Energy Economics 101: The Culprit is U.S.!
By Chris Puplava, April 27, 2006
"In essence, companies with exploration and production operations are in a position analogous to that of a homeowner who bought a house in a popular area just before increased demand for housing caused real estate prices to escalate. The homeowner would not expect to sell the house based on the price paid for it, but rather based on what the house was worth in today's market. Similarly, the fact that an oil company could profitably produce its crude oil at $30 per barrel does not mean that the firm should expect to sell its crude below what increased demand for crude oil has made it worth in the world market today. Indeed, even if a firm were inclined to sell at a price based solely on production costs (and not on supply and demand), that would not reduce crude oil prices. Rather, savvy oil traders would flock to buy the cheaply offered crude oil and then resell it at the higher market price."
Source: Federal Trade Commission Report "Gasoline Price Changes: the Dynamic of Supply, Demand, and Competition"
It seems that whenever gasoline hits $3 a gallon or Exxon-Mobil is releasing its earnings, politicians show how little they understand about global economics and simple supply and demand fundamentals and begin pointing fingers. Politicians are blaming the opposing party and oil companies instead of blaming the real culprits, their constituents and environmental laws and regulations making it hard for new refinery plants. The U.S. is the biggest user of crude oil, and with less than 5 percent of the world's population, consumes 25 percent of its oil. And American motorists refused to downsize their vehicle purchases when energy was cheap. Incremental demand increases coming from China and India, two of the fastest growing economies, are also contributing to rising demand for crude, pushing prices higher. Unlike Americans though, China and India use far less oil per capita.
Figure 1: World Oil
Consumption by Region,
1999 and 2004 (Millions of Barrels per Day)
Oil companies are facing the brunt of attacks, but oil prices wouldn't be topping $70 a barrel if increased demand were not straining supplies. Finger pointing isn't going solve any problems. Politicians should be explaining energy economics and devising policies to mandate conservation instead of searching for scapegoats.
Feuding is even occurring between automakers and oil companies as Exxon-Mobil and DaimlerChrysler go back and forth trading shots. Earlier this week, Jason Vines, vice president of communications for DaimlerChrysler's U.S. arm, asserted that oil companies are contributing to high prices in a posting on a blog published by the company for reporters and financial analysts. He said the auto makers "have spent billions developing cleaner, more efficient technologies� while "big oil would rather fill the pockets of its executives and shareholders, rather than spend sufficient amounts to reduce the price of fuel, letting consumers, during tough economic times, pick up the tab."
The comments from Mr. Vines came on the heels of a cartoon by Exxon Mobil in several newspapers that put the blame for today's energy crunch on auto makers (see below).
Figure 2: Exxon-Mobil Cartoon
Source: University of Wisconsin
The ad hinted that the blame lies with an auto industry that knows how to build more-fuel-efficient vehicles but isn't rolling them onto the market, and that the larger size of Exxon-Mobil is allowing them to achieve economies of scale which reduces their operating cost and allows them to sell cheaper oil. Noting that the average fuel economy of new U.S. autos hasn't improved in two decades, the ad argued that improvements in engine efficiency have been "largely offset" by the rising weight of vehicles, notably pickup trucks and sport-utility vehicles.
Source: Green Car Congress
The truth of the matter is that the price of gasoline/crude oil is determined by simple supply and demand fundamentals. This can be seen with the recent events over the past few months. Oil prices rose when terrorists tried to bomb Saudi Arabia's oil infrastructure. Militants in Nigeria shut down a fifth of that nation's pipelines. Iran threatens an oil export cutoff. Iraq's oil industry struggles with attacks. Venezuela plays politics with oil exports. Russia restricts exports of natural gas. China's government-controlled oil importers, meanwhile, are roaming the earth to lock up new oil supplies, as Japan did before it. Quick question--does Exxon-Mobil control what terrorists or the politicians/leaders of other countries do? If not, then why are the fingers pointed at them instead of the real causes for rising gasoline prices?
What Affects the Price of Gasoline?
The main component for the cost of gasoline is crude oil. Crude oil differs from most other commodities because it is subject to the restrictions of a cartel called OPEC (the Organization of Petroleum Exporting Countries). Other global factors contributing to high gasoline prices include instability in some key oil producing regions (Iran, Iraq, Nigeria, and Venezuela), bad weather (Hurricanes Katrina and Rita) and continued high demand (Chindia). The simplest economic driver for the price of crude oil is the balance between supply and demand. Reduced supply and increased demand for a product generally results in higher prices for that product, especially if it is a commodity.
