Wednesday, November 02, 2005

I Got Mail! (On Oil Economics)

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

Earnings (million $)16675959812685
Nat. gas prod. (million CF/day)98641045210343
Oil equiv. prod. (thousand Bbl/day)421542384277
Proved res. liquid (million Bbl)116511262312171
Proved res. gas (billion CF)603625571855866

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.
Thanks, Tom! It will take me a bit of time to digest all the links and come up with a more thorough comment.
Thanks, again. It makes sense to me for the most part. I don't really understand how hedge funds very well or how they can affect gas prices so much, and if they do, what the problem with this is.

If oil companies aren't expanding production, it might be because they can't anymore, and thus will be harvesting all the profits they can until oil is effectively depleted But, if this is the case, prices should continue to rise until demand decreases (probably never) and alternatives should look more promising. It seems to me that the free market is working well to fix the future problem.

Where is John Galt with his static electricity machine when you need him? I guess the ITER fusion project might solve things though, that is, until we run out of hydrogen.
Some types of hedge funds basically engage in commodity (or interest rate, or exchange rate) speculation, and they often borrow money to take larger positions at that. The problem would be a stampede of oil market speculators driving prices above "rational" levels. The market will tend to work that out sooner or later, but in the meanwhile, somebody has to pay excessively high gas prices.

The major cautions I'd offer regarding your market optimism is that it's not clear that the market sends a conservation/substitution signal that's strong enough (the external costs issue) or soon enough. I'd also argue that there needs to be a lot of public infrastructure reconfiguration done to accommodate the post-oil world, and it's at best not clear that paying the conservation tax to the oil companies is the efficient way to fund it.

But it's definitely true that politicians can make things a lot worse by trying to curry temporary favor with people who are irate about the cost of filling up their SUVs.
Well, as long as you are taking post requests, can I put mine in the queue? Oh, wait, now I'm thinking about the question and I want to be sure that I ask it right (not just nicely). It's going to be about my recent obsession about the idea of how we can have honest numbers in technically complicated areas with high financial incentives for bias in the number in one direction or the other, perhaps specifically with reference to numbers about the federal budget. But I'll postpone until I can be more precise.
See James Hamilton for the apparent reality: the presumed "incentive" hasn't worked (based on the most current data). Instead, the oil companies have been hoarding--cash.

I'd bet on OTEC over ITER if I were you; easier, and convenient to most of the industry's brainpower.

(On the original assumption, refining capacity has increased; it's refineries that have not.

I don't believe--nor do several state governments--it's coincident that prices peaked just before Labour Day weekend, and dropped significantly right after, in a limited version of setting a "market" price. That, though, could have been a combination of higher prices from the companies and the stations themselves trying to find a "windfall" (drivers cannot, after all, buy gas in early August and store it until LD weekend--at least not in sufficient quantity to immunize a significant portion of the population from gouging).

The reward from greater R&D investment is only that of an oligopoly with high barriers to entry: greater market share. If that's not sustainable (if there is a difference in the gas pumped as Mobil regular, Sunoco regular, Getty regular, and the local independent's service station, it's not material), the incentives to expand production would produce a rather flat curve (slope much less than 1).
Thanks, Ken. The Hamilton post (here) is very good.

I think Wisconsin is among the states looking into the late summer price dynamics.
I just read an article about peak oil here.

Excerpt: (No relation to me, BTW) "Smith, CEO of Swiss America Trading Company, contends that oil is not a fossil fuel. Rather, he believes it is being producing deep within the earth and is brought to attainable depths by centrifugal forces of the earth's rotation."

There is still no word on why we aren't all currently flying towards space.
They don't call it "World Nut Daily" for nothin'... oy.
Post a Comment

<< Home

This page is powered by Blogger. Isn't yours?