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  • Explaining Oil Prices

    Posted by Shannon Love on June 11th, 2009 (All posts by )

    [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.

     

    22 Responses to “Explaining Oil Prices”

    1. tomw Says:

      Please write Bill O’Reilly a letter. He is convinced that speculators control the price (retail) of gasoline, via controlling the price of crude.
      He does not differentiate between sweet/light/sour/heavy, nor does he give an explanation for why fuel prices dropped from last summer’s high, except to say that “they” did it, and are doing ‘it’ once again, now.

      Honestly, is there a 3rd grade pop-up book that we can get for him that will explain the different groups, what they do, and how they interact?
      I’ve tried to explain to some people that they should purchase 1/2 a tank or less only when they are near empty, thus putting a little back pressure on the suppliers. The tanks of cars must be a substantial holding area for fuel, and if we reduced our ‘holdings’, it naturally increases the pressure on distributors to lower prices. So some say…

      tom walsh

    2. Shannon Love Says:

      TomW,

      The tanks of cars must be a substantial holding area for fuel, and if we reduced our ‘holdings’, it naturally increases the pressure on distributors to lower prices. So some say…

      The distributors don’t have much control over pricing. Even if they distributed for free, it wouldn’t lower gas prices more than 10% at most. Gasoline is commodity good and price competition is fierce because cars are highly mobile and people can travel relatively long distances to purchase fuel. Everyone in the oil business except the extractors makes their money on volume, not margin.

      Even if distributors did control the major part of pricing, the rolling reserve of fuel in tanks is fairly trivial compared to total gas consumption. After all, most cars go through a complete tank of gas in a week. If everyone kept half a tank but drove the same, all they would do would be to shift 50% of consumption forward three days. That would be only one shift forever, not every week.

      As long as the same amount of gas gets consumed per unit of time, the price of gas will remain the same regardless. The bulk price of milk is the same whether the consumer buys it a gallon at a time or just a pint at a time.

    3. Omri Says:

      “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. ”

      The Energy Information Agency and International Energy Agency, the futures markets in NY, Chicago, Singapore, Dubai, Rotterdam, et cetera, make the situation of primary extractors far more nimble than that. And the first two actually do provide information on worldwide oil extraction, albeit imperfect.

      Part of the problem is that the world’s oil producers are increasingly composed of people engaged in secondary recovery methods, not primary, and they cannot cap and uncap their wells the way primary extractors do.

      Perhaps you should have a visit to RigZone and The Oil Drum and learn a little about these things.

    4. cjm Says:

      the higher prices are going to destroy even more demand. supposedly the world economy is picking up, but i doubt that is the case. so the oil producers will kill more and more of their market with higher and higher prices. kind of like the ny times increasing prices in the face of falling demand.

    5. Whitehall Says:

      I have to disagree on the ability to curtail production at the well. In some formations, one can throttle or stop production but for most, one needs to keep the flow going in a more or less continuoud stream. otherwise, the formation can wax up or just block itself requiring an expensive work-over that may or may not get the oil flowing again.

      For large capital-intensive fields, the sunk costs of oil platforms, pipelines, etc create a huge economic incentive to keep cash flow coming it to service the debt and give some return on capital. The lifting costs are a relative minor part of the total production costs and the more and quicker production, the broader the amortization.

      This is similar to the economics of nuclear power plants. Low production costs and high capital costs. That’s why US nukes are baseloaded.

      I’ll grant that some small fraction of total global production is as Mr. Love describes but I disagree that they drive the market responses for crude prices.

      I would suggest looking at the global production numbers by field, such as sometimes presented on “The Oil Drum.”

    6. Shannon Love Says:

      Omri,

      The Energy Information Agency and International Energy Agency, the futures markets in NY, Chicago, Singapore, Dubai, Rotterdam, et cetera, make the situation of primary extractors far more nimble than that. And the first two actually do provide information on worldwide oil extraction, albeit imperfect.

      The price collapse of last summer and the sudden and unexpected uptick recently show that both the explicit information of government statistics and the information processed by the market still cannot predict oil production and demand 30 to 120 days out. Information is better on the production end by the consumption end has gotten more complex.

