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It was a much simpler world in the early 2000s where gas prices were concerned. As is the case today, the price of crude played the major role in the price of gasoline and at the start of the decade the price of gasoline was a very affordable and generally stable year-to-year.

Getting to the Bottom of Crushing Oil Prices (Part 1 of 2)

It was a much simpler world in the early 2000s where gas prices were concerned. As is the case today, the price of crude played the major role in the price of gasoline and at the start of the decade the price of gasoline was a very affordable and generally stable year-to-year.

Crude oil had averaged out at $28.36 per barrel in 2000 and the retail price averaged about $1.48. But prices were going up from the average price in 1999 of $17.46 per barrel and $1.22 per gallon respectively. The really big news at the time was that OPEC had established a “price basket” of seven crudes and was adjusting production to keep crude oil prices in a $22 to $28 per barrel range.

Shocking, given the low $12 per barrel price (and resultantly lower gasoline prices) motorists had enjoyed in 1998, but still well below a $35 per barrel spike in 2000. There had been a number of such price spikes during the summer of 2000 with regional gasoline prices in the Midwest cresting the $2 per gallon. These “disturbing” prices prompted the usual (for the day) political grandstanding among state attorneys general and those in the Congress and Senate.

A Federal Trade Commission investigation looked into the prices relative to gouging concerns, and as was usual with such investigations there was no finding of wrongdoing.

In 2002, the report stated that the spike: “…appears to have been caused by a mixture of structural and operating decisions made previously (high capacity utilization, low inventory levels, the choice of ethanol as an oxygenate),unexpected occurrences (pipeline breaks, production difficulties), errors by refiners in forecasting industry supply (misestimating supply, slow reactions), and decisions by some firms to maximize their profits (curtailing production, keeping available supply off the market).”

At that point in time few realized how dramatically the factors driving crude oil prices and the resultant gasoline prices would shift. It has been a long time since issues like the relative rates of refinery utilization, or the “Balkanized gasoline supply,” or some regional disruption relative to a problem with a pipeline or refinery made notable headlines in the national media.

These factors are still relevant as contributors to volatility and regional price swings, but since about 2005 they have been completely overwhelmed by the dramatic increases in the price of crude oil. All motorists and undoubtedly most marketers and dealers would gladly exchange an average price at the pump of $1.50 with the occasional spike to $2 per gallon for the massive volatility and peak prices we see today.

This two-part article will take a look at what has changed since 2000 and discuss in specific detail the opposing arguments that today’s prices either reflect natural market forces or are driven by speculation largely linked to large investment banks, index funds, “dark” swaps markets and a bunch of money in search of an outlet. Part one will focus on the functional changes that have taken place through globalization driven demand and a view of decreasing world supply that is driving the supply and demand argument. Part two will look at financial regulatory changes and the argument that out-of-control speculation is driving excessive prices along with the legislative remedies that are now in the rulemaking process.


Supply and demand — China and the developing world

In the latest (Jan. 11, 2011) United States Energy Information Authority Short-Term Energy Outlook the administration expects the price of West Texas Intermediate crude oil to average about $93 per barrel in 2011. And for 2012 EIA expects WTI prices to continue to rise, with a forecast average price of $99 per barrel in the fourth quarter 2012. For gas prices, EIA expects regular-grade motor gasoline retail prices to average $3.17 per gallon this year and $3.29 per gallon in 2012.

“We forecasted growth in world oil consumption this year of 1.4 million bbl/day compared with growth last year of 2.2 million bbl/day in recovering from the recession,” said EIA Chief Economist Tancred Lidderdale in an interview. “The 1.4 million barrel per day growth is similar to the growth of the first half in the last decade say from 2000 to 2007. The uncertainty is that all of the forecast growth is coming from the developing countries: China, India and the Middle East. And how strongly they grow is always going to be a significant uncertainty. A forecast stronger than that would lead to higher prices and that’s what we saw in December. Prices rose on the market and one of the drivers was apparently the news of improving economic outputs.”

As the EIA notes in a country-specific analysis, China is the second largest oil consumer behind the United States. China shifted from being a net oil exporter to a net oil importer in 2006 and the country is also now a net importer of diesel. China’s oil consumption growth accounted for about a third of the world’s oil consumption growth (but not actual consumption) in 2009.

