Part 1 of a discussion about oil prices and profits: the oil market

This is the first of a few posts discussing the price of oil (and gasoline) and the record profits being made by the major oil companies. Part 1 examines the world oil market generally and examines what the market is doing now.

Background

For anyone thinking that I am simply a left-loving liberal, I am about to blow your mind.

Let me tell you a little story to give you an idea of where these posts are going. 1980 was my first chance to vote in a Presidential election. To say that I was raised in a staunchly Democratic family is an extreme understatement. To say that I was not going to vote for Reagan is also an extreme understatement. However, as much as I admired the man on a personal level, there was no way I was voting for Carter. There were several general reasons for that, and there were two policy-specific reasons. One was the boycott of the 1980 Olympics. The other was the windfall profits tax (WPT) on oil companies. The WPT was a stupid idea then, and it is a stupid idea now.

I'll give some of you a moment to go back and make sure you read the foregoing correctly. And by the way, in 1980 I voted for Anderson. My independent streak goes way back and continues, as evidenced by my support for Kinky Friedman for Texas governor (a Kinky update is on the way, especially since he was here in The Falls last week).

I will admit I am not an expert on energy policy. However, I do know some things about it. My junior year in high school the national debate topic was energy policy, so I learned a lot about oil, gas, nuclear, coal, and alternative energy. While an undergrad at SMU, I had courses on energy policy. I grew up in Wichita Falls, Texas, which is oil country. I have friends that became petroleum engineers and one who is one of the largest independent natural gas producers in the country. I had to learn oil and gas law to pass the Texas bar, and I have done some oil and gas work in my law practice. In other words, I have been around and studied the oil and gas business in various ways, so while I am not an expert, I do have some knowledge.

The basics of supply and demand

What follows is only a basic discussion of some of the factors involved in the oil market. The primary things to keep in mind are 1) the oil market is really driven by the principles of supply and demand, and 2) we are talking about supply and demand on a global, not local, basis.

At this point, a rudimentary discussion of supply and demand is needed. For the moment, assume that supply of a given product is fixed. If demand for that product increases, the seller can raise the price because more people want the product, and some people will be willing to pay a higher price in order to keep from not having that product. If there is a decrease in demand, sellers will have to lower the price in order to make the product attractive and thus generate sales.

Now assume that the demand for that product remains steady, but the supply fluctuates. If the supply increases, prices will drop because some seller will be willing to lower the price in order to get the sale rather than have a product just sitting there unsold. If supply decreases, there will be the same amount of people wanting the product, but there will be less of the product. In that case, the seller can charge more for the product because people will be willing to pay a higher price to make sure they get the limited supply. In other words, demand is not just the need or desire for a given product. Demand also includes the price one is willing to pay for that product.

Price can be somewhat controlled through controlling the supply--if it is possible to increase or decrease supply. But when supply cannot be changed and demand increases, prices will go up. As discussed below, this is what has been happening in the oil market

The state of the oil market

Because I am no expert I decided to cite two people who are experts. Daniel Yergin (click on his picture) is one of the leading energy experts in the country. Matthew R. Simmons is the CEO of Simmons & Company International, which provides investment banking services for the energy industry.

Yergin testified before the House Committee on Energy and Commerce on May 4, 2006. He stated that the oil market was very "tight," meaning that supply and demand are closely balanced and a change, however slight, could have a great impact on price. He gave this statement about the status of the oil market today:

Although there is no actual supply shortage, the world oil market is very tight, owing not only to rising demand, but also to a “slow motion supply shock” -- what we have called an “aggregate disruption” in excess of two million barrels per day.

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Today, the balance between supply and demand in the world oil market is very tight.

Yergin also gave some reasons for the tightness of the market, and those will be discussed later.

In February of this year, Simmons wrote a column for World Oil Magazine. In it he stated that over the last ten years

Oil demand grew in virtually every region except the FSU (former Soviet Union). It grew so steadily in the US, that by late 2005, America's usage crossed 22 million bopd, an amount exceeding the entire world's oil use in the early 1960s. The US is the world's largest oil user by more than three times the second largest user (China, which replaced Japan as number two consumer several years ago).

As demand soared, new oil supplies became smaller. Many new finds were tiny satellite fields that could be tied back to under-utilized production facilities, because primary fields had declined.