      Part of the problem is that the world’s oil producers are increasingly composed of people engaged in secondary recovery methods, not primary, and they cannot cap and uncap their wells the way primary extractors do.

      Secondary production is still not significant enough in the total world market to alter my analysis significantly. Even if it were, the basic issue that oil can be left in the ground more easily than other raw materials remains valid. Moreover, the primary produces are the ones that can respond quickly and it is still they who determine the marginal supplies that primarily set the price. Even if they produce a minor amount of oil the speed at which they can increase and decrease production means they act like a small rudder steering a big ship.

      From eyeballing historical price charts, it looks to me that oil and oil product prices are as volatile as they’ve always been and that tells me the basic system has not changed much. Back in the 70’s people thought that OPEC had fundamentally changed the oil industry but once the Western world stopped crippling its own oil industry even that proved untrue.

      If you would like to provide data that shows that the oil market is much less volatile than it was 20 years or more ago, I would certainly take a look at it.

      The most important factor remains the lack of storage. Once the oil leaves the ground it’s going into car tank (or some other product) come hell or high water. Other products don’t have that kind of inevitability and the intuitions we develop based on the prices changes of non-oil products fail us when think about oil.

    7. Omri Says:

      “The price collapse of last summer and the sudden and unexpected uptick recently show that both the explicit information of government statistics and the information processed by the market still cannot predict oil production and demand 30 to 120 days out. Information is better on the production end by the consumption end has gotten more complex.”

      Predicting production 30 days out is barely harder than a Chicago municipal no show job. Look up last month’s figure, and flip a coin to add or subtract a percent. Production has been on a plateau for years now. Information on demand is harder because demand is by definition a hypothetical.

      “Secondary production is still not significant enough in the total world market to alter my analysis significantly. Even if it were, the basic issue that oil can be left in the ground more easily than other raw materials remains valid.”

      Secondary production is what provides the marginal barrel in this market. Primary producers are running all-out because their costs are near $10/bbl. It’s the secondaries who decide to deploy or furlough based on whether the price 4 months out is $60 or $70. And since they have to hire more people and set up more capital to get working, they are the ones who who get left looking like fools when the price goes back down below their costs and the boomtown they built in North Hell, Alberta becomes a ghost town again.

      The primaries, meanwhile, are running all out. but since they don’t provide the marginal barrel, they don’t set the price. The secondaries are too slow to be able to provide price support or price resistance in the market, so they don’t, and so the market is volatile. The tank farm owners, mean while, have their own issues. They can only buy and sell as much oil as their geography permits. And the tank capacity they have in proportion to production is comparable to the portion of a company’s shares outstanding that is in the specialist’s portfolio on the NYSE. (Comparable unfavorably, that is.)

      So: no price support on the downside, no price resistance on the upside. Volatile market. Nothing to do with people being too slow to cap or uncap a well. 15 years ago, Saudi Aramco was able to serve that role. They’re producing at 100% now. 40 years ago, the Texas Railroad Commission was able to serve that role. They went to 100% in 1971.

    8. Subotai Bahadur Says:

      There is another factor that is making oil pricing counter-intuitive, I believe. Right now those who have money to invest, worldwide, have had their options narrowed. If you are looking at stocks, especially in the US; we are waiting for the next shoe to drop [along with the market]. Investing in corporate bonds is now far more risky, because the secured status of corporate bonds has just been replaced by political fiat. Indeed, the collapse of the rule of law in business is a factor holding back all investment. Government bonds are shaky because of the worldwide trend of governments monetizing their debt as they try to borrow their way into prosperity. That leaves commodities. Oil is a commodity that is of value worldwide, available and deliverable, and not subject to one government’s control. Owning or investing in oil does not attract the unwelcome attention of government revenue agents the same way that investing in precious metals. And as it becomes a more popular investment, the price of oil to refiners gets bid up and the increase is passed on a the pump.

      Subotai Bahadur

    9. cjm Says:

      how can oil be used in an investment role, if it can’t be stored (ala gold or other non-food commodities)?