Although the recession generally stunted oil demand internationally, China was less impacted than the United States and its demand is already ramping up. As with the United States, oil consumption is overwhelmingly linked to transportation fuels.

Platts, a leading global provider of energy and metals information, recently released an analysis of Chinese oil demand for 2010 that found an increase of 11.43 percent to an average 8.71 million bbl/day. The oil and gas consulting firm FACTS Global Energy similarly expects China’s oil demand to increase to an average 9.5 million bbl/day in 2011. By comparison, the United States currently consumes about 19 million bbl/day.

In a Feb. 1, 2011, interview in China Daily, Zhang Fuqin, deputy chief engineer with China Petroleum Planning and Engineering Institute, expects China’s demand for oil products to grow at average annual rate of 4 percent to 5 percent in the 2010-15 period based on an annual GDP growth rate of 7.5 percent.

As the standard of living increases in these developing nations so does the ownership of automobiles and the consumption of gasoline as well as the commerce related consumption of diesel fuel.

Correlating with oil consumption, China has become the leader in new-car purchases and Chinese officials expect there to be 75 million cars on the road in 2011 and perhaps 200 million cars by 2020. This compares to approximately 250 million cars in the United States, some of which represent multiple cars owned by a single driver .Chinese economic policy has vacillated between encouraging and discouraging automobile ownership, particularly as current congestion has reached alarming proportions. Obviously, this growth will strain production capacity.

From a near-term oil supply standpoint, EIA expects non-OPEC crude oil and liquid fuels production to rise by 160,000 bbl/day in 2011 and a further 20,000 bbl/day in 2012. EIA expects that OPEC members’ crude oil production will continue to increases by 0.5 and 1.1 million bbl/day in 2011 and 2012, respectively. In general, most estimates see production keeping up with demand for at least some period of time.

Where longer-horizon supply is concerned, the issue of “peak oil,” or at least some variation on the concept relative to the belief that production capacity (and new reserves) will continually decline as demand continually increases, also comes in the play. The timeline for this tipping point varies greatly between a mere handful of years to many decades depending on a range of credible sources.

Where reserves are concerned, BP statistical data notes a general increase in reserves between 2008 and 2009 of about 700 million barrels n Brazil, Denmark, Saudi Arabia, Egypt and Indonesia to a total of 1.33 trillion barrels. Counteracting that is the time required to exploit the new reserves relative to the drop-off in production capacity among a number of mature fields such as those in the North Sea and Mexico. As noted, no specific timeline is accepted as fact at this point, but where the futures markets are concerned a tipping point somewhere between 2014 and 2020 seems to be popular.


Some traditional volatility drivers

As noted previously, the price of crude is the fundamental driver behind current oil and gas prices. However, more traditional regional, national and international motivators relative to regional supply, demand and inventories in both crude and refined products can still play a notable, but more short-term, role in prices. A few recent examples stand out.

“The strikes in France in October triggered gasoline prices to move sharply higher in the New York Harbor market,” said Brian Milne refined fuels editor for Telvent DTN, a leading business information services company that is focused on the agricultural, energy, public safety, aviation, turf, recreation, construction, transportation and environmental business sectors.” That was part of the reason helping the fourth-quarter (2010) rally. That was a month-long strike and we saw gasoline supply drawn down to a 13 month low and it does show you how quickly you can see supply drawn down if something happens.”

Refinery utilization has dropped significantly in the United States since the recession and along with it refiner profits and this has led to over capacity and the closing of some refineries. This is seen as being acceptable in the long run as U.S. demand is expected to continue to be relatively stunted even after the economy improves due to more stringent CAFE automobile mileage standards and the anticipation of at least some continuation of alternative fuel initiatives.

This, for the most part, simply represents the continuation of rationalizing supply and demand in the U.S. refining sector that got underway with a major push in the 1980s after the oil industry was deregulated. At that time, there was a veritable bloodbath roughly half of the U.S. refineries were closed—typically the older and less efficient facilities. The capacity was replaced, and then some, by ramping production capacity at the remaining refineries.

As domestic demand increases refining capacity will become tighter and margins will increase and this will undoubtedly nudge gasoline and diesel prices slightly higher and increase the likelihood of some of the more traditional volatility impacts relative to disruption. Even in the current economy this traditional factor has come into play.

