A lesson on oil prices

A friend of mine asked me a few short questions...and I sent him a very long answer...about oil and gasoline prices. I case you're interested in the subject, here's the conversation:
Hi Ross, It's Pat, and now it's my turn to ask you about something! I'm not sure if it's within your specialty, but perhaps you can shed some light and give me your opinions about the current gas prices. The prices are going through the roof, and the oil companies are making a killing profit-wise. Of course it looks like they're gouging the public to death, but is it really as simple as the world needs more oil and the companies just keep rising the prices to what the world is willing to pay for? Or is there another factor which is setting the price of gas which they are less in direct control of, say the commodities traders, and the oil companies are benefiting indirectly from how gas is being bid up. I'm interested in understanding the system both for curiosity and due to discussions with people in the OR, and I thought you might have some insights into this. Thanks! Pat
And here's my response Hey Pat, Good questions. So, it's true that oil companies are making a lot of money, but actually their % returns aren't outrageously high. The key to the whole line of questioning revolves around how oil prices are set...and they're NOT set by oil companies. They're set primarily in futures markets, where participants range from producers (natural sellers), to consumers (refiners, airlines hedging future costs, etc., i.e.natural buyers), to speculators who could either be buyers or sellers or not be in the market at all. There is a lot of finger-pointing at speculators right now, and clearly they're having some influence, but it seems fairly clear that just as you'd learn in Econ 101, it's a question of supply and demand. A lot of the time that you see big moves in commodity prices, it's because one of those two things has had a sudden shift. For example, when there's a drought, the supply of grain drops while demand remains relatively constant, so price goes up. That's basically what's happening with oil, with substantial increases in demand coming from China and India and other developing nations and with the US adding large quantities of oil to the Strategic Petroleum Reserve, with no real change in supply. There's nothing you can do about that demand, and there's basically nothing we should do about US demand because "doing something about it" basically means asking/forcing people not to drive, not to heat their homes as much, etc., all things that people should be absolutely free to do, and let the market force of price help people determine what's most important and where they can conserve. However, what we can do...what we should have been doing for a decade...is to develop our own domestic oil sources, including offshore drilling and drilling in ANWR. Even if those would produce a relatively small % of US oil needs, you have to remember that prices are set "at the margin", meaning that when you get to a point where supply and demand are fairly evenly matched, a small change in one of them can mean a big change in prices. Another point to make: Oil is traded around the world in US dollars. With the US dollar weakening so much, it means foreigners can buy a lot more oil at the same price (in their currency) or the same quantity of oil at higher prices (in their currency). For example, if oil goes from $50 to $75 per barrel, Americans see their gas prices go up a lot. But for a European, if the Euro goes from $1 to $1.50 over that same time period, then oil has remained at 50 Euros per barrel! Alternatively, if oil had stayed even briefly at $50 while the Euro went up to $1.50, Europeans could buy 50% more oil without spending any more money!!! That increased demand forces up the price of oil, with Americans taking the full brunt of increases whereas foreigners are somewhat shielded by their stronger currency. So, a big part of the price increase can be blamed on the Federal Reserve cutting interest rates too far. In fact, their most recent statement implies they're afraid of inflation...which they sure should be. The next move in rates almost certainly has to be an increase, but the US dollar is still weakening meaning that the market thinks the Fed will wait too long to raise rates and maybe also that they market fears that the US government will start becoming even more reckless with spending than they have been. And, to get even more technical, if the Fed and the market are afraid of inflation, investors tend to look toward "hard assets" as investments, including oil and gold. Again, in my view a substantial part of the problem of high oil prices is caused by the Fed having interest rates too low. One could argue that they're causing a "bubble" in oil the same way they caused a bubble in housing by keeping rates too low several years ago. FYI, a bit over 40% of our oil imports come from OPEC. They are refusing to produce more. This is certainly in part because the consumption of petroleum prices has seemed fairly price-inelastic, i.e. the use of oil and gasoline hasn't dropped much with the price going up a lot. However, I also believe it's because they'd have a hard time producing a lot more since they've been rather negligent in maintaining and improving their oil field well equipment. Also, interestingly, OPEC just cut their estimates for 2008 global oil demand for the second time in just a few months. As I was saying about prices being set at the margin, at some point this reduction in demand will have a downward impact on prices if it's not offset by higher demand elsewhere or by lower supply. For now, OPEC is pretty happy seeing prices up far more than demand is down, and I don't blame them for doing what they're doing even though I hate paying so much to fill my car. What would you do if you were