    10. Pat Says:

      In some countries, where a union strike can stop distribution to gas stations, gas can become scarce very quickly. This may be apocryphal but I read that, under such circumstances, the Irish government issued regulations that said drivers must pay for a full tank of gas whenever they filled up. It sounds like an Irish joke, but it wasn’t.

    11. Subotai Bahadur Says:

      Cjm

      While oil storage is limited, there is betting on the prices in the future, and in ownership of quantities of it while it is in transit from the wellhead, to the refiner, and to the eventual retail distribution of whichever product it ends up as. People buy and sell contracts at all stages, some hoping for actual delivery of the commodity, but most as investments.

      If there are more dollars [yen, pounds, or whatever] pursuing these delivery contracts [as investors move from paper to commodity investing], it bids up the prices. Thus, there is more upwards pressure on prices than would be justified by the normal commerce.

      I am not claiming, by the way, that this is the only reason; just that it is an additional factor that is out of the ordinary.

      Subotai Bahadur

    12. Carl Ortona Says:

      this is actually very good … and i mean the comments (for the most part thoughtful — rare for any blog); Shannon; your entries are usually very thoughtful and i enjoy and learn from them; no snark intended — what is the ratio of small/diffuse groups to large extractor conglomerates (nationalized and/or transnational)? Have a couple friends who work for oil service companies and even they are sometimes befuddled — because they are on time to response jobs in the gulf. Obviously, once the tap is running, you are up against it, but even the gulf of mexico is littered with rigs that are on hiatus (but could produce at huge volume once the switch gets ticked back on … but even they are over pockets … as big as they are … that might be productive for a year or two … but then aren’t). that ignores the question of bottlenecks at the port(s) of entry and flow management/traffic management on a large scale. great topic that most people don’t contemplate

    13. tyouth Says:

      About what % of total production is from primary producers and what % from secondary during times of low, usual, and high production?

    14. Shannon Love Says:

      Carl Ortona,

      …what is the ratio of small/diffuse groups to large extractor conglomerates (nationalized and/or transnational)?

      I don’t know for certain. I no longer track the oil industry in any detail. The ratio has been decreasing steadily throughout the last century and probably from the first oil well. East Texas prior to WWII used to be littered with hundreds or thousands of small extractors who ran at most a few dozen wells each. Today, such people are fairly rare but far from extinct. However, even today, in North America, the actual ownership of mineral rights for oil and natural gas is widely dispersed. Drilling companies lease the rights to drill and extract oil from hundreds of thousands of property owners.

      The ration of small to large extractors is not particularly important to my argument. What matters is the number of extractors in the oil industry versus the number of small extractors for other mineral resources or other products. Compared to copper, aluminum or even coal, oil has a much greater diversity of extractors than any other similar resource. This causes its economic behavior to differer.

      My post is not really about the oil industry but rather about how the economic intuition that people develop when buying every other product fails them when they try to understand oil and gasoline price changes.

      The most important factor is the inability to store oil and petroleum products in any significant qualities. This means that once the extractors pump the oil, it has to be consumed. The storage problem would give us substantially the same economic behavior even it we only had one extractor in the entire world.

    15. Rob Says:

      I think that this article is brilliant. It focuses on structural and underlying causes instead of ranting against greed.

      The lifting of a billion people out of abject poverty in India and China and around the world, has caused the demand for energy to rise. This is not a bad thing. However, rising oil prices is one result.

      A serious, mature response to this would be a focus on increasing energy supply, diversity of energy sources and reducing structural bottlenecks. What we have instead are solar fantasies and politically correct knee-capping of other alternate solutions.

      If we are serious, we will pursuit an all-of-the-above energy independence strategy.
      This strengthens the security of the United States and by smoothing the energy supply curve, and the threat of high oil prices, protects some of the poorest people around the world from sudden economic disaster.

      That strategy might include:

      Shale oil
      Alaskan natural gas pipeline
      Offshore oil
      Open Anwar
      Nuclear
      Improved, extended and smart electrical grid
      Biofuel
      Flex fuel for cars
      Clean coal
      Hydrates
      Geothermal
      Tar sands
      Electric vehicles
      Composite materials yielding lighter and more efficient cars
      Increases in energy use and thermal efficiency

      None of these is a solution all by itself. But taken together they can help the entire world to a brighter future.