(emphasis added). In other words, there has been little flexibility in terms of changing the amount of the supply and demand has been increasing. Higher prices have thus been inevitable.

Reasons for the tight market

Both Yergin and Simmons explained reasons for the tight oil market. As noted above, Yergin in part attributed the tightness to "'slow motion supply shock'--what we have called an 'aggregate disruption' in excess of two million barrels per day." He quantified this disruption in supply (meaning in effect a loss of supply available on the market) as follows:

But what has now become clear in 2006 is that we are experiencing a slow motion supply shock—an aggregate disruption that, at present, we would put at 2.2 million barrels per day.

* Nigeria 550,000 barrels per day (bd)
* Venezuela 400,000 bd
* Iraq 900,000 bd
* US Gulf 324,000 bd

According to Yergin, a significant portion of Nigeria's production has been disrupted by "an insurgency in Nigeria’s Delta region. Workers have been evacuated, and the local insurgents are threatening further attacks." And speaking of insurgencies, we all know about the one in Iraq. Production in the U.S. Gulf coast is off due to Katrina and Rita.

Although not included in the above list, Yergin also mentioned that "the ratcheting up of tensions over Iran’s nuclear program with a fear of a disruption of Iran’s 2.5 million barrels per day (mbd) of exports" was a big concern and that "in a market this tight, the risk of escalation is enough to send crude oil prices up."

Yergin also explained that a tight market that can be adversely affected by any kind of real or perceived problem.

A good part of Gulf of Mexico production is slated to soon start up again (as is hurricane season). In the meantime, other transitory interruptions elsewhere in the world can, at least for short periods, take additional oil off the market.

These disruptions have, with the strength of demand, resulted in a very tight oil market and one that is more vulnerable to any further problems. Market psychology—anticipation of risk—becomes more powerful, translating into a scarcity or risk premium. We currently estimate that premium at $10–$15 a barrel. At the present time, the most important contributors to the premium are the unrest in Nigeria, and uncertainty about what will happen there, and the ratcheting up of tension over Iran ’s nuclear progress and the fear that in one way or another, Iran ’s 2.5 mbd of exports may be disrupted, with additional collateral effects.

Simmons described other reasons for the tightness of supply:

The North Sea is in steep decline, and Mexico, China, Argentina, Oman, Syria, Egypt, Yemen and Colombia seem to be experiencing irreversible declines.

Non-conventional oil from Canada's oil sands and Venezuela's Orinoco region makes up about half of both producers' output. Non-conventional oil is now commercial, but it remains extremely energy-intensive to turn into usable form. Most new oil found globally is either heavy or sour, or both. What seems to have passed peak supply is light, sweet oil - the easiest oil to produce and the simplest to refine into light, finished product.

Stated differently, production is down in general in some areas, and in others, all the good and easy-to-get oil is gone, meaning that what is left takes more money to extract, and higher costs means higher price.

Simmons also explained that while the OPEC nations in the past were always able to increase production to help bring down prices when demand increased, their ability to do that ceased in 2005 because they were producing at maximum levels just to meet the demand. Not only that, but the future does not look all that promising in spite of the fact that OPEC nations are working to upgrade 12 existing producing fields, there are two problems: First, such work will not "add significant new supplies before 2009," and secondly,

all these "new" projects are complex oil fields that were found years ago and lacked the ingredients to be key producing fields. Some of these projects' performance risks are high enough that nobody should assume that they will happen on schedule, on budget or at projected output targets.

This shows that even in the OPEC nations (most of which are in the Middle East), the easy-to-get oil is largely gone. What this indicates is that worldwide, any significant amounts of additional oil will not reduce the price of oil because of the increased cost of extraction.

No one country or group can control the oil market, especially the U.S. and especially now.

The oil market is a worldwide market, and perhaps the only one that we, as ordinary citizens, are subject to in our daily lives. Given this global nature, the oil market is not capable of being controlled by any one country or portion of the market. At SMU, one of my political science teachers was Hank Jenkins-Smith. SMU was one of his first teaching gigs, and since then he got his Ph.D and is now a professor at Texas A&M's Bush School of Government and Public Service (yes, I see the irony for me). Anyway, Jenkins-Smith described the world oil market and attempts to control it in a way that stuck with me. He said to take a bathtub filled with water (or oil if you prefer), take a board that covers half the tub, and then press the board down onto the water. What happens? Does the overall level of the water get pushed down? No. Is it possible to control only a portion of the water with the board? No. No matter what you do, no portion of the water can be controlled with the board alone, and the level does not change. The point is that any country trying to control the oil market and oil prices is just as futile as trying to control water in a tub with a small board.