The cost of gasoline has gone up primarily because refiners are paying considerably more for crude oil. As of July 2005, a barrel of crude oil sold for more than $60.00. This compares to prices three years ago, in July 2003, when the average price for a barrel of crude oil was under $30.00 and the average national price of a gallon of gas was less than $1.50 (Source: EIA). As the main input (crude oil) for gasoline doubled from 2003 to 2005, is it any wonder that the finished product doubled from $1.50 to $3.00?
A report issued by the Federal Trade Commission in July 2005 stated that 85% of the changes in the retail price of gasoline in the U.S. are caused by changes in the price of crude oil, which is determined in the world market (not by oil companies!). Other important factors in the price of gasoline include increasing worldwide demand, supply restrictions, and governmental regulations, such as �clean fuel� requirements and taxes (See the full FTC Report).
As the main driver for the cost of gasoline is the price of crude oil, which is predominantly determined (85%) by the market from supply and demand factors, a dramatic increase in demand or a supply shock will send the price of crude up as well as gasoline. This is exactly what happened in 2004 as the chart below demonstrates the predicted versus the actual demand for crude.
Figure 4: 2004 Predicted vs. Actual Crude Oil Demand Increase,
Million Barrels per Day
The unexpected demand from China and India as well as the rest of the world propelled the price of West Texas Intermediate Crude (WTIC) from $35 a barrel in January 2004 to $55 in October of 2004 (see chart below).
Figure 5: 2004 Price Chart of WTIC
The vast majority of the FTC�s investigations revealed market factors to be the primary drivers of both price increases and price spikes, which are in turn determined by the laws of supply and demand and not the oil companies. To emphasize this point the study used a case example demonstrating the laws of supply and demand at work.
The case study illustrated several key points regarding gasoline price spikes on the regional level. The report investigated retail gasoline prices in Phoenix, Arizona during August 2003. Phoenix gasoline prices were $1.52 per gallon at the beginning of August 2003, but rose to $2.11 per gallon by the third week of the month, a 39% jump in prices! The catalyst for the jump in prices was a supply shock where a pipeline ruptured on July 20, 2003 coupled with the failure of temporary repairs, led to reduced gasoline supplies in the Phoenix area. As reduced supply caused a spike in prices, an increase in supply from corrections to those disruptions lead to prices quickly returning to their original levels.
The shortage of gasoline supplies in Phoenix caused gasoline prices to increase sharply. To obtain additional supply, Phoenix gas stations had to pay higher prices to West Coast refineries than West Coast gas stations were paying. West Coast refineries responded by selling more of their supplies to the Phoenix market.
I'd like to post below the main findings of the FTC from their report on the price of gasoline conducted last summer. I've summarized it a bit to make it more concise.
Main Commission Findings
supply, demand, and competition for crude oil are the most important
factors in the national average price of gasoline in the United
Over the past 20 years, changes in crude oil prices have explained
85 percent of the changes in the prices of gasoline nationwide.
Since 1973, according to the Report, production decisions by OPEC
have been a significant factor in the prices that refiners pay for
crude oil. The demand for crude oil has grown significantly over the
past two decades as well, leading to higher prices at the pump.
refiners compete with refiners all around the world to obtain crude
oil. Refiners in the U.S. now import more than 60 percent of their
crude from foreign sources, up from 43 percent in 1978. The prices of crude oil produced and sold domestically also are
linked to world crude prices.
supply, demand, and competition produced relatively low and stable
average real U.S. gasoline prices from 1984 until 2004, despite
substantial increases in U.S. gasoline consumption. The Report
indicates that U.S. consumer demand for gasoline has risen
substantially, especially since 1990. Since 1984, increased gasoline
supplies from U.S. refineries and imports helped meet increasing
demand and kept gasoline prices relatively steady. For
most of the past 20 years, real average retail gasoline prices in
the United States, including taxes, have been at their lowest levels
since 1919, with U.S. refiners adopting more efficient technologies
and business strategies that have allowed them to produce more
refined product for each barrel of crude they process.
