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By Robert Rapier on Jun 17, 2014 with 10 responses

The Oil Markets as a Thanksgiving Turkey

This week BP (NYSE: BP) released their Statistical Review of World Energy 2014. This is always a big event for energy wonks, and as always I will break it down in a series of articles. My goal is always to flesh out important tidbits that were perhaps overlooked by the media. Here are some of the major findings from this year’s release that have been reported. In 2013:

  • US oil production had the largest increase in the country’s history
  • US oil demand grew at a faster pace last year than China’s, although China’s overall energy demand grew faster
  • Asia increased solar output last year more than Europe for the first time ever
  • Emerging economies accounted for 80% of energy consumption growth
  • Global oil production rose to a new all-time high

In one of those overlooked tidbits I like to point out, while global oil production did indeed set a new record — rising in 2013 by 557,000 barrels per day (bpd) over 2012 — without the US increase of 1.1 million bpd, global production would have declined by 554,000 bpd. But I will take a deeper dive into that starting next week. Today I want to talk about Iraq.

Or, more precisely the impact the unfolding events in Iraq have had on the global oil markets, and more specifically how those oil markets actually work. I had an interesting discussion with someone last week, after a remark was made about oil companies using any excuse — like potential supply disruptions in Iraq — to immediately jack up oil prices.

I explained that this is not how the oil markets work. In some cases you do have countries (e.g., Saudi Arabia) setting prices, but most of the oil on the markets is simply determined by how much people are willing to pay for it. ExxonMobil (NYSE: XOM) doesn’t say “I think I will raise the price of oil today by $5 a barrel.” What they earn in most cases is based on contracts tied to the price of oil set on exchanges like the New York Mercantile Exchange (NYMEX). There the price of oil is determined by buyers and sellers. It is influenced by fear, greed, supply, demand, hoarding, speculation — you name it.

Here is an illustrative example. The person I was discussing this with works at a supermarket. So I said to imagine the oil markets like this. Thanksgiving is approaching, and 30 families would all like to buy a turkey from the local supermarket. Unfortunately, this is the only supermarket in town, and they have only 10 turkeys. If the supermarket prices the turkeys at $1, they will be gone very quickly. In fact, unless the supermarket limits purchases to one per family, some enterprising person may buy them all up so they can resell them for a higher price.

If the supermarket prices them at $20 each, some of those families are going to decide they don’t have to have turkey for Thanksgiving. This is rationing by price. At certain price points, fewer and fewer people are going to buy the turkeys. At $100 each, nobody will buy them. At $1 each, they won’t last long.

Now imagine that the supermarket decides to allow the price to be determined by bidding. The 10 turkeys are priced by the amount the 30 families are willing to bid. Everyone is willing to bid a dollar or three or five, but people start to drop out as the price rises. Poorer families may not be able to afford a $20 turkey (although the poor may hang in longer than you might imagine, especially if they have no other options).

Further imagine that there is no limit on how many turkeys a family can buy. Someone who thinks these turkeys will be worth a lot more in the future could buy them all up. One family could buy up all 10 turkeys, outbidding the other 29 families. Or a local financial institution who has no need for them at all, but sees an opportunity to make money from a shortage, could get involved in the bidding (which happens on a large scale in the oil markets). This is speculating, and is one of the factors that sets oil prices.

To close the loop on the situation with Iraq, imagine that news comes along that 2 of the 10 turkeys are at risk of not being delivered to the supermarket. Suddenly instead of 30 families bidding for 10 turkeys, you now have them bidding for possibly only 8. Now instead of the top 10 bids being accepted, only the top 8 are accepted. This means that the overall price is higher.

That is the analogue to the situation in Iraq, and why oil prices react quickly to the possibility of some of Iraq’s oil supplies being taken offline. Iraq’s oil production has risen 8 years in a row, and makes up 3.7 percent of the world’s oil supply. This global supply has very little spare capacity in the system, so oil removed from the global supply has a disproportionate impact on the price.

So while the oil companies aren’t directly setting prices, they do of course benefit in this situation (unless they happen to have production in Iraq that is taken offline). As oil prices rise — due to whatever mechanism — the profit per barrel of oil increases. However, people often confuse cause and effect. Profits rose because oil prices rose in the market. Oil prices weren’t increased in order to boost profits. If that’s the way things worked, you would never see profits go down and the oil industry wouldn’t be cyclical as it has been for decades.

Link to Original Article: The Oil Markets as a Thanksgiving Turkey

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  1. By Røbertøe Andersøn on June 17, 2014 at 3:22 pm

    I don’t like the Turkey analogy because there’s lots of other foods – ham, beef, chicken- that can be substituted for turkey. We’re finding out – too late- that oil, the commodity that economists have always deemed to be expendable, replaceable and no more important than any other input variable were WRONG. Economists and everyone else have thought, and treated any analysis, like there is no difference between pre-peak and post-peak economics, foreign policy and business operations. WRONG again.

