By Julian Delasantellis
In 1980, Paul Simon sang of a "One Trick Pony", an animal that "does one trick only - it's the principal source of his revenue". These days, the world's major oil companies are a lot like this animal. They do one thing - engineering price rises by restricting gasoline supply through manipulation of oil-refinery output - really, really well and, much like the pony, they make lots and lots of revenue from this activity.
In my April 4 article in Asia Times Online, Crude: Barrels of fun to crack you up, I explained how the rise in prices of world oil products going on at that time was not, as the popular media were then proclaiming, the result of tensions over the 15 British sailors then being held by Iran; it was more the result of the lack of any spare capacity worldwide to refine oil, a condition that, at the very least, the oil companies found serendipitous. Now that the sailors are home, safe and sound in the warm, loving bosoms of their literary agents, you might have expected oil and gasoline prices, if only just for show, to give back some of their March gains.
Not on your life, as all US drivers know. Like vampires, they now fear each new rising of the sun, for it is then they will learn just how much retail gasoline prices have risen overnight. According to the US Department of Energy's Energy Information Administration (EIA), average US retail gasoline prices have risen every week since early February. The national retail average of US$2.876 for a gallon of regular gasoline (75.98 cents per liter), as of the April 16 report, is the highest price since the historical twin peaks of just under $3.10 early last summer and just after Hurricanes Katrina and Rita in the early autumn 2005. The national average masks wide regional disparities; lower in the Midwest, but on the west coast, the average is already at $3.195 (84.4 cents a liter).
But like those of a bad magician at a child's birthday party, the oil companies' tricks are showing. Government-released oil-industry data, along with the oil futures markets, are showing the world just exactly how this trick works - lucky for them the world, as usual, is looking elsewhere.
When the US media report on what's happening in the oil markets, what they are really reporting on is a commodity called West Texas Intermediate. WTI is what is called a commodity benchmark - it's the basis for the crude-oil futures contracts traded at the New York Mercantile Exchange (NYMEX).
When a trader commits to buy, say, 10,000 oil futures contracts, and does not then sell or roll over the contracts prior to one of their monthly expirations, the trader has no intention of having 420,000 gallon pitchers filled with oil delivered to the trading floor in Lower Manhattan. Instead, written into the specifications of the futures contract is a proviso that the seller of the oil must deliver the commodity to the nexus of oil-pipeline connections at Cushing, Oklahoma - from there, the owner of the crude oil can make arrangements for the product to be delivered to and refined at one of the many nearby Gulf of Mexico Coast and Midwest refineries. Europe has its own oil benchmark, Brent Crude, originating out of the oil-drilling platforms in the North Sea, and traded at London's International Petroleum Exchange.
WTI can be refined into a less polluting, "cleaner" fuel than Brent, so it normally trades at a premium of about $1 above what Brent is trading at. However, this year, the reverse is happening, and is happening rather dramatically. On April 10, the premium for Brent over WTI widened to a historical high of more than $6 a barrel.
What's happening here, in the fall-off in demand for WTI and the accompanying surge in Brent, is that the oil companies are becoming so brazen in their attempts to manipulate the markets for petroleum products that it's becoming very, very obvious.
As I noted in my April 4 article, crude oil, by itself, has very little utility. It must be processed, refined, into its usable component products of gasoline, diesel fuel, home heating oil, and jet fuel. The reason WTI is losing relative value to Brent is that it's becomijavascript:void(0)
Publish Postng harder and harder to do that at the traditional networks of refiners that service Cushing. The oil companies have recently shut down so much US refining capacity that there is no place for the crude oil at Cushing to go, no refinery with spare capacity to process it. The massive network of underground oil-storage tanks at Cushing is full, and oil being stored in tanks makes money for no one except the owner of the storage facilities. If you can't refine WTI, there's no reason to buy WTI.
In my April 4 article I demonstrated how oil companies were not building the new refining capacity necessary to meet surging world oil demand; figures from the EIA indicate that they're not even adequately using the US refinery production capability that they already have.
US oil refineries operated at less than 87% of capacity for the first three months of 2007. With the exception of 2006, when production was inhibited by the continuing effects of Hurricanes Katrina and Rita, and the recession year of 2002, that's the lowest average capacity-utilization rate for the first three months of the year since 1992. (Oil companies defend their low early-in-the-year refinery-utilization rates by claiming that they use these months for repairs, for maintenance, and to shift their production mix from winter home-heating-oil blend to summer gasoline blend; be that as it may, it did not prevent US refineries from operating at more than 93% capacity during the first three months of 1998, 92% in 1999, and 91% in 2005.) The refinery capacity-utilization rate reported on February 16 of this year, 85.2%, was one of the lowest weekly rates not affected by Katrina and Rita since the early 1990s.
