Monday, September 15, 2008

The Economics of Oil Prices

This past weekend oil prices shot to near-record highs again after several months of decline. While on a weekend trip to visit the grandparents, we were unpleasantly surprised to see gas prices climbing as quickly as the gas station attendants could change their signs. Even at high prices, many stations were selling completely out of gasoline.

To understand the reason for the fluctuations, we must first see the big picture. Oil prices have been increasing over the last few years for a number of reasons. More demand is one of the most important factors. The United States has been using more oil every year. The demand of other countries is increasing as well. China and India are both becoming industrialized nations. As they industrialize, they use vastly more oil than they did in the past.

Additionally, much of the easily tapped oil has already been drilled. Oil fields are increasingly difficult and expensive to tap. Even nations like Saudi Arabia have already pumped much of their easily accessible reserves. New oil fields are often found far out to sea or in very inhospitable areas, such as the arctic. There are new sources of oil, such as Colorado’s oil shale, but many of these are also more expensive to produce. Many oil-rich areas are also politically unstable, which makes the supply of oil uncertain.

Furthermore, oil prices have also been affected by the weak US dollar over the last few years. When the dollar is weak relative to other currencies, it takes more dollars to pay for the same barrel of oil.

Over the summer, oil prices have been driven down by several factors. First, high oil prices did what global warming alarmists were unable to accomplish: They persuaded people around the world to use less oil. Oil demand declined in the first half of 2008 and is forecast to continue falling in 2009.

Basic economic theory is that as prices rise, demand will fall. This has been true in other oil spikes as well. When oil prices increased sharply in the 1970s and 1980s, they led to economic slowdowns, which, in turn, caused the price of oil to drop. In the 1980s, the price of oil not only dropped, it collapsed and didn’t recover for about twenty years.

The dollar also gained over the summer of 2008. As the dollar grew stronger, the relative price of oil decreased. As the dollar increased in its value, it took fewer dollars to buy each barrel of oil.

A final factor in the oil price decline was President Bush’s decision to repeal the presidential ban on offshore oil drilling in mid-July 2008. Conservative estimates are that there are at least 18 billion barrels of oil off the coasts of the United States that are currently off limits to oil companies. Drilling will still not be allowed unless the congressional ban is allowed to expire, but President Bush sent a clear message to oil producers that the supply of oil might increase dramatically in the next few years. The effect was an almost immediate decline in the price of oil.

Many people place the blame for high oil prices squarely at the feet of the oil companies. While the oil companies once had the ability to set prices, that is no longer true. Most producing countries nationalized their oil fields and facilities in the 1960s and 1970s. They then formed OPEC, a cartel tasked with organizing oil production and stabilizing prices. Currently oil-producing countries set the price for their oil and buyers simply choose whether to buy or not. Given the high demand for oil, usually the choice is to buy regardless of price.

There are few cures for high oil prices. One is to reduce demand. This can be accomplished through alternative energy sources. One of the most practical solutions is to shift to electrical power. Electricity could be supplied cheaply through nuclear, wind, and solar power. All of these energy sources require large capital investments to start, however. Costs to consumers for new cars and home heating systems would also be significant. Conservation is promising way of reducing demand as well.

Increasing oil supplies is the other way to reduce oil prices. Billions of barrels of domestic oil reserves are going unused because of environmentalist-inspired bans on drilling. These oil reserves could be used to buy time to shift to other energy sources. Because much of the pre-production work has already been done, these oil reserves could be brought to market in as little as two years.

Supply could also be increased by new sources of oil. A process to turn coal into gasoline was invented by the Germans in WWII. Since the US has some of the world’s largest reserves of coal, this process holds much promise. Due to large investments for facilities to process the coal, this is not cost effective when oil is cheap, but is being considered now.

A common question is why retail gasoline prices rise faster than oil prices. The answer can be found in how gas stations are supplied. Over the past few years, gas stations have only been making a few cents profit on each gallon of gasoline. When gas prices rise, the station owner knows that his next shipment of gasoline is going to be more expensive. He raises prices so that he will be able to pay for the next shipment of gasoline. If he doesn’t increase the price immediately, he knows that he will lose money.

Conversely, when prices fall, the gas station owner sees an opportunity to make a little more profit for a short time. As he loses customers to gas stations with lower prices, he will eventually have to lower his own prices or be stuck with a large inventory of gasoline.

Last weekend, the run on gas stations had several factors. One is that the newest refinery in the US is over thirty years old. Due to government restrictions and costs, refinery capacity has not kept pace with increasing demand. As a result, US refineries are operating at about 97% capacity. When there is any interruption, such as that caused by Hurricane Ike, there is the possibility of an interruption of supply and a resulting shortage.

Another factor is that the public was panicking. Even though news reports were saying that there was no possibility of a shortage, as prices rose, the word went out among friends and families that it was time to fill up, before prices rose further. This created an artificial surge in demand. As economic law tells us, when demand rises, price follows. As station owners saw that they were going to sell out, it was obvious that it was better for them to sell out at a higher price than a lower one.

This may strike some as price gouging, but it can actually be a good thing. Rising prices prevent hoarding by those who don’t need the product. If someone doesn’t need gas, they won’t pay the higher price. Therefore the gas will be available for someone who does need it and is willing to pay the higher price. If the price stayed low, then hoarders would quickly snap up all available supplies.

Oil prices will probably decline again in the next few weeks, but $100 per barrel oil is likely here to stay. As long as demand remains high and supplies are constrained with no slack available at the production facilities, we should prepare for price spikes every time there is an interruption, whether real or perceived. The only real answers are to reduce demand through conservation and alternative energy sources, while simultaneously boosting supply and production in the short term.

The Prize, Daniel Yergin, Simon & Schuster, New York, 1991,-2009-oil-demand-forecasts/

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