[update 2009-06-12 10:00am: Please keep in mind that this post is about how people’s economic intuition goes awry when thinking about oil. The features internal to the oil industry are not as important as the differences between the oil industry and all other industries. It is these difference that cause people to misunderstand oil pricing. ]
Oil prices are headed up even though the world economy is headed down. [h/t Instapundit] What gives? Shouldn’t a declining economy lead to decreased demand which keeps down prices?
Well, yes and no. Oil is a strange commodity. It doesn’t change price and availability in the same pattern as other commodities that are based on natural resources. This strangeness arises out of the technology of oil production, distribution and refining.
Several factors give oil an unusual economic profile:
First, let me define some terms. Extractors are people who own oil wells or drilling rights. They decide whether oil come out of the ground. Distributors move raw oil from the wellhead to the refinery. Refiners/retailers refine and sell petroleum end-products. Sometimes one entity (e.g., a nationalized oil company) performs all of these functions but usually this is not the case.
(1) A large and diverse group of people are extractors: Although we think of oil as being the province of a handful of national governments and major multinational corporations, compared to other natural resources, oil comes from a much more diverse range of point-of-extraction owners. Only a few dozen mines in three or four countries supply most of the world’s copper. In terms of ownership, only a handful of governments and private institutions own those mines. By contrast, there are thousands of people in North America and even in other parts of the world who own one or two little oil wells.
This means that a lot of people decide how much oil gets pumped out the ground.
My own rural middle-class family ended up owning some oil wells for a few years that produced a few thousand dollars a year. It didn’t come to a lot, spread over an entire extended family, but every little bit helped. For a time, our decisions minutely influenced the supply of oil for the entire planet.
(2) Extractors have fine control over the amount of oil they pump: If you own 10 wells, you can choose to pump from all 10 or from any number of them down to zero. Moreover, you can pump as much or as little out of any particular well as you like. The only limits are set by your distributor. You can’t pump more than he can move and you can’t pump so little that it doesn’t pay for him to move it.
You can’t do that with other resources to same degree. A coal mine has to produce at a fairly high level to justify the cost of keeping it open. Miners have some leeway in adjusting production but nothing close to that of oil extractors.
Oil extractors can significantly alter their level of production in a matter of days or weeks. Heck, on pressurized wells, turning production on and off is just a matter of opening and closing a valve.
(3) Inactive oil wells keep: You can cap an oil well and leave it for decades and then come back and start production in under a week. No other commodity gives extractors this option. Mines, even open-faced mines, must be constantly maintained or they flood and collapse. Closing and reopening a mine is a major undertaking.
(4) Extractor price sensitivity: Because of (2) and (3), extractors react quickly to changes in prices. When prices go up, they open the spigots, when prices go down, the extractor can turn the spigot off and wait for higher prices.
This is especially true of wells that have a high “lifting cost”. Lifting cost is the cost of getting oil to the surface. The lifting cost of some wells is very high, upwards of $50-$70 a barrel. These wells only operate when oil prices are high. When the price drops below the lifting cost, the extractors turn these wells off until prices rise again.
(5) Distributors and refiners can’t store oil: This is the most important factor of all. There is no economical means of storing large amounts of oil save pumping it back into the ground. The big oil tanks you see around are just temporary buffer tanks at refineries or the ends of pipelines. Once oil comes out of the ground anywhere in the world it is going to be an end product within a maximum of 120 days.
By contrast, most other natural resources can be easily stored for long periods. This makes it easy for distributors and refiners of those commodities to store up against falling prices or to take advantage of suddenly increasing prices.
Once oil is pumped it is going to move through the system to be sold as an end product as inexorably as a boulder rolls down a mountain side.
By combining all of these factors it’s easy to see why oil is such a boom and bust business. A vast and diverse group of extractors decide how much oil to pump based on their estimation of demand 30 to 120 days in the future. They can quickly adjust their production to match their estimates, especially when it comes to stopping production. However, once all these extractors have made their decisions, the future supply of petroleum products is fixed and nothing can alter it.
Many people believe that the sudden drops in gasoline prices indicate that the prices were artificially high. From the factors above you can see that such sudden prices corrections come from the inability of distributors and refiners to reduce supply to meet reduced demand. Unlike the producers and sellers of other goods, refiners/retailers have no short-term control over how much of their product they sell. Once the extractors pump the oil and hand it off to the distributors, the oil has to be consumed by someone. In principle, it wouldn’t matter if the price dropped to zero. They can’t store oil, so they’d just have to just give it away. When people suddenly stop driving in response to high prices, an economic downturn or some unforeseen major event, the supply of oil takes weeks or months to adjust. In the interim, gasoline prices drop like a rock.
The current rise in prices comes from a similar effect. 30 to 120 days ago extractors believed that future prices would be low so they stopped pumping as much oil. Since they have no central coordination, and since no one knows how much oil is actually pumped at any given time, too many extractors stopped pumping at once. When the supplies get short, retailers can’t just order up more end products and refiners can’t just make them. They both have to wait for the extractors to decide to pump more oil and for the oil to make its way through the system.
So there you have it. I’ve glossed over a lot of factors such as cartels, futures trading, currency markets, inflation, etc., but in the end those factors don’t routinely affect pricing anywhere near as much as the technological factors. This is why for all their ranting and posturing politicians never do anything to substantially change the short-term price of petroleum products. Neither they, no any other human being, can control the supply of petroleum products once the oil leaves the ground, and if you can’t control supply you can’t control price.
[update 2009-06-12 10:00am: After reading the comments already posted, I want to emphasize that the primary factor in oil’s odd economic behavior is the inability to store it or most petroleum products. I can’t think of any other raw material or manufactured good that can’t be either stored or disposed off. With any other product you can store it indefinitely, sell it in an alternative market, recycle it or simply throw it away. We develop our economic intuition of how pricing works based on all the other products that don’t have to be consumed. This intuition fails with oil because oil has this unique facet.]