This is indeed how the world oil market works. It is supply and demand in a big way. Here's an example that is current. The price for a barrel of oil is over $70. And we used to think that $40 a barrel was outrageous. Seventy dollars is shocking, if not outrageous. If the United States was the only major consumer of oil, we would be in a position to affect the price--maybe. Assume for a moment that we could say to the oil producers around the world "We are not going to pay that price, and if you continue to charge that price, we will simply stop buying oil." If that was possible, the producers would eventually have to drop the price in order to generate demand.

However, the United States is not the only major consumer of oil. Europe in its entirety is a major consumer, but others countries really affecting the old supply and demand indices are India and China. Here are countries with HUGE populations that are trying to develop major economies through industrialization. Such economic growth requires vast amounts of raw materials and ENERGY. It takes energy to get the raw materials. It takes energy to get the raw materials to some place where they can be made into other materials. It takes energy to convert those raw into other materials. It takes energy to run the manufacturing facilities. It takes energy to then get the finished manufactured goods to market. China alone is creating a HUGE demand for energy, and the reality in today's world is that that energy is provided largely by oil.

That means if it was possible for us to significantly reduce our consumption of (and thus demand for) oil, China's demand would not decrease. Indeed, China's demand could increase, for their would be more oil available on the world market.

Here's part of what Yergin told the House Committee on Energy and Commerce about China's effect on the oil market:

The last decade has witnessed a substantial increase in the world’s demand for oil, primarily because of the dramatic economic growth in developing countries, in particular China and India. As late as 1993, China was self-sufficient in oil. Since then, its GDP has almost tripled and its demand for oil has more than doubled. Today, China imports 3 million barrels of oil per day, which accounts for almost half of its total consumption. China ’s share of the world oil market is about 8 percent, but its share of total growth in demand since 2000 has been 30 percent.

There is another reason why any significant drop in U.S. demand for oil would likely not change China's demand--foreign investment, and more specifically, U.S. investment. As stated, China has a HUGE population, which means that China is a HUGE potential market, which means that plenty of U.S. companies are drooling to invest in that market. As the market and China's economy develop, is China's demand for energy is going to decrease? The answer is "no." Why? because China will continue to develop what made its economy grow--manufacturing--and that means continued demand for oil as described above. And are U.S. companies going to stop investing in China? I pretty much doubt it.

Part of what this means is that the oil companies are not the only entities who could be blamed for high oil prices, but I am getting ahead of myself.

Part of what I am trying to establish is that when supply cannot be increased, the only way to control the price of oil is through reduction of demand. Another part of what I am trying to establish is that reducing demand is going to be very difficult--if possible at all--because China's demand is not going to decrease and very well may increase.

And now for more good news--the chances of the U.S. being able to affect the price of oil are slim. As Yergin testified,

In the 1970s we imported a third of our oil; today, it is on the order of 60 percent. Our oil imports are larger than the total oil consumption of any other country in the world. What this means is that we are highly integrated into the global marketplace—and are affected by what happens in the market.

In other words, our addiction to foreign oil will keep us from being able to affect a downward change in the price of oil.

Conclusion

Today's global oil market is such that any change in supply or demand will have a significant impact on the price of oil. Demand right now is very high, and that is not going to change. Supply cannot be increased enough to counter the high demand and thus bring down the price of oil. Moreover, it appears that supply will at best remain stagnant for a few years. Given that the global oil market is very much a supply and demand market, the facts indicate that high prices for oil are here to stay for at least a few years. The price could drop IF the situation with Iran is resolved peacefully, the insurgency in Nigeria ends, Iraq becomes stable, etc., but even if those things happen, I do not see the price of oil going back to the $30-40 range.

Thus, the price of oil will probably remain high, and that means the price of refined petroleum products will also remain high. And those factors mean the oil companies will still be making huge profits. In future posts, I will examine whether those profits are fair or whether the oil companies are ripping us off and should be stopped.