Seasonal refinery switchover and maintenance cycles still improve prices (though sometimes the downward adjustment has lagged of late).And Milne noted that the market moved up when the St. Croix refinery in Hovensa was down for repairs and with additional impact from ConocoPhillips New Jersey refinery maintenance and a Canada refinery shut for maintenance. That triggered an inventory drawdown. With specific products, such as distillates, fairly recent changes in the marketplace can be expected to have a notable, national impact.

“One thing that is important to note is that there really is little difference anymore between heating oil and other distillates, specifically diesel,” said John Kingston, Platts global director of news. “They’ve all pretty much gone to lower sulfur. I’ve always felt that the higher sulfur level did give some sort of a safety valve. If you had a bone chilling winter and you have some sort of supply problem you can always bring in very high sulfur stuff from Europe and other areas of the world. That is not going to be available anymore.

There is always the possibility that the government is going to grant a waiver but these markets tend to react very quickly, so you fuel the spike in heating oil you can imagine rather quickly some trader going and buying high sulfur stuff and immediately selling about one month into the Nymex and delivering against it. That’s not going to be available anymore.”

Kingston noted another concern relative to low sulfur diesel as prices fell is that refineries might delay the construction of hydrotreaters, which are used to de-sulfur diesel. “We’ve been O.K. now because we have plenty of spare capacity, but if there’s going to be a strain on the system over the next couple years. I think you’ll probably see it in the diesel market,” he said. “Will that capacity — that was so strained back in 2008 — be strained again? There was always some feeling that some of the strain came from just transitioning to lower sulfur diesel levels in Europe and that maybe the market has kind of gone through that transition. Time is going to have to play out.”

Finally, the impact of political uncertainties in the Middle East, such as the recent turmoil in Egypt and potential confrontations with Iran, as well as in other oil-producing countries, will continue to play a significant and fairly traditional role in driving the markets relative to supply concerns.


The price of the dollar

The U.S. dollar is used (at least for now) as the currency for the world’s oil market. Therefore, when the price of the dollar is strong the price of oil, and therefore refined products, to the U.S. consumer tend to be lower. “Right now we’ve been seeing the dollar strengthen recently, but we saw the dollar moved sharply lower and that pushed up your domestic prices,” said Milne. “And not only that, but when you have a weakening currency your investors will look to assets that will hold or gain value over time. So if you think you can hold it in dollars and the dollar is going to weaken that is not good. You want something that will preserve that cash, actually make money on it, and commodities were seen as a good way of doing that.” The latter issue noted by Milne will be discussed in greater detail in part two of this article.

The value of the dollar can also have some global demand-related impacts. “The relationship between the value of the dollar and oil prices is very complex,” said EIA’s Lidderdale. “There is the fundamental theory that as the value of the dollar declines, relative to the Euro, oil essentially becomes cheaper in Europe because they are buying it in dollars and selling it in Euros. And because the price is lower, demand goes up in Europe and therefore the price has to globally increase to restrain demand elsewhere and maintain a balance.”

Lidderdale noted that the estimated impact of this demand factor is relatively small. He also outlined how U.S. domestic economic policy has impacted the price of oil from a demand standpoint.” As the U.S. economy is stimulated through monetary policy, because China maintains a relatively fixed exchange rate with the United States that stimulus is transmitted overseas,” he said.” A stimulus to the U.S. economy is also a stimulus to the Chinese economy and that growth in demand translates into a growth in crude oil demand, which pushes oil prices up. And the rise in oil prices for other reasons can affect the value of the dollar as it effects a change in relative asset valuation between oil-producing economies and oil consuming economies. So over the long run there is definitely a relationship between the value of oil and the value of the dollar.”

This wraps up the case generally presented by the investment banks, some mainstream economic and political pundits and to some extent the EIA that significant global supply and demand factors primarily drive current oil prices and the resulting prices of refined products. In part two we will present the case that these factors, even should they be accurate long-term assessments of the market dynamics, cannot account for the extraordinary increases in oil prices since roughly 2005.While much has changed in the world relative to the physical product, similar and extraordinary changes have occurred relative to the players in the futures markets and the rules under which they operate.


Keith Reid is editor in chief of National Petroleum News and Fuel Oil News, publications of M2MEDIA360 (publiser of Landscape and Irrigation magazine).

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