You could see the workings of the oil companies' trick as it developed. In early January, refinery capacity utilization stood at a healthy 91.5%, and the gasoline crack spread, the crude-oil-to-gasoline price ratio (the crack spread is explored in depth in my April 4 article) that defines the profit to be made from refining crude oil into gasoline, stood at a fairly low $7.154. NYMEX gasoline futures were then trading for less than $1.45 a gallon, the lowest prices for more than a year. It was then, with US gasoline demand still very strong, that the reduction in refinery capacity utilization began; all of a sudden the financial press was full of stories related to various and sundry "accidents" and "repairs" that were causing US refineries to shut down and/or limit production.
By late March, as the Iran/UK crisis began, and as crude-oil supplies at Cushing began to build, NYMEX gasoline futures had risen to $1.95, and the crack spread was near $19, meaning that oil companies were making just under two and two-thirds times the profit on every gallon of gasoline sold that they had in early January. On April 13, gasoline futures topped out at more than $2.20, up more than 75 cents since January. On that day, the crack spread stood at just under $28, meaning that the business of refining oil into gasoline was now four times as profitable as it was just three months previously.
Therefore, is it any surprise that the oil companies have now decided that all those needed "repairs" and "maintenance" can be put off for a while? The most recent report released by the EIA shows that oil refinery capacity utilization now stands at 90.4%, up 5 percentage points from two months previously.
Now that it's so much more profitable to sell the stuff, they might as well make some of the stuff.
With refineries producing this now much more valuable commodity flat-out, it's possible that the worst of the motorists' short-term pain has already been afflicted, but in the longer term, there is no cause for sanguinity. The first of the three big US summer driving holidays, Memorial Day, Independence Day and Labor Day, is still weeks away (May 28); many analysts see a real possibility of mid-to-late-summer US gasoline prices averaging in the mid-$3 range nationally, and closer to $4 a gallon ($1.05 a liter) on the west coast. Until the root cause of these price spikes, the oligarchic nature of the oil distribution and refinery system allowing oil companies to engineer and sustain supply restrictions virtually at will, is addressed, you'll always be reading about something, somewhere, be it Iran, Nigeria, Canada, or Cushing, Oklahoma, that is causing gasoline prices to skyrocket.
Imagine what it must be like to be some young eager-beaver oil-refinery manager seeking to rush his facility back into service before corporate headquarters thinks the time is right. This is the response he might get from the head office, sung to the tune of Paul Simon's and Art Garfunkel's 1966 hit "The 59th Street Bridge Song" (more commonly known as "Feelin' Groovy":
Slow down, you move too fast
You've got to make this shortage last
Hear the consumers' whines and moans
The oil business - it's just so groovy!
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved. )
Tuesday, April 24, 2007
Wednesday, April 4, 2007
Crude: Barrels of fun to crack you up
By Julian Delasantellis
In 1949, the movie It Happens Every Spring chronicled the professional baseball exploits of a bookish US Midwestern science professor, played by Ray Milland, who discovers a chemical coating for baseballs that will make them impossible to hit. However, if somebody was making a movie called It Happens Every Spring in 2007, the subject would not be baseball, but the now annual spring reaming that oil consumers are once again undergoing at the hands of the world's oil interests.
Since the seizure of 15 British sailors in the Shatt-al-Arab waterway by Iranian revolutionary guards on March 23, the price of a barrel of crude oil on the New York Mercantile Exchange (NYMEX) has risen over US$5 a barrel, to just under $67. The American media delight in conflating these separate incidences into one causation; besides the nightly parade of red-in-tooth-and-claw neo-conservatives diverting attention from their disastrous misadventure in Iraq by baying for Iranian blood on US cable TV, a Google search with "Iran", "seizure" and "crude oil" as parameters is now returning over 150,000 articles.
For the world's oil interests, this is delightful. Just like the guy doing card tricks at the traveling carnival, your vision gets distracted by kinetic irrelevancies he does with one hand while the real action goes on unnoticed right under your nose with his other.