- Regional differences in access to gasoline supplies and environmental requirements for gasoline affect average retail prices and the variability of regional prices. Different regions of the country differ in their access to gasoline supplies, and these differences affect gasoline prices. Gasoline prices on the East Coast, in the Midwest, and in the Rocky Mountain states are significantly more variable than Gulf Coast gasoline prices, due to the availability of excess refining capacity along the Gulf Coast. In addition, regional environmental requirements for �boutique� fuels, such as CARB gasoline requirements in California, can limit substitute gasoline supplies and can thus lead to cost increases during supply shortages.
Price Gouging: Real or Political Hot Air?
Politicians and political talk show hosts (Bill O�Reilly) have been making the argument that there is possible price gouging on the part of refiners/gasoline producers. To dispel this myth, I have already presented the case above that 85% of the price of gasoline is determined by the price of crude oil which is determined by the world market for crude oil, not the manipulation of oil companies. The myth of price gouging by refiners can be refuted by simply looking at the economic fundamentals. To understand the price of gasoline one must look at the cost structure from input to product. If world crude prices rise, then U.S. refiners must offer and pay higher prices for the crude they buy. Facing higher input costs from crude, refiners charge more for the gasoline they sell at wholesale. This requires gas stations to pay more for their gasoline. In turn, gas stations, facing higher input costs, charge consumers more at the pump.
To assert that refiners are guilty of price gouging could easily be proven or refuted by looking at what refiners charge gasoline dealers, which is what they have control over. If U.S. refiners are artificially raising the price of gasoline then the relative scale of the price of gasoline to crude should be noticeably higher once taxes are removed from the price of gasoline, as taxes are controlled by the state and federal authorities.
To illustrate this relationship the figure below from the FTC study compares the U.S. annual average price of gasoline (excluding taxes) with the annual average price of a recognized crude oil benchmark, West Texas Intermediate (WTI), from 1984 to January 2005. When crude oil prices rise, gasoline prices rise because gasoline becomes more costly to produce.
Figure 6: Comparison of
the National Average Price of Gasoline and the
Price of West Texas Intermediate Crude (1984-Jan. 2005)
There is a strong correlation between the price of gasoline and crude over the past two decades with there being small gaps and deviations that can be explained by looking at the supply and demand for gasoline. The current spike in gasoline recently has been the result of several factors. Three refineries on the Gulf Coast shut down by last fall�s hurricanes are only now reportedly beginning to return to operation, or soon will be. Additionally, some refineries that were not damaged by the hurricanes deferred planned fall maintenance until this spring, so as to maximize production immediately following the hurricanes. However, this means that we now have refineries undergoing previously scheduled spring maintenance, plus those that had deferred maintenance from last fall. Refiners switching from gasoline with MTBE to gasoline reformulated with ethanol as well as seasonal repairs. This has led to a shortage of gasoline with inventories below their lower average levels with an imbalance between supply and demand, where production has been falling in the face of rising demand, (see charts below).
Figures 7-9: U.S. Gasoline Production, Demand, and Inventories
The Law of Supply and Demand
Figures 4 and 5 demonstrate the law of supply and demand on price, where prices rise to find the equilibrium price where supply and demand are equal. The rising demand for crude oil caused the price to increase from $35 a barrel in January 2004 to $55 in October of 2004. Figure 6 demonstrates the direct relationship between the price of crude oil (refiners input) to gasoline (refiners finished product) where there is little evidence to show price manipulation on the part of U.S. refiners. Figures 6-8 show this in action presently where gasoline has risen due to falling production and rising demand.
To further expand on the relationship of supply and demand in the price of gasoline and crude oil I'd like to focus on the power of The Organization of Petroleum exporting Countries (OPEC). OPEC is a cartel designed specifically to coordinate output decisions and to affect world crude oil prices. OPEC demonstrated their market power by influencing supply in 1973-1974, where market forces no longer were the sole determinant of the world price of crude oil. OPEC members agreed to limit how much crude oil they would produce and to embargo the sale of crude oil to the U.S. The result was that crude oil prices had tripled from $4 to $12 per barrel.
What the public and politicians need to understand from economics is that price is a self correcting mechanism. Higher prices encourage producers to supply more and consumers to demand less. Rising supply and falling demand will then lead to lower prices. Lower prices lead producers to supply less and consumers to demand more, leading to a price increase.
The supply shock to the U.S. was a tremendous hardship that ultimately had a silver lining. Higher world crude prices due to OPEC�s actions increased the incentives to search for oil in other areas, and crude supplies from non-OPEC members such as Canada, the United Kingdom, and Norway have increased significantly. In 2003, almost 30 years after the first oil embargo, OPEC�s total crude production was about the same as in 1974. The difference is that in 2003 OPEC accounted for only 38 percent of world crude production as compared to 52 percent of world crude oil production in 1974.
