Sunday, January 6, 2008

Refining the Truth on Oil

I was in Gallup, NM the other day, my kind of place when I seek to escape from urban life. Formerly dubbed “the drunk city”, the night-life sounded promising, so I walked into the most decent-looking establishment, went straight to the bar and ordered a gigantic cheesecake. My order did not go unnoticed by the surrounding guests, who were already on their nth beer, and soon enough we were engaged in the usual introductory chat on where we're from, what we do and how many guns we own.

The conversation took a promising turn to politics, when an avid shotgun owner of three began a passionate Bush-bashing. Intrigued by the apparent inconsistency in values, I probed further, only to get the following response: “Look at where gas prices are! All thanks to ‘effing’ George Bush!”

Hmm.. Of all the things one can blame Bush for, gasoline prices is probably the least pertinent. And here is why:

The market for oil is not entirely different from the markets for other products. There is demand, and there is supply, and there are also a few other factors such as geopolitics, weather or market speculation. So let’s take them one by one.

Blame it on China? Growing global demand for oil is an obvious candidate for higher oil prices. That’s partly true, though demand has not grown fast enough to fully explain the surge in prices. Indeed, despite swelling petroleum consumption by the likes of China and India, these countries still account for just a tenth of global consumption, compared to, say, America, which consumes a quarter of the total. And oil demand here has been fairly stable.

Capacity squeeze. That said, even a small increase in demand can make a difference when the ability to accommodate it is limited. Which turns us to the supply side. Underinvestment has meant that global refining capacity (which is how many barrels of crude can be processed per day) has been expanding by a meager 1% annually over the past decade. This is less than the growth in consumption, stretching the available refining capacity to the limits, and pushing up prices.

And then you have the occasional drops in supply due to hurricanes, unrest in Nigeria, a nuclear Iran and, of course, the Iraq saga.

Back to the futures. This combo of factors has encouraged bets that oil prices will keep on rising, driving up the prices of the so-called "oil futures" (basically contracts that preset the price of a barrel of oil a trader will receive in, say, three months). Oil futures prices have risen even further, as some see them as a vehicle to protect themselves from a falling dollar or from declining interest rates on, say, deposits or US Treasuries. And for reasons that I won't discuss here, oil futures prices play a significant role for the price of oil today.

Finding solutions. So what can Bush do? Kill America’s “addiction to oil”? Hard to see it happen without the use of the “T” word to prohibitive levels or the promise to exterminate every SUV in the country—a measure I would support on purely aesthetic grounds!

Bully OPEC to produce more? Well, diplomatic logistics aside, a recent university study in Germany suggests that the price-setting power of OPEC has diminished, partly because its capacity to accommodate additional demand has declined.

Impose price controls? But why then stop on oil? What about house prices, or even milk prices, which have also surged?

OK, maybe he could have done something to reduce geopolitical tensions... maybe.

Truth is, we'll likely have to live with high gas prices for a quite a bit longer; at least until new investment translates to additional capacity and/or alternative sources of energy take hold.

As for the meantime, the man at the bar had a handy solution on how to fuel ourselves, borrowed from a popular country song: “Whiskey for my men, beer for my horses”.

Glossary: Demand, supply, refining capacity, OPEC, alternative sources of energy, whiskey and beer.

Useful links:

Give me a break: Oil prices

"The $100 barrel" from

A primer on gasoline prices

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