Nations fight and young soldiers die over access to crude oil, but, for something universally esteemed as the most valuable commodity in the world, a barrel of crude oil, 42 US gallons or 159 liters, is surprisingly useless. You can't put it in your gas tank, and it won't heat your home. Crude oil must be processed, or refined, to make it into usable products such as gasoline, jet fuel, heating oil or diesel. The world's popular media focus far too much attention on where oil is produced, like the area around where the British marines were seized, and far too little on where it is refined, where the real action is.
Before the mid-1970s, the oil business was a lot easier to comprehend than it is now. Seven major transnational oil companies (The Seven Sisters was the name of a 1975 book by Anthony Sampson detailing their activities), all but two of them American, vertically dominated the entire process of oil production, transport, refining and retailing; a gallon of petrol could very well start as Texaco's property as it emerged from the ground as crude oil in Saudi Arabia, and it would remain Texaco's property until you paid someone to pump it into your car's fuel tank, after which he would then wash your windows and check your oil.
Around the time the Arab members of the Organization of Petroleum Exporting Countries (OPEC) initiated the oil boycott of America in the wake of the 1973 Yom Kippur war, the nations of OPEC began to realize just how lucrative the process of pumping oil out of the ground could be. Gradually, most of the oil production facilities within the national borders of the OPEC nations were nationalized away from the Seven Sisters. Aramco, the collaborative joint enterprise (or, depending on your perspective, the monopoly) of US oil companies operating in Saudi Arabia, became fully owned by the Saudi government in 1980.
The oil companies may have lost the production facilities, but their worldwide networks of refinery facilities, what the oil business calls its downstream operations, remained intact, and, as the oil companies soon learned, in this they would be able to earn a lot more money with a lot less public scrutiny.
Over at NYMEX, besides trading in futures in crude oil, they also trade futures in the major derived products made and marketed from crude oil, gasoline and home heating oil. Besides the stereotypical loudmouthed and clothed peripatetic Brooklyn guy with two years' college working as a floor trader, the energy futures markets exist to serve the wide variety of producers and consumers in the world's oil markets.
Thus, any small retailer of home heating oil can buy futures, legal contracts that guarantee future delivery of the product at a set price, in sufficient quantities to meet his winter supply needs long before it gets cold; by locking in prices he can guarantee supplies even if prices then rise or supplies get disrupted. An owner of a small chain of gas stations can lock in supplies and price of product long before the summer driving season. Most importantly, through commodity brokers, the world's large producers and refiners can, and do, sell product into the market, and, in the case of the large oil companies' refinery operations, can buy crude product to be refined and then sold through their refineries.
The important point illustrated by NYMEX's futures structure is that, unlike the days of the vertically integrated Seven Sisters, the process by which petroleum moves from producer to consumer now contains at least two transactions. There is one transaction which consists of the producer selling to the refiner, another in which the refiner sells to the retailer.
By their very nature, there is a symbiotic relationship between the prices of crude oil and the prices of the products made from it. Crude oil is the raw material of product production, so, if the price of the raw material rises, refiners, to defend their operating profit margins, will seek higher prices for the products as well. Likewise, if the price of the products rise, it will put upward pressure on crude, since, with the products now commanding a higher market price, there will be an extra incentive, creating more demand, to buy more crude, refine it into product, and sell it back into the market.
However, crude prices and the prices of its products do not move in absolute lockstep. A 5% rise in crude over some period of time may produce a 3%, a 4% or a 6%, 7% or 8% rise in the products. If the products' prices are moving higher at a greater percentage rate than the crude, it means that it is becoming comparatively more profitable to be a refiner than a producer of oil, since what you are receiving as a price for your finished product, the petroleum finished products, is rising faster than what you are paying for the raw material you need to make that product, crude oil.
A complex mathematical formula called the "crack spread" ("crack" being the industry jargon verb defining the process in which crude oil is refined into products) illustrates this ever-dynamic price relationship between crude and its products. As it rises, crude's products are becoming comparatively dearer than crude itself. No matter what the media are reporting about the world's various far-flung crises, if the crack spread is rising, the products, especially gasoline, are leading crude oil up, not the other way around.
So what's the crack spread doing during the current Iran/UK crisis? Just like It Happens Every Spring, it's rising, but this year it's rising earlier, faster and higher than previously. From being under 10 for most of the previous six months, it has surged to almost 25 recently. It pulled back a bit early last week, but by Friday, March 30, it was on the move again, closing at 18.37, up 12% on the day.
Every time the price of crude rises and the Western popular media accuse OPEC nations of price gouging, their defense is that it's not them, it's the Western oil companies. The rising crack spread essentially proves their point. There's no real shortage of crude oil; actually, the world is awash in it. Spare refining capacity, that's another story.