    • By Robert Rapier on June 17, 2014 at 3:39 pm

      Yes, there are foods that can replace turkey, but I used Thanksgiving specifically because for many, it isn’t Thanksgiving without turkey. For example, I am pretty sure that in my 46 Thanksgivings we had had turkey 46 times. :)

    • By Optimist on June 17, 2014 at 7:17 pm

      How are they WRONG? GTL technology exists and can be used to convert natural gas into liquid petroleum, as is done at the Oryx plant in Qatar. CTL exists and can be used to convert coal into liquid petroleum, as is done by SASOL in South Africa.

      I guess oil is still too cheap to make the alternatives good investments.

      • By Røbertøe Andersøn on June 17, 2014 at 8:36 pm

        You are honing in on the problem. Oil is still too cheap to make alternatives work and its already too expensive to allow global economies to grow.

        There’s a couple of economic train wrecks embedded in our current free market approach to oil and resource depletion. The one is environmental- climate change. True environmental costs are not reflected. But putting that aside, there’s a growing school of economics that demands the recognition of the substantial fundamental differences between a pre and post peak environment.

        Contrary to conventional economics, post-peak oil production is
        actually worth vastly more than pre-peak output. But this core
        fundamental was not even on economists’ radar screens. Every project I’ve ever worked on in my career (+30 years in the oil business) incorrectly discounted the future value of oil. This has been proven to be way off base. Further, oil is vastly more important than any other economic input variable. Its not expendable and replaceable although treated as such. So we developed, pumped and consumed lots of oil at economics that were too cheap. We’ll pay lots more in the future because oil was incorrectly valued in the past. And these post peak economics will not allow non-energy sector economic growth. No growth equals no debt service.

        U.S. oil production peaked, in 1970 at less than $3 per barrel. Using
        the same type of faulty economics, the U.K drained most of its North
        Sea supplies into sub-$12 per barrel economics. We both will now import oil at $120-plus. How prudent was this? So free markets functioned properly?

        Our economic signals encouraged maximum oil output, monetization and consumption because economics insinuated oil wasn’t anything special & some other energy supply would flow into the inevitable higher prices. It hasn’t, and it might not.

        The much-heralded invisible hand of free markets has delivered too-rapid energy resource depletion, sky-high peak energy prices,pollution, oil wars and huge wealth transfers to very unsavory regimes. Unfortunately, the imperative energy solution seems to be invisible, as well.

        I’d say we got it WRONG.

        • By Optimist on June 17, 2014 at 9:08 pm

          Well, that’s one way of looking at it.

          What do you make of fracking becoming economic at $100+/bbl? And if a certain oil price could make previously unrecoverable oil recoverable, what would prevent it from happening again in the future?

          Why do you say that oil is too expensive to allow global economies to grow? The global economy is still growing (in spite of everything), isn’t it?

          There is no oil price that kills the global economy. At really high prices, we all work for our allies, the Saudi’s. But, luckily, before we get there, the current prices would tend to reduce demand and get more supply to market.

          And, of course, at some price renewables might even make sense.

          “Every project I’ve ever worked on in my career (+30 years in the oil business) incorrectly discounted the future value of oil.”

          Or were people being conservative on purpose? Making predictions is not a hard science, and never will be.

          “The much-heralded invisible hand of free markets has delivered too-rapid energy resource depletion, sky-high peak energy prices,pollution, oil wars and huge wealth transfers to very unsavory regimes.”

          Not quite, IMHO. Resources are far from depleted. Energy prices are far from sky-high. That might change soon, as events in Iraq unfolds. Pollution is an ongoing problem: we can always pollute less, and we will. At least those of us outside authoritarian regimes. Oil wars has a nice ring to it, but it is really a meaningless term. How might recent events in the Middle East have unfolded differently if they had no oil? Wealth transfers to our “unsavory” allies in the Middle East is a function of politicians creating an expectation that cheap oil is a birthright. Then again, the politicians are only doing it to please the uneducated voters.

          Indeed, the invisible hand is no savior, and conservatives would do well to recognize that. It’s just that the invisible hand tends to work better than anything else we’ve tried so far.

          Do you have a workable alternative to the invisible hand? Please, no reference to the “benevolent” dictator that Peak Oilers always fantasize about. No dictator ever stays benevolent very long…

          • By Røbertøe Andersøn on June 18, 2014 at 9:43 am

            Fracking is a problem posing as a solution. Trickles of energy for long term pollution problems. The only thing that makes it viable is U.S. tax policy that allows the deduction of exploration and drilling costs and depletion allowances (that can exceed initial expenditures).

            The U.S. economy isn’t growing. 2014 GDP is mimicking the 30s thus far. There’s too much analysis that inversely correlates oil prices and economic growth. Google is your friend. I don’t want to hijack this thread any further. Its supposed to be about Robert’s work which I have a great deal of respect for.

            Let me just close with this. Neither our economics or nearly any other analysis acknowledges any difference between our pre-peak and post peak environment. Isn’t it getting obvious that this is hugely flawed? I’d love to see Robert address this.

