have to rise before people cancel their vacations? Before they move closer to work? Once the current oil volatility settles, maybe in a couple of years, we will have a fabulously accurate answer to that question. As for now, I found an oil demand elasticity estimate of .1, meaning that gas prices would have to rise by 10% to induce a 1% reduction in usage. Compared to other goods this is particularly extreme; in other words, we are more addicted to oil than most other goods.

How the Market Works

Markets determine how much of a good is sold, and at what price, by the intersection of supply and demand. Supply curves are upward sloping, meaning that as a price of a good rises, producers of the good want to sell more of it. Demand curves are downward sloping, meaning that as the price of a good increases, people want less of it.

The demand side is easy. Individual people have no affect on the price of oil; they simply decide how much oil they want to use given the market price. The supply side is where all the magic happens. Oil companies have to find the oil, which is a pain in the ass. They pump the easiest stuff first, then move on. It is critical to understand this investment decision. If all of the Great Lakes were made of oil instead of water, oil companies would be willing to sell gas really cheap because all they would need is a bucket to scoop it out--their fixed cost would be relatively low.

Sadly, the Great Lakes oil would be quickly used because it would be so cheap. The oil companies would then have to pump oil from deeper into the ground. They would need seismographs to find the oil, drills to access the oil, and numerous environmental permits. Their fixed cost would increase dramatically, and this cost would be incorporated into a gallon of gas. As oil becomes more scarce, it becomes more expensive to pump out of the ground, causing the supply curve to shift upward and raising the general price of oil.

Oil exploration does not continue forever. Oil companies know how much it costs to search for the next oil site, and will not undertake drilling or exploration if the market price of oil will not produce a positive return on investment. That point is is the single most important policy implication of oil economics. If the price of oil is high, more exploration investments will be profitable, leading to increased oil supply, and reduced oil prices. Consider this excerpt from The Economist:

No one in the Saudi oil ministry has forgotten what happened after the oil shock
in the 1970s. The Arab boycott called in 1973 to protest against Western backing
for Israel tripled oil prices. But it also prompted oil exploration in tricky
places such as the North Sea and conservation measures that reduced demand. The
result was a long-term slump in crude prices and a drop in the Saudis' market
share.

Markets work, and this is a beautiful thing. The simple supply and demand interaction outlines by Adam Smith in 1776 can predict almost any outcome--maybe not perfectly, but darn close. Free markets create incentives, and incentives drive behavior. If oil costs too much, oil companies will explore more, and the price will go down. Then, people will demand less of the oil at the new higher price, and the price will go down. So prices go down! Suppliers then cut back while people consume more, and the process reverses itself. The market always gravitates towards its equilibrium.

Market Failure: The Government

The 'how the market works section' above is one of the shortest sections of this post, because markets are pretty simple.....except when the government screws them up. The first government market distortion is environmental permits. For places where drilling is allowed, this is relatively small potatoes--maybe several months of waiting and a couple hundred thousand dollars; I really have no idea, but my guess is that it doesn't distort the investment decision. But consider the extreme, where exploration is prohibited by the government for environmental or other reasons (think ANWAR). In this case, the oil companies cannot move along their natural progression of supply sources, causing a dramatic upward shift in the supply curve and artificially high prices.

Government market distortion #2: TAXES! The tax concept is easy to illustrate using a business decision that most of us have to make at some point: buying a house. A common bit of information listed for potential buyers is the total annual taxes. Let's say a million dollar house in Annapolis incurs a $15,000 per year tax bill. Fine. If a million dollar house in a less desirable area cost only $14,999 in taxes each year, would you buy that house? Of course not. But what if the less desirable house had a tax bill of only $1000 per year? That's a big difference--maybe enough to change your investment decision. As noted above, the oil companies calculate the profit they expect to make from pumping through comparison of the cost of that pumping operation and the market price of refined oil. Taxes simply add to the cost of production. The higher that taxes are, the lower the return on investment, the less oil that is explored, the lower the supply, the higher the price.