Fox News is dealing with consumer concern over rising US energy prices by working overtime to make sure that their newsreaders speak the name "Al Gore", the Oscar winner for An Inconvenient Truth and former US vice-president and Democratic party candidate for president in 2000, as the audio accompanying video of US gas stations displaying $3 a gallon or more prices for gasoline on their signboards. Much like the conditioned-reflex therapy attempted on Alex in A Clockwork Orange, in which he was administered a nausea-inducing and respiration-suppressing drug while watching violent films, thus making him associate the two, the intention here is apparently to make viewers think of, and associate Gore with, the current financial unpleasantness of filling their cars with fuel.
This is an ever-more popular theme in conservative efforts to shift responsibility for the fact that gas prices have reached stratospheric heights under the Bush administration. Supposedly, Gore bears total responsibility for current high prices solely from his previous advocacy of a 50 cent a gallon tax on US gasoline sales to fight global warming. A potential 50 cent rise is, of course, meant to terrify the viewers away from the twin evils of either changing the channel or voting Democratic, but, in reality, it's only just about what the private competitive markets have given US consumers since January.
A more substantive observation than the above is the charge that the political left's allies in the environmental movement, along with the wholly bipartisan American phenomenon of NIMBYism ( not in my backyard) have stifled any new construction of oil refineries within the United States.
Well, something has. There has not been a new refinery opened in the US in 31 years; during that time, the actual number of refineries operating in the US has dropped from 301 in 1981 to 149 in 2003. (This is less dramatic than it seems; US refiners have consolidated many of their, older, smaller capacity refineries into fewer large-capacity refineries.) If more refinery construction had been allowed, it is argued, the refinery capacity crunch implied by rising crack spreads and rising pump prices would never have occurred.
This argument might have more credence but for the fact that oil refining is a process and business that occurs all over the world, and there is no law that states that a gallon of petroleum products consumed in the United States has to be refined in the United States. (Free market conservatives, who are always defending low wages paid to labor by talking about the global market for labor, are not as quick to apply that same principle to the global market for petroleum products.) According to the Oil and Gas Journal, 96 of the world's countries have operating oil refineries within their borders; of the world's 10 largest-capacity oil refineries, only two, ExxonMobil's refineries in Baytown, Texas, and Baton Rouge, Louisiana, are in the US. (The world's largest-capacity oil refinery, the Paraguana Refining Complex in Venezuela, ships almost the entirety of its product of 940,000 barrels a day to the US east coast.)
If environmental Luddites are preventing creation of new US refinery capacity, surely that can't be true in the 95 other countries where refineries are currently sited, not to mention the 100 or so other countries where they are not. Many of these countries are in the Third World; they are desperately poor, and local environmental movements, if they exist at all, are at most nascent. Surely, if the oil companies knocked on their door asking to build a new refinery or expand a currently sited one, they would not say no.
But, like Sherlock Holmes' dog that didn't bark, the story here is the knocks on the doors that don't come, the world refinery capacity that isn't being built.
According to the Energy Information Administration of the US Department of Energy, total world refinery capacity has only increased 1.5% from 2000 to 2005, from 81.53 to 82.8 million barrels a day (mb/d).
This is in the face of surging world oil demand, particularly from the newly industrializing nations of China and India, not to mention the current American rite of passage practice of making sure that, just like mom and dad have, every American teenager has a brand-new 15 miles per gallon sports utility vehicle to drive the six blocks to the massive parking lot outside their secondary school.
According to the International Energy Agency, from 2003 to 2006, world oil demand increased by an average of 2.1% a year. Demand in 2005 was 83.7 millions of barrels per day (mb/d), with refinery capacity that year at 82.8 mb/d, it means that the world is short almost 1 million barrels a day of fuel. Take out refinery capacity taken out for repairs, maintenance, accidents and the unforeseen (in the immediate aftermath of Hurricane Katrina, nine US Gulf Coast refineries, representing 12% of US production, were shut; for many the shutdowns lasted many months) and you get the picture of markets for petroleum products that have much stronger tendencies to rise than to fall.
During the summer of 2000, California electricity supply crisis, when large parts of the state were being subjected to daily electricity blackouts, the late Ken Lay, at that time chief executive officer of the Enron Corporation, a major player in the California wholesale electricity market, mocked David Freeman, chairman of the California Power Authority, by, according to Freeman, stating: "It doesn't matter what you crazy people in California do, because I got smart guys who can always figure out how to make money."
