Thursday, April 27, 2006

The Phony Rationale for high Oil Price

The Phony Rationale for high Oil Price
by Joel Peskoff

Gasoline prices have passed the $3 mark. “At one Chevron station in downtown Los Angeles, motorists had to fork over $3.35 a gallon yesterday for self-serve regular “ (Wall Street Journal, April 18, 2006) But what’s driving these prices? The short answer is that there is no short answer. What is clear is that many of the reasons given for the rapid rise in oil prices do not withstand scrutiny and are nothing more than spin.

The Motley Fool website explains the components that comprise the cost of a gallon of gasoline:

Component April 10, 2006 April 12, 1999
Crude Oil $1.59 $0.35
Refining Cost and Margin $0.63 $0.70
State and Federal Taxes $0.57 $0.48
Distribution and Marketing $0.01 $0.09
Price Per Gallon $2.80 $1.62

Table 1

As Table 1 shows, the only significant price change is in the price of crude oil. “Since 1869 US crude oil prices adjusted for inflation have averaged $18.59 per barrel compared to $19.41 for world oil prices.” (Source: WTRG Economics) Oil for May delivery rose beyond $71 on the New York Mercantile Exchange on April 19, 2006. However, when one examines the fundamentals, we observe an obvious disconnect. According to the U.S. Dept. of Energy, petroleum stock (the amount of petroleum in storage) is at an eight-year high. Natural gas is at a five-year high in supply. Crude oil supply stock is at all time highs too. Bloomberg reports, “Stockpiles climbed 3.2 million barrels to 346 million last week, the highest since May 1998...” Therefore, today’s high prices are not caused by an oil shortage.

Stocks (Million Barrels)

Stocks Change From Last
04/21/06 Week Year
Crude Oil 345.0 values are down -0.2 values are up 20.6
Gasoline 200.6 values are down -1.9 values are down -10.7
Distillate 115.6 values are up 1.0 values are up 13.0
Propane 32.880 values are up 2.407 values are up 1.346

Chart 1 (source: US DoE)

Chart 1 clearly shows that crude oil stocks are far above average levels. Yet, prices are at record heights. Why?

To answer that question, we need to analyze the reasons given in the media for higher prices and separate out economic factors from baloney.

The main rationales heard for rising oil prices are:
• Shortage of Refineries
• The War in Iraq
• Risk Premium due to Geopolitical turmoil
• Demand from Developing Countries, (particularly China)

Shortage of Refineries

“[OPEC President] Daukoru said a shortage of refineries to turn crude oil into products like gasoline and heating oil was behind a four-year rally that has taken oil from $20 to $72 a barrel and he predicted continued strength. "The market will remain tight and will remain product-driven, not upstream-driven, for the next five years,” he said. (Source)

My only response is huh? A refinery shortage is a reason for crude prices to drop, not rise. If Ben and Jerry’s can’t churn milk into ice cream fast enough, they surely aren’t going to buy more milk at premium prices. Likewise, if refiners cannot convert crude into gasoline fast enough, they’ll cancel shipments not pay extra. It is unimaginable that refiners will pay a premium for new oil when they can’t process what they already have. "It doesn't do a lot of good to have a rise in crude if the refineries can't run it," said Phil Flynn, analyst at Alaron Trading Corp. in Chicago.

It’s important to note that the refinery shortage is a legitimate reason for gasoline prices to rise in general but it does not explain the current gasoline price rise (excluding the effect of crude oil rises.)

Chart 2

(Source: US DoE)

Although gasoline stocks have dropped, it is still within its seasonal average range (Chart 2). (It’s the trend that’s alarming.) According to the Washington Post, “U.S. gasoline demand is higher… [but only] 1.2 percent above a year ago…” In addition, “Distillate inventories, which include diesel and heating oil, dropped 4.6 million barrels to 117.4 million barrels. They remain more than 12 percent above year-ago levels.”

The War in Iraq

Without doubt, the War in Iraq has diminished the world supply of crude oil. However, the extent is exaggerated. According to the CIA, the 2005 Iraqi oil production was 2.03 million barrels a day, while the prewar production was 2.093 million barrels a day. The London-based Centre for Global Energy Studies (CGES) estimated 2005 production at about 1.9 million barrels a day, lower than the 2.6 million it estimated for before the 2003 U.S.-led invasion. The world produces approximately 85 million barrels per day. A loss of 700,000 barrels per day is not responsible for the dramatic price increase. Moreover, as Chart 3 depicts, in May of 2004, a year plus after the U.S. invasion, crude prices were still below $40.

