Marginal Utility

by Tom Bozzo

And I will consider doing blog requests, at least for now, when asked nicely. This one is from my conservative buddy Bryan Smith, who asks some fair questions:

A big story over the past few days has been oil companies making billions in profits while people are paying high prices at the pump. But, gas prices and oil prices are set entirely by market forces, correct? And, there is certainly a big "fear" premium in the market for oil prices right now. The oil companies could be doing something like increasing refining capacity (to ease supply fears) or increasing oil pumping, but I imagine these have been hampered by government regulations / environmental objections / 'not much more oil to drill' issues. Don't the giant oil company profits mean that there is tons of money in the business and that there are ample opportunities for new businesses to thrive and ample opportunities for businesses focusing on the development of alternative fuel technology? Or is there something sinister going on?

Last things first. Is there something sinister going on? Probably not, though the full story may depend on how you define "sinister." The pre-Katrina fuel price run-up was accompanied by a surge in press reports of refinery outages and accidents, which I'd noted a few months ago superficially called to mind some of the supply manipulations from the Enron-fueled California electricity crisis. The timing of the Katrina gas price spike (and subsequent fall) also doesn't seem to line up very well with that of the refinery closures and subsequent recovery of capacity, and so I'd be less than shocked if I were to see evidence that a flood of money from hedge funds exacerbated the increase. I wouldn't consider that sinister, even though I have no reason to think that my interests and those of hedge fund investors and/or managers are aligned.

It is true that the high prices would be expected both to spur efforts to expand oil production and/or refining capacity, and to encourage various forms of conservation and substitution to reduce the consumption of oil and the refined products. What I've cheekily called the "truckageddon" hammering domestic vehicle sales (which continued in force in October: See the GM and Ford sales reports) is, in part, one example of the latter. That, in turn, has led somnambulent auto executives to snap to attention in regards to adoption of fuel-saving technologies in large vehicles. More questionably, it's also spurred fuel-subsitution efforts such as ethanol mandates. Given current production processes, which use a considerable amount of natural gas as well as diesel, ethanol isn't look like a very good substitute. We can hope that the ITER folks hit pay dirt and we can have fusion-powered electric everything while we're still able to enjoy it.

How the big oil companies have responded to their incentives to increase production and exploration is a matter of controversy. The industry justifies its profits by emphasizing its re-investment of earnings in exploration, as well as by highlighting relatively low ratios of net earnings to sales compared to the S&P 500 as a whole. But production at the integrated oil companies hasn't been following prices upward. For instance, here are some stats on ExxonMobil's "upstream" business, from EM's 2004 Annual Report:

ExxonMobil Exploration, Development, Production, and Gas & Power Marketing

Year	2004	2002	2000
Earnings (million $)	16675	9598	12685
Nat. gas prod. (million CF/day)	9864	10452	10343
Oil equiv. prod. (thousand Bbl/day)	4215	4238	4277
Proved res. liquid (million Bbl)	11651	12623	12171
Proved res. gas (billion CF)	60362	55718	55866

So EM hasn't been producing any faster in response to the oil and natural gas price increases, and has not increased its liquid oil-equvalent reserves. (The reserve estimates themselves are a matter of potential controversy, as Royal Dutch/Shell recently reduced its claimed reserves by nearly 4.5 billion 'barrels of oil equivalent.')

The possible onset of "peak oil" has an implication for refinery investment. Refinery capacity is tight in no small part because of increasing suburban sprawl and the "taste" for using large truck-like vehicles for personal transportation. Conservation and substitution relieve the capacity constraint, and with it some of the incentive to expand capacity further. If we're close to the oil production peak, then it's also unlikely that we'll ever stake a claim to more oil than we're refining and burning now (the rapidly growing consumer classes in China and India would have something to say about that). Given the large capital investments and long asset life for refineries, if "peak oil" is coming soon, then it doesn't make sense to build capacity to refine incremental oil production that may never materialize.

Last, while oil and gasoline prices are largely determined by market conditions, the market doesn't prevent the oil companies from collecting large economic "rents" (the difference between the market price and the economic cost of production; see also PGL at Angry Bear here). The "fear premium" component ends up working like a conservation tax that's being paid to the oil companies instead of to the government where it could be used to pay for, e.g., some of the military expenditures that would notionally stabilize the region. Those are, by the way, large external costs not incorporated in the market prices.

It follows from all of this that fostering low prices for their own sake is counterproductive to the extent that it short-circuits the market's conserve-exploit-substitute signals to various actors.