The main thing that Lay's smart guys, as well as the people in the oil industry who are not building new refinery capacity, have figured out is that the market for energy is very unique. When demand is high and supplies are tight, you make less money selling your product than by not selling it. This is what Enron did through taking offline much of California-dedicated electricity-generating capacity for strategically timed (in the California summer, when air-conditioning puts intense demand on power supplies) "maintenance". This drove prices up and created scarcity, not just in California, but all across the western US's interlinked electricity power transmission grid.
"Maintenance" is the same reason that the oil companies annually, including this year, give for taking refinery capacity offline in spring, driving prices up, and setting the world's drivers up for the fuel price increase season that now lasts into early autumn.
This yearly problem, and the tightness in the world's petroleum products markets in general, could be alleviated with new refinery construction, but, as demonstrated above, this is not happening. Oil refinery construction can be a difficult and expensive process, one which probably requires the company to go into debt by either issuing corporate bonds or taking out lines of credit with large commercial banks.
Much better to take the money that would have been spent on refinery construction and use it more judiciously, on things like risk-free short-term dollar or euro treasury securities (currently earning about 5.25% annually) and increased and enhanced corporate salaries, perks and dividends. This strategy is certainly working; oil company profits are skyrocketing. Early this year, ExxonMobil, the world's largest oil company, reported the largest-ever quarterly and yearly profits, $10.71 billion and $36.13 billion respectively, ever reported by an American corporation.
In classical economic theory, excessive price rises are self-defeating for companies. For one thing, they are supposed to tempt other competitors into the market, lured by the profit potential of those high prices, and eventually those high profits would be arbitraged, taken away by other companies, in the market. This does not happen in the petroleum products markets.
The "barriers of entry" for a new competitor, the costs, time and complexity of setting up new refinery capacity and distribution networks are enormous, and so the oil business stays what it is has been for many years, a comfortable little oligarchy, with only occasional new members, like LUKoil in Russia and China National Offshore Oil Corporation in China. Both these now major players in the international oil markets solved the high initial barriers of entry problems by emerging out of the cadavers of former state-owned entities during the eras of communist economic management.
A more substantial reason why this situation continues is the very unique demand profile of petroleum products.
Economists use the term elasticity of demand to describe how sensitive demand for a product is to changes in price. For a product with what is called perfect elasticity, each percentage increase in price is met with equal and opposite reduction in demand, say, a 5% increase in price causes a 5% reduction in demand. In this circumstance, excessive price increases make no sense; what the company picks up in the extra price it loses in reduced demand.
Because they are so essential to modern life, petroleum products have one of the most inelastic demand profiles of any product in the world. It is estimated that in the US, far and away the world's biggest consumer of oil products, their elasticity of demand is around 10%, meaning that for every 10% rise in price there is only a 1% reduction in demand. Only healthcare has a demand elasticity profile anywhere near this low, and, as more healthcare costs are shifted away from insurance companies to actual consumers, economists believe that even healthcare's demand elasticity is normalizing.
Enron knew this when it pounced on California's newly deregulated electricity markets. Over a century ago, US president Theodore Roosevelt knew this when he campaigned for the breakup of the Standard Oil trust. In essential industries with high barriers of entry, you either impose prudent regulation, or the companies run rampant. However, in a capitalist world still dominated by the neo-liberal laissez faire economic consensus, corporate regulation has gone out of style. Therefore, on a fairly frequent basis, you get these news events - like the seizure of the British sailors - that the popular media say are the causes of rising prices, but, in reality, are only distractions, diversions that condition consumers to accept higher prices. The real issue is the continuing uncompetitive nature of these essential markets.
It Happens Every Spring had a happy ending. Ray Milland, who had been playing baseball secretly to earn money to marry his fiance (faculty salaries apparently as lucrative then as they are now), is worried that, if his future father-in-law, the college president, finds out, the wedding will be called off, baseball players apparently being then seen as rather rough individuals. Not to worry, his future father-in-law already knew, and was totally accepting.
He need not have worried. It's not like baseball players were then, or are now, inherently corrupt, dishonest and morally bankrupt.
Like ... oil company executives?
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved. )
In 1949, the movie It Happens Every Spring chronicled the professional baseball exploits of a bookish US Midwestern science professor, played by Ray Milland, who discovers a chemical coating for baseballs that will make them impossible to hit. However, if somebody was making a movie called It Happens Every Spring in 2007, the subject would not be baseball, but the now annual spring reaming that oil consumers are once again undergoing at the hands of the world's oil interests.