            Peak oil:
            ~does not mean we will run out of oil. We never will. (lots of it isn’t financially or net energy viable.)
            ~means we can no longer grow oil supplies like we have for +150 years.
            ~means the political power shifts from oil consumers to producers.
            ~means the propensity for oil wars escalates.
            ~means prohibitively high energy costs.
            ~means onerous wealth transfers to our adversaries.
            ~means conventional economics got it wrong.

            • By TimC on June 18, 2014 at 10:16 am

              “Historically, there has been a tight link between oil production and global economic growth. If oil production can’t grow, the implication is that the economy can’t grow either. This is such a frightening prospect that many have simply avoided considering it.” – James Murray and David King, “Oil’s Tipping Point Has Passed”, Nature Comment, 2012.

              Optimist seems to be one of those who prefers to avoid considering it. The problem is not oil price, it is oil supplies, and the inability to expand them. Higher oil prices driven by inadequate supply can never solve the problem of inadequate supply. Fracking, GTL, CTL, and other nonconventionals that only make economic sense in undersupplied markets will not provide the supply growth that will allow the world to side-step the grisly prospect of endless recession. And we will be deciding who gets the drumsticks by breaking more than a wishbone.

  2. By Forrest on June 17, 2014 at 4:33 pm

    Your spot on with market setting the price. Cause and effect on market selling price are well known, but hard to predict the impact other than generalities of increase or decrease cost. Anytime supply is close to demand the market swings are more pronounced. Minor hiccups in supply chain will have dramatic influence on price of petrol. Plant shutdowns for switching to boutique summer blends of low VP blend stock, hurricane forecasts, news of fuel saving technology, battery advancement, economy, to name just a few. Oil price is volatile, and because of being so, a exceptional opportunity for speculators. Back 8 years ago, an investigation on corruption of financial institutions as it was thought they were exploiting oil futures during this period of rapid price swings. Teacher retirement fund was one that made a fortune playing the oil markets. This speculation will push the price of oil higher than normal market influence, but, also, acts to dampen demand quicker. Problem with oil, the market is somewhat inflexible, i.e. you can’t suddenly trade in for a Prius.
    The volatility of oil markets is key to understand the math of ethanol claim to save the public one dollar per gallon of gas. That is a overall figure of fuel costs including economic influence of markets. While ethanol is 60-80 cents cheaper typical per gallon at the trading markets, the rest is per economics of stabilizing gasoline price and increased competition. These are only economic estimates on savings and can never be proven, the fact remains when ethanol pumps one million barrel/day fuel on the market it dampens price. Ethanol wholesale fuel cost is a stabilizer to prevent as rapid and high price swings. Also, this influence is magnified per the growing popularity of ethanol plants contracting and delivering directly to retail. Gas stations installing denatured ethanol tanks and E10 tanks. Blender pumps allow customers their choice of mix. Ethanol has more room to compete and can make a decision to compete on price, when avoiding the typical oil supply chain hand-offs and control.

    • By Optimist on June 17, 2014 at 7:48 pm

      An alternative is always a good idea – I’ll spot you that. It is also why the US should allow ethanol imports from Brazil. Another alternative.

      On the whole ethanol is too way too small to make a real difference on price, and $1/gal is a ridiculous claim.

      On speculators: speculators can act to stabilize prices (buy low, sell high) or destabilize it (buy high, sell low). But before you write your Congressman a strong worded letter, consider this: the market has this covered. The speculator who stabilizes prices will make money, the other kind loses his shirt. So unless you’re inclined to believe that speculators like to lose money, thank them for stabilizing prices.

      The current crisis in Iraq is a perfect example. No doubt there are speculators out there who have started buying, contributing to prices already rising. In effect, these speculators are betting that things will get worse in Iraq before they get better. If supply does indeed get interrupted, there would be a fairly significant rise in the oil price, and these speculators would make a tidy profit. But also note, they’d be selling oil into a market where demand exceeds supply, thus contributing to stabler prices during the interruption.

      Of course, it may also become apparent in the next few days that Iraqi supplies are safe, and the oil price would return to pre-crisis levels. In this case, the speculators would have bid up the oil price unnecessarily. They’d also lose their shirts doing so…

  3. By Poechewe on June 21, 2014 at 12:27 am

    Most of what Robert says about oil prices is about right and probably works that way most of the time. But not always. If somebody can sell a product at a higher price, and get away with it, they will.

    In the late 1970s, a period of inflation, the prices of consumer products (oil, antifreeze, etc.) for oil companies often rose faster in prices than anything else. There was a reason. An informal agreement developed among a number of oil companies: raise the prices every six months according to the rate of inflation, and add nine percent. The formula tended to add to inflation but was useful for the small companies that often packaged consumer products for the oil majors.

    Also, one subset of gas stations tend to sell gasoline at higher prices: very able auto mechanics who own a gas station in a wealthy area who aren’t interested much in selling gasoline: so they keep their prices high. And a certain percentage of people pay them.

    Although I know a few things, I’m still trying to understand exactly how gas station owners can do well for a number of years and suddenly start going out of business when prices start rising. And why is it that the same corner will have four or five nationwide names selling gasoline one after the other?

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