in their situation? Again, I'd re-emphasize that although OPEC has a lot more control over the market than any other single player or even category of players, such as all oil companies combined, even OPEC doesn't set the price. They try to manipulate the price to their advantage, to get futures traders of all types (including themselves) to get prices as high as they can without destroying demand. But they don't just say "here's the price". Regarding gasoline, when oil is in the high $40s per barrel, it represents about 50% of the cost of a gallon of gasoline. According to the Dept. of Energy, when oil averaged $39 per barrel from 2000 to 2007, it accounted for about 48% of the cost of gasoline. With oil averaging $68 in 2007, it represented 58% of the cost. With oil up at these prices, it's probably something like 3/4 of the cost. The rest is made up of refining, taxes, and distribution and marketing costs. According to the DOE, "distributing, marketing, and retail dealer costs and profits totaled 10% of the gasoline price, down from the 2000-2007 average of 12%." I hear too frequently these days complaints about speculators and calls for a "windfall profits tax" on oil companies. These complaints are wrong-headed and dangerous. Speculators provide a very important market function, providing liquidity where there aren't natural buyers or sellers at a particular price and time. Also, speculators can (and often do) drive down the prices of things. If speculators were keeping oil prices "artificially low", would anybody be thanking them. Furthermore, I think it's reprehensible to attach a moral value judgment to the reason somebody makes a trade or investment. If someone is willing to commit capital, whether to hedge or speculate, he's just another market participant filling an important niche in a free market. I'd also point out that millions of Americans own oil company stocks, directly or indirectly, and that to the extent that dividends and stock prices are going up, it's at least a partial recapture of some value that we're losing from high oil prices. I understand that shares aren't distributed equally or anything like that, but oil companies are a big part of the S&P 500 which is in turn a big part of most people's 401(k) plans, so there are millions of Americans profiting along with the oil companies. As far as a "windfall profits tax", I simply think that's an insane concept. First, it's economically stupid. Oil companies, just like any other company, needs a certain return on invested capital to justify being in existence and to justify expansion. If their tax rates are raised so that their returns fall below those levels, they'll simply raise prices...because they must to survive! A "windfall profits tax" on oil companies will be nothing more than a tax on all Americans. Secondly, a windfall profits tax is immoral. What if you bought shares in a biotech company and they found a cure for lung cancer and the stock which you bought at $10 went to $200. And then what if the government said that both the company and anyone who owned stock in the company had "made too much money" and should pay an extra tax "to give back to society"? First, that's obviously immoral. Second, how easy do you think it would be for the next biotech which is trying to cure, let's say breast cancer, to raise money if investors know that they'll bear 100% of the cost of failure but attract a special high tax rate if the company succeeds? Furthermore, when you bought that stock at $10, were you not "just a speculator"? Just because something is a commodity doesn't make it any less of an investment and doesn't make trading it somehow less ethical than trading anything else. People trade whatever they want to, and the free market generally does a great job of figuring out what should be traded a little and what should be traded a lot, what should be going up in price and what going down. As soon as government starts picking winners and losers, the whole system collapses as incentive for risk-taking and entrepreneurship is destroyed. A guy on the radio around here was suggesting regulating oil and gas like utilities. That is also a HUGE mistake. Utilities are regulated because they are monopolies. Oil and gas are highly competitive industries. If you think energy prices are high now, just wait until the government starts trying to "help". History has demonstrated repeatedly that windfall profits taxes, price controls, and the like, are the surest way to destroy supply. Remember the gas lines in the 70s? Well take that and make the problem an order of magnitude bigger in this generation's economy. That's what we're looking at if government starts interfering. One of the biggest problems with the oil debate is that people believe government has much more control over prices than it actually does. And, if you recall your basic economics, prices change as supply and demand change. If government does something to lock any of those in place, i.e. to limit supply (such as by cap-and-trade) or to limit price, then only the other parts can vary. If they limit supply, then the price skyrockets. If they limit price, then supply goes away if price would be increasing in a free market. To answer one or two of your questions very briefly and directly, oil companies are profiting but not gouging. They happen to have invested in a commodity that's going up in price. Good for them. They are not "making a killing" profit-wise in terms of returns on capital, in comparison to many other industries. Obviously they're doing a lot better than they used to, but returns years ago were disastrous. And I repeat, oil companies are NOT raising prices. The market is! Well, that was a long answer to what you probably thought was a short question. I hope you found it interesting and helpful.
  • Greg Staff
    Comment from: Greg Staff
    05/28/08 @ 06:02:53 am