Since the seizure of 15 British sailors in the Shatt-al-Arab waterway by Iranian revolutionary guards on March 23, the price of a barrel of crude oil on the New York Mercantile Exchange (NYMEX) has risen over US$5 a barrel, to just under $67. The American media delight in conflating these separate incidences into one causation; besides the nightly parade of red-in-tooth-and-claw neo-conservatives diverting attention from their disastrous misadventure in Iraq by baying for Iranian blood on US cable TV, a Google search with "Iran", "seizure" and "crude oil" as parameters is now returning over 150,000 articles.
For the world's oil interests, this is delightful. Just like the guy doing card tricks at the traveling carnival, your vision gets distracted by kinetic irrelevancies he does with one hand while the real action goes on unnoticed right under your nose with his other.
Nations fight and young soldiers die over access to crude oil, but, for something universally esteemed as the most valuable commodity in the world, a barrel of crude oil, 42 US gallons or 159 liters, is surprisingly useless. You can't put it in your gas tank, and it won't heat your home. Crude oil must be processed, or refined, to make it into usable products such as gasoline, jet fuel, heating oil or diesel. The world's popular media focus far too much attention on where oil is produced, like the area around where the British marines were seized, and far too little on where it is refined, where the real action is.
Before the mid-1970s, the oil business was a lot easier to comprehend than it is now. Seven major transnational oil companies (The Seven Sisters was the name of a 1975 book by Anthony Sampson detailing their activities), all but two of them American, vertically dominated the entire process of oil production, transport, refining and retailing; a gallon of petrol could very well start as Texaco's property as it emerged from the ground as crude oil in Saudi Arabia, and it would remain Texaco's property until you paid someone to pump it into your car's fuel tank, after which he would then wash your windows and check your oil.
Around the time the Arab members of the Organization of Petroleum Exporting Countries (OPEC) initiated the oil boycott of America in the wake of the 1973 Yom Kippur war, the nations of OPEC began to realize just how lucrative the process of pumping oil out of the ground could be. Gradually, most of the oil production facilities within the national borders of the OPEC nations were nationalized away from the Seven Sisters. Aramco, the collaborative joint enterprise (or, depending on your perspective, the monopoly) of US oil companies operating in Saudi Arabia, became fully owned by the Saudi government in 1980.
The oil companies may have lost the production facilities, but their worldwide networks of refinery facilities, what the oil business calls its downstream operations, remained intact, and, as the oil companies soon learned, in this they would be able to earn a lot more money with a lot less public scrutiny.
Over at NYMEX, besides trading in futures in crude oil, they also trade futures in the major derived products made and marketed from crude oil, gasoline and home heating oil. Besides the stereotypical loudmouthed and clothed peripatetic Brooklyn guy with two years' college working as a floor trader, the energy futures markets exist to serve the wide variety of producers and consumers in the world's oil markets.
Thus, any small retailer of home heating oil can buy futures, legal contracts that guarantee future delivery of the product at a set price, in sufficient quantities to meet his winter supply needs long before it gets cold; by locking in prices he can guarantee supplies even if prices then rise or supplies get disrupted. An owner of a small chain of gas stations can lock in supplies and price of product long before the summer driving season. Most importantly, through commodity brokers, the world's large producers and refiners can, and do, sell product into the market, and, in the case of the large oil companies' refinery operations, can buy crude product to be refined and then sold through their refineries.
The important point illustrated by NYMEX's futures structure is that, unlike the days of the vertically integrated Seven Sisters, the process by which petroleum moves from producer to consumer now contains at least two transactions. There is one transaction which consists of the producer selling to the refiner, another in which the refiner sells to the retailer.
By their very nature, there is a symbiotic relationship between the prices of crude oil and the prices of the products made from it. Crude oil is the raw material of product production, so, if the price of the raw material rises, refiners, to defend their operating profit margins, will seek higher prices for the products as well. Likewise, if the price of the products rise, it will put upward pressure on crude, since, with the products now commanding a higher market price, there will be an extra incentive, creating more demand, to buy more crude, refine it into product, and sell it back into the market.
However, crude prices and the prices of its products do not move in absolute lockstep. A 5% rise in crude over some period of time may produce a 3%, a 4% or a 6%, 7% or 8% rise in the products. If the products' prices are moving higher at a greater percentage rate than the crude, it means that it is becoming comparatively more profitable to be a refiner than a producer of oil, since what you are receiving as a price for your finished product, the petroleum finished products, is rising faster than what you are paying for the raw material you need to make that product, crude oil.
