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‘”The 5-minute ENEGY Blog: OIL PRICE ‘MYSTERY'”

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Tim Dunn is the president of CrownQuest, an oil exploration company, and the author of many previous “5-minute ENERGY Blogs.” Previos posts in this serious on energy for beginners (which would appear to include most of the Obama Administration) can be found here.

The 5-minute ENERGY Blog

POST 9: OIL PRICE “MYSTERY”

We have previously established that oil is a green, organic, solar-packed miracle fuel that has spawned an explosion of human productivity around the world. Perhaps that is why there is so much attention paid to its cost. Even though at $85/barrel, a 12 ounce can of oil costs only about 19 cents, when oil prices increase substantially Congress begins hearings to find out why, as though it’s a mystery.

It’s not.

The New York Mercantile Exchange, or NYMEX created a contract to trade West Texas Intermediate (WTI) Crude in 1983, a couple of years after American oil was deregulated. From that point forward crude oil pricing became very transparent. The NYMEX works very similar to a stock exchange, except it trades contracts. Each WTI oil contract is a purchase and sale of 1,000 barrels in a given month delivered to a tank located in Cushing Oklahoma. Most contracts get settled in cash, but it is important to note that a holder of a contract can insist on physical delivery. This requirement puts a severe limit on speculation.

The commodity markets are quite amazing. You can trade just about any agricultural product, including hog carcasses and whey. There is also a market for precious metals and a large array of energy products. There is even a market to trade weather (Heating Degree Day is a large factor in energy usage.) Through this exchange parties can trade risks and make more definite plans.

Southwest Airlines somewhat famously “bought” several years of fixed jet fuel prices via the commodity markets, and it kept their ticket prices lower for some time. On the other side of that trade might have been an oil company like CrownQuest who locked in a fixed price and had to pay the difference to SWA.

But for a company like CrownQuest, locking in our future price provides a lot of financial certainty. We can borrow a lot more from banks, for instance, because they know what the price will be. So even though we might leave a lot of profit on the table, we still come out ahead because we can do things we wouldn’t otherwise be able to do.

Perhaps the Pavlovian reaction of politicians to call for hearings about oil or gasoline prices stems from a former era; prior to 1983 and the NYMEX oil contract pricing was mysterious. I asked my boss in 1979 or so how oil prices were determined. He was a 20 year engineer at Exxon, and only sort of knew. Back then the price was set by big refiners (large oil companies) who set a “posted price” for crude oil, and that’s what they paid. It seemed no one really knew how they came up with the price.

I think the reality is they came up with a price that grew demand for their product, oil. Up until the early 1970’s, the major oil companies had planning departments that would forecast world oil demand, look around the world to see where the best places to meet the demand came from, and drill accordingly. This era resulted in amazingly low and stable oil prices. So we in the US got used to low, stable prices.

The private sector major oil companies controlled enough of world oil production to control the price, and when they did they kept the price low. For example, until around 1980 Exxon, Mobil, Texaco and Chevron owned and controlled Aramco. That gave them effective control of the Saudi Arabian production levels for much of that time. However, there came a day when that control ended.

I remember one of the Exxon Engineers who worked as a top manager in Aramco during the 1970’s telling me that the planning department had decided that Arabia needed to make investments to produce 12 million barrels per day in order to meet expected demand, and the Saudi government said “We don’t want to produce more than 8.” He said he wrote in his journal “The world changed today.” That set the stage for subsequent price jumps. (Today, Saudi Arabia still has the biggest influence on prices, and still is reluctant to produce more than 12 million barrels per day.)

Today, private sector major oil companies no longer control very much of the world’s oil production. Many majors like Mobil and Texaco no longer even exist. Aramco is controlled by the Saudi government. An estimated 85% of the world’s reserves are now controlled by governments. And, more directly applicable to oil pricing, oil prices are now determined by an open market exchange, the NYMEX.

So next time you hear about Congressional hearings, or a pin-headed commentator railing against Big Oil raising prices think “85% of the world’s reserves are controlled by governments and the price is set by the market via NYMEX” and you will know all that’s needed. Using a major oil company as a whipping boy for price increases is about thirty years out of date.

Hughniverse

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