Government market distortion #3: price ceilings. Taxes, at least, are a traditional and therefore relatively predictable circumstance. When the government regulates such a specific condition as how much a business can charge for its goods and services, that market will inevitably have a mismatched supply and demand. Supply curves are upward sloping and demand curves are downward sloping; the market price and quantity produced are determined by their intersection:

Now lets take a look at what happens in the case of price ceilings:

Based on the above graph, the free market price would be 600 and the quantity produced would be 5 (I am just reading the numbers on the axes for simplicity). But in this market, the government has mandated a price of 400! So, the quantity demanded equals 7, but the quantity supplied eqauls 3--creating an oil shortage of 4. Price ceilings create supply shortages. China is the example that we can point to in the oil market.

Who Determines Price and The Role of Wall Street Speculators

Supply and demand, even when corrupted by market imperfections, always determine price. If you are ever in a market where the government or some panel of "experts" sets the price, run. Far away. The price of oil is high because world demand is outpacing supply, largely due to political reasons. Demand growth has been unexpected, and there is no excess supply capacity to lower prices in the short run.

Regarding said market (supply) imperfections, we now have to consider them. In a competitive market, producers are numerous and any given producer cannot affect the price of the good being sold. In the oil business, OPEC is a cartel and can control the price of crude by limiting or expanding short-run supply. Note: Exxon, Shell, or any other individual "big oil" company cannot affect the price of oil. They probably couldn't even affect the price if they colluded, and I would hate to see the governmental regulator-types the day after they learned of big-oil collusion. Big oil are price takers, and if you don't believe me you can believe the IMF.

Politics and stupidity also affect the price. Domestically, there has not been a new refinery built in my lifetime, impeding long-term supply growth. OPEC has similarly neglected its infrastructure, causing the same result. We are currently seeing the fruition of this recipe for disaster.

Suppliers as a whole can only move along their supply curve--meaning adjust their level of production based on price--if they have mobility in their production both downwards AND upwards. If total production capacity is at the level of demand, an increase in demand causes a supply shortage and the price starts to move upward. It's been a wee bit since since I stayed current with such things, but I learned the sustainable estimate of industrial capacity to be 82%--meaning that if industrial production is more than 82% of its maximum potential, there tend to be inflationary pressures that push the price of the good upward. Oil production is nearer to 100%, and indeed the price is going up.

There are some who play the blame game with financials, professing the evils to various degrees of either corporate greed and $20 million CEO bonuses, or speculators on Wall Street. The Petroleum Marketers Association of America is certainly a loud voice in this room, fulfilling their charge to support gas station owners. The truth is, neither of these 'evils' affects the market fundamentals enough to have even the smallest effect on oil prices. Let's talk speculators first. They deal in future contracts, which essentially means that they bet on the future price of oil deliveries. The first crucial thing to remember is that each future contract has 2 parties: the buyer and the seller. Each party wants to make money, so one side is betting that the price will go up and the other that the price will go down. If they are wrong too often, they will alter the prices they are willing to agree to. The other thing about futures is that they are contracts for actual physical deliveries of oil in the future. But, traders have no interest in receiving the oil, so they sell their futures before they come to maturity. If the supply and demand conditions at that time dictate a different spot price than the price of the future, the trader could make or lose a lot of money--but the price of oil at that time is still dictated by the market fundamentals.

The CEO compensation thing is even more of a joke. Last year, Exxon's CEO got a bounus of $20 million. (Note: Exxon = Exxon Mobil). I am not going to compare that to sales--not even to profit. In the 4th quarter of last year, Exxon spent $6.2 billion on oil exploration. This means that the CEO's bonus was three one-thousandths of 1 percent of the money they spent on oil exploration IN THE FOURTH QUARTER! The scale of Exxon's operations is beyond comprehension, which is why people have trouble accepting the scale of the pay. Let me assure you of 2 things: #1: if their board of directors thought they could hire a CEO that would make them more money for less pay, they would find that person, and #2: giving $20 million to a CEO has absolutely no effect on oil exploration investment decisions, therefore no effect on supply, therefore no effect on the prices you pay at the pump. People got really mad when Exxon gave their old CEO a $400 million retirement package. Consider this: most of that money was in stock, and Exxon's stock valuation is $468 billion. So, in return for making Exxon the largest public company in the world and steering the ship while the stock price went up 500%, the Exxon board gave that guy nine ten-thousandths of 1 percent of outstanding stock. Give me a break. They can do what they want--it's their money and it doesn't affect our money.