A complex mathematical formula called the "crack spread" ("crack" being the industry jargon verb defining the process in which crude oil is refined into products) illustrates this ever-dynamic price relationship between crude and its products. As it rises, crude's products are becoming comparatively dearer than crude itself. No matter what the media are reporting about the world's various far-flung crises, if the crack spread is rising, the products, especially gasoline, are leading crude oil up, not the other way around.
So what's the crack spread doing during the current Iran/UK crisis? Just like It Happens Every Spring, it's rising, but this year it's rising earlier, faster and higher than previously. From being under 10 for most of the previous six months, it has surged to almost 25 recently. It pulled back a bit early last week, but by Friday, March 30, it was on the move again, closing at 18.37, up 12% on the day.
Every time the price of crude rises and the Western popular media accuse OPEC nations of price gouging, their defense is that it's not them, it's the Western oil companies. The rising crack spread essentially proves their point. There's no real shortage of crude oil; actually, the world is awash in it. Spare refining capacity, that's another story.
Fox News is dealing with consumer concern over rising US energy prices by working overtime to make sure that their newsreaders speak the name "Al Gore", the Oscar winner for An Inconvenient Truth and former US vice-president and Democratic party candidate for president in 2000, as the audio accompanying video of US gas stations displaying $3 a gallon or more prices for gasoline on their signboards. Much like the conditioned-reflex therapy attempted on Alex in A Clockwork Orange, in which he was administered a nausea-inducing and respiration-suppressing drug while watching violent films, thus making him associate the two, the intention here is apparently to make viewers think of, and associate Gore with, the current financial unpleasantness of filling their cars with fuel.
This is an ever-more popular theme in conservative efforts to shift responsibility for the fact that gas prices have reached stratospheric heights under the Bush administration. Supposedly, Gore bears total responsibility for current high prices solely from his previous advocacy of a 50 cent a gallon tax on US gasoline sales to fight global warming. A potential 50 cent rise is, of course, meant to terrify the viewers away from the twin evils of either changing the channel or voting Democratic, but, in reality, it's only just about what the private competitive markets have given US consumers since January.
A more substantive observation than the above is the charge that the political left's allies in the environmental movement, along with the wholly bipartisan American phenomenon of NIMBYism ( not in my backyard) have stifled any new construction of oil refineries within the United States.
Well, something has. There has not been a new refinery opened in the US in 31 years; during that time, the actual number of refineries operating in the US has dropped from 301 in 1981 to 149 in 2003. (This is less dramatic than it seems; US refiners have consolidated many of their, older, smaller capacity refineries into fewer large-capacity refineries.) If more refinery construction had been allowed, it is argued, the refinery capacity crunch implied by rising crack spreads and rising pump prices would never have occurred.
This argument might have more credence but for the fact that oil refining is a process and business that occurs all over the world, and there is no law that states that a gallon of petroleum products consumed in the United States has to be refined in the United States. (Free market conservatives, who are always defending low wages paid to labor by talking about the global market for labor, are not as quick to apply that same principle to the global market for petroleum products.) According to the Oil and Gas Journal, 96 of the world's countries have operating oil refineries within their borders; of the world's 10 largest-capacity oil refineries, only two, ExxonMobil's refineries in Baytown, Texas, and Baton Rouge, Louisiana, are in the US. (The world's largest-capacity oil refinery, the Paraguana Refining Complex in Venezuela, ships almost the entirety of its product of 940,000 barrels a day to the US east coast.)
If environmental Luddites are preventing creation of new US refinery capacity, surely that can't be true in the 95 other countries where refineries are currently sited, not to mention the 100 or so other countries where they are not. Many of these countries are in the Third World; they are desperately poor, and local environmental movements, if they exist at all, are at most nascent. Surely, if the oil companies knocked on their door asking to build a new refinery or expand a currently sited one, they would not say no.
But, like Sherlock Holmes' dog that didn't bark, the story here is the knocks on the doors that don't come, the world refinery capacity that isn't being built.
According to the Energy Information Administration of the US Department of Energy, total world refinery capacity has only increased 1.5% from 2000 to 2005, from 81.53 to 82.8 million barrels a day (mb/d).