Figure 10: U.S. Annual
Average Gasoline Consumption and
Real National Gasoline Prices (1978-2004)
The high prices due to OPEC�s oil embargo lead to two interesting events. The first was increased global exploration that reduced OPEC�s control on the price of crude by reducing their share of world production from 52% in 1974 to 38% in 2003. Second, the U.S. consumer responded with a decrease in gasoline consumption. Between 1978 and 1982 U.S. gasoline consumption fell significantly and remained lower during the 1980s than it had been at the beginning of 1978.
In 1978, U.S. gasoline consumption was about 7.4 million barrels per day. By 1981, in the face of sharply escalating crude oil and gasoline prices and a recession, U.S. gasoline consumption had fallen by roughly a million barrels per day, averaging about 6.5 million barrels per day. As gasoline prices began to fall in the 1980s, U.S. consumption of gasoline began to rise once again.
One of the results of falling oil prices from the peak in 1981 to the bottom in 1998 was profits fell for oil companies and refiners. With falling prices the oil industry began to consolidate to achieve better cost structures to be competitive through economies of scale.
Figure 11: U.S. Refining
Number of Operable Refineries (1949-2003)
The number of refiners as seen by Figure 11 dropped sharply coinciding with falling oil prices while existing refiners expanded capacity to keep total capacity level. In 1973, total U.S. crude refining capacity was 13.6 million barrels per day, produced by 268 refineries. By 1981, total U.S. crude refining capacity had peaked at 18.6 million barrels per day, produced by 324 refineries. In 2003 the number of refiners dropped to 150, less than half the number of refiners that existed in 1981.
The Importance of Profits and Reality
The importance of profits and the reality of simple business decisions could not be put more eloquently or simply than the FTC report with the excerpt below.
In essence, companies with exploration and production operations are in a position analogous to that of a homeowner who bought a house in a popular area just before increased demand for housing caused real estate prices to escalate. The homeowner would not expect to sell the house based on the price paid for it, but rather based on what the house was worth in today's market. Similarly, the fact that an oil company could profitably produce its crude oil at $30 per barrel does not mean that the firm should expect to sell its crude below what increased demand for crude oil has made it worth in the world market today. Indeed, even if a firm were inclined to sell at a price based solely on production costs (and not on supply and demand), that would not reduce crude oil prices. Rather, savvy oil traders would flock to buy the cheaply offered crude oil and then resell it at the higher market price.
To expand on the importance of profits, which is put very simply by the FTC report, I pasted below their arguments.
Profits play two necessary and important roles in a market economy. First, profits compensate owners of capital for the use of the funds they have invested in a firm. The level of profits for a firm, as well as the rate of return on those investments in that firm, will be influenced by supply and demand, in addition to regulatory conditions. Second, profits are a reward for an investor�s willingness to bear the risk that an enterprise will not be successful and the investment will be lost. If the enterprise instead is successful, an investor may receive a high rate of return. High rates of return signal possible profit opportunities and thus encourage investors to reallocate resources across the economy, investing new capital in areas of high rates of return.
Profits play the same roles in the oil industry. The oil industry, which produces more than 80 million barrels per day of petroleum products, is one of the largest in the world. A great deal of investment must support the enormous infrastructure required to find and produce crude oil, transport it to refineries, produce finished petroleum products, and distribute these products throughout the world. Investors expect compensation for the use of their funds in supporting this business. Profits also compensate firms for taking risks. The oil industry faces many types of risks. Potential changes in the macroeconomic climate, at either the national or the global level, and general uncertainty about future prices pose investment risk for all industries, including oil. Other risks are more specific to the oil industry. For example, production levels may be lower than expected at an oil field, or war or terrorism, in some areas, may destroy crude production assets or reduce their values. At downstream levels, refinery margins may fall if the price of gasoline falls relative to the price of crude oil. New environmental requirements may increase operating costs or require substantial new capital investments. Over the longer run, energy saving innovations at the consumer level may reduce the demand for refined petroleum products.
Is Gasoline/Oil Really Expensive?