Energy Policy and The "Long-Term" Argument

So, what energy policy will lower the price we are paying for gas? This question is undoubetedly why you are still reading this post. Our government cannot control demand to any effecient extent. They cannot control supply that is owned by soverign nations. Individual people can push oil prices down by figuring out ways to consume less, and the government can affect prices by allowing supply capabilities to increase. It's as simple as that.

Imposing a "windfall profits" tax on oil company profits is an example of what the government should NOT do. Whether it's a regular tax, a 'windfall profits' tax, a fee, a cost of getting a license, or any other name for an action when the government takes money from a business--the result is always the same. The supply curve shifts upward because the producer cost structure goes up, and prices are higher for us.

I don't think I will be so presumptuous as to suggest I have a perfect solution. But, I don't think the government does either. In the general sense, I think government should lift restrictions and let the energy companies figure out where drilling, or other energy sources will be viable.

The reason why I think this is the proper attitude is that nobody has been able to figure out a good solution yet. Let's talk about the demand side solution. There is little argument, if any, that individuals reducing their own energy consumption cannot be bad. However, any government mandates to control such behavior is an overreach--the benefit does not justify the reduction in liberty.

As for the supply side solution, it's even more confusing. Let's say we mandate battery powered cars--how would we equip the power grid to handle the increase in electricity demand to recharge 100 million batteries every day? Natural gas power plants? Coal? Nuclear? As for ethanol, increased demand has been linked to rising corn prices, and plowing pasture land to plant corn for ethanol releases a negative carbon footprint on the atmosphere!

Some make the argument that energy companies are cannot be trusted to think of long-term solutions because the demands of public stock ownership and of capitalism in general create pressure to make short-term profits. That hazard is certainly possible, but rest assured that businesses would invest in new technologies if they were viable, and the government is not helping that potential return on investment. More importantly, politicians are even less likely to favor long-term solutions because they have to be re-elected every 2, 4, or 6 years!

Petroleoum economics is the same as any other economics--you just have to understand supply and demand. It is fair to say that increasing demand, constrained supply, and fear of supply shock are all pushing up crude prices. Sadly, the oil market is a study in political economy rather than pure economics; 93% of oil reserves are owned by soverign nations. While nations can generally be considered profit maximizers in the oil market, there are politics that undoubtedly determine allocation of the precious resource.

The market will eventually reach the correct prices and resource allocations. If there are high oil profits, companies will undertake more exploration projects, supply will increase, and the oil price will drop. If supply is depleted, companies will work to develop alternatives to meet the energy demand. These companies are expert in such matters, and the government is not. Furthermore, the government cannot do anything to speed a move to market equilibrium: taxes on oil profits discourage exploration, and subsidies for finding more oil delay the development of other technologies. However disappointing or angering some might consider my conclusion, it is the same as it usually is: the government should stay out of the way.

Let me end with the someone else's words, and a rather elegant summation of the future of energy:

The last time such alternatives were widely discussed was during the early
1970s. Then, too, a spike in the price of oil coincided with a fear that natural
limits to supply were close. The newspapers were full of articles on solar
power, fusion and converting the economy to run on fuel cells and hydrogen.

Of course, there was no geological shortage of oil, just a politically manipulated one. Nor is there a geological shortage this time round. But that does not matter, for there are two differences between then and now. The first is that this price rise is
driven by demand. More energy is needed all round. That gives alternatives a
real opening.

As these alternatives start to roll out in earnest, their rise, optimists hope, will become inexorable. Economies of scale will develop and armies of engineers will tweak them to make them better and cheaper still.

Competition should do the rest—for the fledgling firms of the
alternative-energy industry are in competition with each other as much as they
are with the incumbent fossil-fuel companies. Let a hundred flowers bloom. When
they have, China, too, may find some it likes the look of. Therein lies the best
hope for the energy business, and the planet.