    Great explanation, Ross. As I write this (6:50 am CST), oil prices have “plummeted” below $127/bbl. I’m willing to bet that before the day is out, democrats will take credit for the drop in price, citing their recent bill signed by President Bust that stopped the flow of oil into the strategic petroleum reserve (SPR). While prices are, as you said, set at the margin, it’s unlikely that halting the 70,000 BPD going into the SPR had any effect. The 70,000 BPD represents less than 0.60% of our 14,000,000 BPD of imports. I can’t find the source right now, but in something like 23 of the past 26 years, oil prices have reached an annual peak in late May. Look for gasoline prices to drop for much of the summer – and look for the democrats to take credit. Greg

  • The Freak
    Comment from: The Freak
    05/28/08 @ 10:46:57 am

    All true, but I think the oil market (like any market) is susceptible to bubbles. I think we're in somewhat of a bubble now as traders have overestimated demand and the price-elasticity. I think the dramatic rises in oil prices are done, and we might see significant reductions in 6-12 months. It will be interesting to see which politician ends up claiming success for lowering prices (although they will have had no actual influence). A stronger greenback might help too, but that's not in the cards for the next couple of years.

  • Keith
    Comment from: Keith
    05/28/08 @ 12:56:54 pm

    Ross, Great post! However, I do have to argue that the US government does has a say in gas prices and it has to do with the Fed, Congress and the President. The Fed can get it right by starting to get away from dropping $$$ from helicopters and raising interest rates. That will build more confidence in the dollar and we would immediately see a drop in oil prices. With the price of fuel rising so much, we cannot stick our heads in the sand and assume companies will not pass along their raw material inflation costs to the consumer. It is starting to happen with the airlines and now DOW Chemical. I believe that the Fed knows this and that they will start raising interest rates. The second thing that needs to happen is the President, and McCain for that matter, have to talk about a strong greenback and put pressure on Congress to reign in spending. How likely is that to happen during an election year? Not very likely with a lame duck and one of the most hated Presidents in quite a time and a pandering politician in McCain. It doesn't even warrant my time to talk about the other two useless idiots because economic theory is of no use to Marxists. Just like any bubble, it has happened because of cheap money and and a weak dollar. For those that believe hard assets will continue to rise, they have to look no further that a few years in the past to see how the Fed and runaway spending led to the dotcom bubble and housing bubble. I fully expect that this commodity bubble will go the way of the previous two fiascos. Keith

  • Comment from: Rossputin
    05/29/08 @ 08:00:40 am

    Freak, I bet the US dollar strengthens somewhat more and somewhat faster than people expect once 1) the market realizes any recession, if it happens at all, will be shallow, and 2) the broader market realizes that the Fed's next move is up, not down, and probably sooner than the historical 13 months between the last cut in a series and the first raise.

  • Kevan McNaught
    Comment from: Kevan McNaught
    05/29/08 @ 09:29:21 pm

    Ross, OF TAXES, SUSIDIES, MANDATES, TRADE BARRIERS AND PRICE CONTROLS... Basic economics says if you want more of something, susidize it. If you want less, tax it. Talk of levying windfall profits taxes on oil & gas providers may make for good sound bites, but it will reduce supply & therefore raise prices. Strangely enough, the largest subsidies per energy equivalent are not to oil producers, but to ethanol producers. In addition, gov't is mandating one of the only alternative fuel sources more expensive than gasoline as an additive to gas, while diverting corn & other food stuffs from the food supply and creating food inflation. Unfortunately, after our gov't essentially guaranteed windfall profits in ethanol by meddling in the markets, our (relatively) free market attracted competition from Brazil, but not to worry. We simply erected tariffs that would artificially raise the cost to U.S. consumers for cheaper Brazilian ethanol, while protecting domestic producers from the rigors of competition. As one poor policy has begotten a worse one, each fix compounds the problem and delays its resolution. Most recently, we're hearing talk from some of price controls. Oh, what a tangled web we weave! Price is the natural attractant of more supply, substitution, and innovation. If left to its own devices, the market will resolve the "problem" more efficiently than gov't action. As prices rise, more investment is made in search of supply, and as that supply hits the market, a more permanent resolution to a shortage emerges. As consumers deal w/ the costs, individuals get more fuel efficient cars, companies find it cheaper for employees to work from home, & conservation in general becomes worth the trouble. Thus, demand is reduced. Finally, price makes other forms of energy profitable, so innovations in solar, wind, & coal gasification proliferate. On top of gov't action creating negative unintended consequences, perhaps the most damaging part is the positive things that don't happen because of gov't action.