      Limiting our efforts to only those sunny breezy solutions beloved of the green left will leave us freezing on our bicycles in the dark.

    16. Rob Says:

      And the storage thing.
      Since storage is so important to the stability of the whole energy market; isn’t there something that our spendthrift class in Washington DC can do to promote storage.

      What if we were allowed to lease storage capacity in the strategic oil reserve salt domes to Texas refiners. They could buy oil when it is cheap and store it until they needed it when oil is expensive.

      Oil is one of the most concentrated form of energy there is. It is unclear why storing it should not be economically viable. How can the government encourage this?

      Encouraging management of those fields that can throttle and vary their production to limit production at low oil prices and maximize production at high prices would seem to be partly a function of tax laws and financial rules. Maybe these should be reexamined.
      Again selling your oil only when the price is high, does not seem like a financial disaster to me, but it requires a long term investment view that is not encouraged in the current energy industry.

    17. WCWC Says:

      Yes I was going to say as in the case of the strategic petroleum reserve, oil can be stored. But only in special circumstances is it relatively easy, like the salt domes.

      How abundant/rare are salt domes, and could a market for storing oil theoretically be created if a salt dome owner (private or public) chose to rent out storage volume? Or do transport costs render this possibility moot? Perhaps economies of scale (like a deliberate government reserve-building program not bothered about profits) are needed.

    18. cjm Says:

      the energy density of oil is something like 1/2,000,000 that of uranium; fyi. that’s right, one pound of uranium has the same energy as two million pounds of oil.

    19. Whitehall Says:

      The costs of storage are both in physical difficulty and expenses as well as the time value of money. Plus, why make an unnecessary commodity price bet? Storing large volumes of oil is risky speculation where the costs just keep on running. Like a bank savings account with running service charges and a return in some foreign currency with no fixed exchange rate.

      CJM is correct – uranium does have 200,000,000 times the energy density of oil or coal. Current technology can only extract a portion of that advantage though.

      Although Mr. Love did not respond to my earlier posting, on further reflection it would be interesting to compare the “turndown ratio” of global oil production versus the consumption volitilty.

      For OUR family wells, there is no production throttling possible for geological reasons.

    20. Shannon Love Says:

      Whitehall,

      I have to disagree on the ability to curtail production at the well

      Well, apparently it is possible because oil cartels have many times over the last century rapidly changed the amount of oil they pumped. The Texas Railroad commission did it for a time in the 1920’s and OPEC did in 1973 and afterwards. Yes, circumstances of geology, climate, technology, finances or politics can make it difficult to impossible for some oil fields but that is completely irrelevant to my argument. What is relevant is that it oil extractors can collectively alter production levels much easier than the producers of any other raw material or manufactured product. The relative (not absolute) ease makes oil supplies change in a different manner than the supplies of other goods.

    21. Shannon Love Says:

      WCWC,

      How abundant/rare are salt domes, and could a market for storing oil theoretically be created if a salt dome owner (private or public) chose to rent out storage volume?

      From all I’ve read, salt domes are not economical for normal storage. I’m not sure they’re enough of them to buffer our entire oil consumption. You also have the problem that their are different types of oil requiring separate storage.

      I don’t there is much of an economic incentive for distributors or refiners to use such a buffer because they rely on futures contracts to protect against financial shocks. Since oil is highly (but not perfectly) fungible, everyone in the refining and distribution part of the system pay roughly the same price for oil so they suffer no competitive disadvantage in passing that price along. I

      On the other hand, the strategic reserves holds over a 30 day supply. It holds 727 million barrels and we consume 20 million a day, so it is possible to sock away a lot of oil. I think you would need a new system of futures contracts to manage it.

      Another consideration is that you might not want to create a buffer. Prices are information and when you pay high prices for gas you send a signal to extractors to increase production. A physical buffer of oil would slow that signal down and might actually make things worse.

    22. renminbi Says:

      Cjm – You mean enriched Uranium, don’t you?