According to the FTC report, their data show that from 1986 through 2003, using 2004 dollars, real national annual average retail prices for gasoline, including taxes, generally have been below $2.00 per gallon. By contrast, between 1919 and 1985, real national annual average retail gasoline prices were above $2.00 per gallon more often than not. If taxes are excluded, the data show that real annual average retail gasoline prices in the U.S. did not rise above $1.20 per gallon between 1986 and 2003, and generally ranged between $0.80 and $1.05 per gallon. In 2004, however, those prices rose sharply to $1.44, which is the highest real national annual average retail price per gallon since 1984, but it remains well below the 1981 high of $2.10 per gallon (see chart below).
12: U.S. Annual Average Nominal and Real Gasoline Prices, Excluding
The data above shows that until recently, we have actually been paying less for gasoline than in the past. What gives? The difference is the purchasing power of the dollar. The more the Fed prints, the less our dollars buy and the Greenspan Fed is king of money printing as seen by the chart below.
13: M3 Money Supply
As the Fed has been printing money at full steam ever since 1994, the dollar's purchasing power has fallen dramatically, especially in the past few years as the dollar index has fallen from 120 to 87, a decline in the dollar of 27.5%. The falling dollar is just as much a part for the rising price of gasoline as it has been for a ridiculous rise in home prices across the nation.
Reality is that the price of crude is determined by world markets which in turn is controls the price of gasoline. Higher oil prices lead to reduced demand and increased supply as well as technological advancement and change. Figure 3 above shows the dramatic improvement in fuel economy in the 1970s that resulted from higher oil prices. As prices are on the rise today, more and more hybrids are coming to the market as their appeal increases. A Consumer Reports article released earlier in the year made the argument that after paying the premium and other factors, hybrids were more expensive to own by and large. The premium of owning a hybrid is reduced with higher fuel savings resulting from higher fuel prices that would be reduced even further if the government provided higher tax refunds. Who wouldn�t want a hybrid if gasoline goes to $4-$6 a gallon and who would want to own a Hummer III with 16/20 mpg or the Hummer II with consumer averages reporting high single to low double-digit mileage? Last year when oil/gasoline spiked sales of trucks and SUVs fell off a cliff and dealers weren't taking them in for trade-ins (click here to read commentary I provided last year). As shown above, price is a self correcting mechanism and higher prices will lead to conservation and reducing oil profits will only cause them to reduce capital expenditures and reduce incremental supply.
Europe artificially inflated their gasoline with taxes to levels far above our own in response to high oil prices in the 1970s. This led to a shift in consumer preferences to smaller cars that achieved better fuel economy with automakers taking the cue from consumers and produced smaller cars for European markets. What did we do here in the U.S.? We built lighter AND bigger cars. Americans wanted the big cars as gasoline was cheap in the 1980s and 1990s. Now prices are rising with consumers complaining more but we still want to drive our big SUVs and trucks, something has to give here. This time politicians don't need to inflate the price of gasoline through taxes to change consumer preferences from big cars to small cars and hybrids, the market is going to do that for them. If you're a believer of "Peak Oil" things aren't going to change but get worse. Falling production rates in the face of rising demand will lead to higher prices and more conservation here and abroad as we switch towards alternatives.
The markets finished on a positive note today with the DOW up 28.02 points to finish at 11382.51 with the S&P 500 up 4.31 points to close at 1309.72, and the NASDAQ was up 11.32 points to close at 2344.95.
The markets were up in early trading after Federal Reserve Chairman Ben Bernanke hinted at a pause in the central bank�s increasing rate-cycle. He also made it clear a pause in interest rate increases wouldn�t necessarily mean the Fed was done raising interest rates when he said, "Of course, a decision to take no action at a particular meeting does not preclude action at subsequent meetings."
In sector analysis, semiconductors ($SOX) pharmaceuticals ($DRG), utilities ($UTIL), biotechs ($BTK) and computer software stocks ($GSO) were some of the most significant gainers, while Oil services ($OSX), energy ($XOI), networkers ($NWX) and home builders (HGX) all moved lower.
In commodity news, gold futures for June delivery fell $5.70 to $636.30 an ounce with silver spot prices falling $0.20 to $12.68 an ounce. Crude oil futures also fell with the June contract down 96 cents to $70.97 a barrel.
In company news, GlaxoSmithKline (GSK) rose 4.5% after a surprise 25% profit rise in the first quarter with Bristol-Myers Squibb (BMY) surprising analyst with strong sales. Celgene Corp (CELG) shares jumped 12.8% after the biotech companies earnings topped analyst estimates from a rise in revenue of more than 60%.
Have a pleasant weekend,
© 2006 Chris Puplava