The Price of Oil

I have decided to address this issue because so little is understood about this phenomenon. 

Even before the present spike in the price I was receiving circular e-mails that apparently were getting wide circulation. One of these urged boycotting Venezuelan oil by not buying any oil at Citco gas stations. Another urged boycotting gas stations bearing the Exxon-Mobil banner as a way of forcing their gas prices down. Another propounded by John McCain and seconded by Hillary Clinton suggested a two month suspension for the summer of the federal excise tax on gasoline. Barack Obama opposed it. I am glad to say that neither McCain nor Clinton actually introduced legislation to that effect and no such legislation has been introduced.

Unfortunately, none of these proposals has any merit. They all show an incredible lack of understanding of how markets operate and what effect our actions have on markets.

Basically, prices are set by the law of supply and demand. This is true whether we are talking about prices on the stock market or of commodities. When there is more demand than supply of any given commodity the price of that commodity will rise until supply and demand come into balance. If there is more supply than demand the prices will fall until supply and demand come into balance. 

The only way that prices can be effected artificially other than price controls, which creates other evils, is by changing one side or the other of the equation. Thus OPEC was formed to control the price of oil by controlling supply. During the Carter administration OPEC decided to drastically reduce supply causing long lines at gas pumps and driving the price of gasoline up drastically. This time, however, OPEC is pumping at, or very near to capacity, and so they, even if they wanted to, cannot increase supply. Some may say why would they want to? The answer is simple and is the reason why in the past OPEC has increased supply when prices have gone up. The more that the price of oils escalates the more alternate fuels become competitive and the more incentive there is for the world to take steps to find alternative energy and or find means for conservation. This is something that OPEC, all the oil producing states and the oil companies fear, for if and when that happens their days of wealth inflow drops and eventually stops.

At the moment the world has a capacity to produce eighty-five million barrels of oil a day. Demand is at eighty-seven million barrels. The price will keep rising until supply and demand are in balance. 

Some believe that the US can solve this problem by accessing its own reserves, which have been off limit because of their environmental sensitivity. But this is totally false. If ANWR were opened to drilling it would increase the profits of the oil companies because they would have slightly more to sell, but it would not have a noticeable effect on oil supply. It is estimated that it would take ten years to bring this oil supply to fruition and then “it would result in additional oil production of a peak 780,000 barrels per day in 2027, according to the mean case developed by the Energy Information Administration in a revised assessment of ANWR potential. That would result in trimming $0.75 (in 2006 dollars) off the projected cost of a barrel of oil, according to the EIA”

Thus only a decrease in oil consumption will bring the price down. A reduction in the excise tax as advocated by McCain/Clinton would discourage the reduction in gas consumption thus keeping the market from coming into balance and cause the price of gas to increase by the amount of the tax. Thus the price of gas would remain the same, but instead of the money going into the Highway Trust Fund to keep our roads in repair, it would go into the pockets of the oil companies. Taxing the oil companies as Clinton advocates would keep them from profiting from the windfall, but would have no effect on the price of gasoline. Some benefits from the high prices have already occurred. “General Motors Shifts Focus to Small Cars in Sign of Sport Utility Demise” says the headline at page one of this last Wednesday’s Business section of the New York Times.

As it happens, as painful as the price of gas is to consumers and truckers the world over may be, it is the result of the failure to anticipate this crisis. Had taxes been raised, or had CAFE fuel standards been increased years ago, gas consumption would have gone down and the spike we now have might have been avoided, but even that is questionable because in a globalized market the price is set by world wide demand and unless the whole world demand goes down prices will go up.

It is interesting to note that T. Boone Pickens who made his fortune in Texas oil is now investing in Wind Turbines. Here is a quote from Market Watch, 

“Billionaire T. Boone Pickens said Thursday he's placing an order to buy 667 wind turbines from General Electric as part of an estimated $2 billion in start-up costs for his four-phase Pampa Wind Project. Pickens' Mesa Power LLP will buy the GE turbines, which will be capable of generating 1,000 megawatts of electricity, enough for 300,000 average U.S. homes. When complete, the Pampa Wind Project will cover some 400,000 acres in the Texas Panhandle. 'You find an oilfield, it peaks and starts declining, and you've got to find another one to replace it," said Pickens, who once operated one of the largest independent oil and gas production companies. "It can drive you crazy. With wind, there's no decline curve."

Finally, some have suggested that the weak dollar is at least partly responsible for the high cost of gasoline. Again this is a misconception. Since the price of oil is denominated in Dollars it makes no difference how weak the dollar is for the price of oil in the US. If oil were denominated in Euros it would be a different story. As it is the weak dollar is making oil more expensive in non-dollar countries, but not for the US.

It is time to come to grips with reality!