Thursday, September 13, 2007

Oil Prices

Many people have complained over the last two years that crude oil and, thereby, gasoline prices have been too high. This, they claim, is due to the unscrupulous practices of the major oil companies. This is a fashionable statement to make especially out in the Hamptons where most of the people who are most upset by this have their own private jets and are frustrated that their trips to St. Barts are becoming so costly that they can only invite 15 of their closest friends instead of the more civilized number of 25. Though most oil companies have been setting records for profit on a quarterly and annual basis, the high prices are not their fault for the following reasons.

First, this current surge in price in completely different than all other surges in crude oil price since oil has been used as the major transportation fuel around the world. There were price spikes in 1973, 1979 and 1991. At those times prices rose as a result of fears about the SUPPLY of oil being constrained. In other words, those price spikes were supply-driven. This time the case is different. Worldwide DEMAND is largely responsible for driving prices upwards as potentially massive markets (China, India, Vietnam, Thailand) have begun to consume petroleum at astounding rates. There is really no way to solve this problem in the future because, by almost every estimate that I have seen, the Chinese and Indian economies will continue to grow.

Second, there are not enough refineries and oil companies have no incentive to build new refineries. Demand in America for petroleum has grown steadily despite high prices and the fears of a weakening economy. It seems that nothing will deter Americans from driving their cars. As demand in America has grown, however, refining capacity has not. Therefore, bottlenecks have developed and the amount of petroleum that can be delivered to the market is therefore limited. Why have the oil companies not built new refineries? The way that the government is talking is making every oil company believe that there will be no future subsidies in oil production or refining and that competitors (ethanol producers, biofuels producers) will receive the bulk of the governmental benefits. To recoup the massive capital loss that is necessarily made when building a refinery takes decades. If a serious effort is going to be made over the next 30 years to move towards an ethanol-based fuel system, no oil company will be able to make a profit by building more refineries.

Third, oil prices are based on the costs of drilling and transporting oil to the market. This seems simple but there is also another factor involved when buying and trading oil. Traders must consider how expensive it is to deliver one barrel of oil to the market and how expensive it is to deliver the NEXT barrel of oil to the market. If that next barrel of oil is coming from a region that is highly unstable due to war, unfriendly regimes, the presence of cartels or simply higher drilling and operations costs, the price will rise. This is an important fact of economics: prices are based on cost and also on how difficult it is to find another one of the same product (this is why diamonds are so expensive, this is why Kobe Bryant gets paid so much- finding another one of him is difficult or maybe impossible).

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