Chart 3
(Source : US DoE)

In addition, oil production gains in Russia have more than made up any loss from Iraq. As one can see in Chart 4, Russia’s production is up by 1.5 million barrels per day since the start of the Iraq War.

Chart 4

(Source: WTRG)

Risk Premium

The Motley Fool article points to “Risk Premium” as one fact or driving up crude prices. WTRG also points to risk premium as a factor when it said, “During much of 2004 and 2005 the spare capacity to produce oil has been under one million barrels per day. A million barrels per day is not enough spare capacity to cover an interruption of supply from almost any OPEC producer. In a world that consumes over 80 million barrels per day of petroleum products that adds a significant risk premium to crude oil price and is largely responsible for prices in excess of $40 per barrel.”

To understand this argument, let’s review what risk premium is (Finally my MBA comes in handy.) Risk premium is the extra return that an investment must provide over the risk-free rate to compensate for market risk. (The return on Treasury Bills is considered a proxy for the risk-free rate.) When an investor invests in a risky asset – either a stock or commodity, the investor demands a higher overall rate of return in order to compensate for the possibility that that asset may fall in value. Otherwise, the investor will choose to take his or her money and invest it in T-bills.

With respect to oil drilling, drilling must compensate with a risk premium because there is a high probability that a well drilled will be dry. However, that risk premium has been rather constant through the decades and can’t be responsible for the current rise in crude prices.

The risk in today’s world is the risk associated with Iran cutting off supplies due to geopolitical reasons (such as concerns about Iran's nuclear program.) Yet, when we examine this, it also doesn’t follow economic logic. The people exposed to the risk of Iran (as an example) cutting off oil supplies are not the same people benefiting from the risk premium. The users of the oil products are at risk of a supply cut-off while the suppliers face no risk at all. Meanwhile, the producers benefit one-sidedly from higher prices. Saudi Arabia is earning double the value of its oil than it did just a few years ago. However, Saudi Arabia isn’t taking any risk from an Iranian oil cut-off to the West. Should a cut-off arise, they face no economic lose. On the contrary, their oil will be more coveted and they will surely demand higher prices for it then. Likewise, two years ago, Texas oilmen were able to make a handsome profit by selling their oil at $35 per barrel. It does not cost any more to pump a barrel of oil than it did two years ago. However, those oilmen are now able to sell their oil for $72 dollars a barrel. Are domestic suppliers assuming any additional market risk (compared to three-years ago) that they must be compensated with an extra risk premium? I don’t think so. The suppliers are in the cat-bird seat, set to make additional return, not less return, should a world-wide disruption occur.

The only counter-argument to this is that the Texans and Saudis aren’t really demanding any more for their product, since they rely upon the world futures markets to dictate the price. There is some merit to this argument. Speculators in the futures markets are indeed bidding up the price. “Prices are being guided by institutional money managers who are holding between $100 billion and $120 billion in commodities investments. That's at least double the amount three years ago and up from $6 billion in 1999, according to Barclays Capital.” (Source: the Wall Street Journal) Translation: Hedge Funds, who have no economic interest (as opposed to airlines and distillers) for the futures market beyond speculation, are driving the oil market higher. Like the stock speculators of the 1920’s that collaborated to drive individual stocks higher only to unload them at a later date, there isn’t any force on the short side either large enough or that has an interest, in lower prices.

In a traditional market, speculators gamble. They’ll either be right or not. In this market, speculators aren’t gambling, they’re controlling the market and oil suppliers are all too eager to enjoy the higher price. If OPEC wanted to bring prices down, they merely would have to sell oil at the spot price of $50 per barrel and the futures speculators wouldn’t be able to cover their margin calls. But neither OPEC, nor any other supplier has any interest in doing that.
Demand from Developing Countries, particularly China is driving up prices
China’s total demand of oil is 6.5 million barrels per day. Its oil demand is projected to reach 14.2 million barrels per day by 2025, with net imports of 10.9 million barrels per day. China consumes about one million barrels per day more each year. At less than 1.5% of world demand, China’s additional demand is a minor factor in the 100% increase in world oil prices over the last two-years.
In summary, there really isn’t any rational reason why current oil prices are rising, except market manipulation by speculators. This is not to say that there isn’t a long-term energy problem that needs to be addressed. Eventually, the world will run out of oil but the current oil pricing is not causally related to that fact. In the short-term, there is plenty of oil.