This is in the face of surging world oil demand, particularly from the newly industrializing nations of China and India, not to mention the current American rite of passage practice of making sure that, just like mom and dad have, every American teenager has a brand-new 15 miles per gallon sports utility vehicle to drive the six blocks to the massive parking lot outside their secondary school.
According to the International Energy Agency, from 2003 to 2006, world oil demand increased by an average of 2.1% a year. Demand in 2005 was 83.7 millions of barrels per day (mb/d), with refinery capacity that year at 82.8 mb/d, it means that the world is short almost 1 million barrels a day of fuel. Take out refinery capacity taken out for repairs, maintenance, accidents and the unforeseen (in the immediate aftermath of Hurricane Katrina, nine US Gulf Coast refineries, representing 12% of US production, were shut; for many the shutdowns lasted many months) and you get the picture of markets for petroleum products that have much stronger tendencies to rise than to fall.
During the summer of 2000, California electricity supply crisis, when large parts of the state were being subjected to daily electricity blackouts, the late Ken Lay, at that time chief executive officer of the Enron Corporation, a major player in the California wholesale electricity market, mocked David Freeman, chairman of the California Power Authority, by, according to Freeman, stating: "It doesn't matter what you crazy people in California do, because I got smart guys who can always figure out how to make money."
The main thing that Lay's smart guys, as well as the people in the oil industry who are not building new refinery capacity, have figured out is that the market for energy is very unique. When demand is high and supplies are tight, you make less money selling your product than by not selling it. This is what Enron did through taking offline much of California-dedicated electricity-generating capacity for strategically timed (in the California summer, when air-conditioning puts intense demand on power supplies) "maintenance". This drove prices up and created scarcity, not just in California, but all across the western US's interlinked electricity power transmission grid.
"Maintenance" is the same reason that the oil companies annually, including this year, give for taking refinery capacity offline in spring, driving prices up, and setting the world's drivers up for the fuel price increase season that now lasts into early autumn.
This yearly problem, and the tightness in the world's petroleum products markets in general, could be alleviated with new refinery construction, but, as demonstrated above, this is not happening. Oil refinery construction can be a difficult and expensive process, one which probably requires the company to go into debt by either issuing corporate bonds or taking out lines of credit with large commercial banks.
Much better to take the money that would have been spent on refinery construction and use it more judiciously, on things like risk-free short-term dollar or euro treasury securities (currently earning about 5.25% annually) and increased and enhanced corporate salaries, perks and dividends. This strategy is certainly working; oil company profits are skyrocketing. Early this year, ExxonMobil, the world's largest oil company, reported the largest-ever quarterly and yearly profits, $10.71 billion and $36.13 billion respectively, ever reported by an American corporation.
In classical economic theory, excessive price rises are self-defeating for companies. For one thing, they are supposed to tempt other competitors into the market, lured by the profit potential of those high prices, and eventually those high profits would be arbitraged, taken away by other companies, in the market. This does not happen in the petroleum products markets.
The "barriers of entry" for a new competitor, the costs, time and complexity of setting up new refinery capacity and distribution networks are enormous, and so the oil business stays what it is has been for many years, a comfortable little oligarchy, with only occasional new members, like LUKoil in Russia and China National Offshore Oil Corporation in China. Both these now major players in the international oil markets solved the high initial barriers of entry problems by emerging out of the cadavers of former state-owned entities during the eras of communist economic management.
A more substantial reason why this situation continues is the very unique demand profile of petroleum products.
Economists use the term elasticity of demand to describe how sensitive demand for a product is to changes in price. For a product with what is called perfect elasticity, each percentage increase in price is met with equal and opposite reduction in demand, say, a 5% increase in price causes a 5% reduction in demand. In this circumstance, excessive price increases make no sense; what the company picks up in the extra price it loses in reduced demand.
Because they are so essential to modern life, petroleum products have one of the most inelastic demand profiles of any product in the world. It is estimated that in the US, far and away the world's biggest consumer of oil products, their elasticity of demand is around 10%, meaning that for every 10% rise in price there is only a 1% reduction in demand. Only healthcare has a demand elasticity profile anywhere near this low, and, as more healthcare costs are shifted away from insurance companies to actual consumers, economists believe that even healthcare's demand elasticity is normalizing.
Enron knew this when it pounced on California's newly deregulated electricity markets. Over a century ago, US president Theodore Roosevelt knew this when he campaigned for the breakup of the Standard Oil trust. In essential industries with high barriers of entry, you either impose prudent regulation, or the companies run rampant. However, in a capitalist world still dominated by the neo-liberal laissez faire economic consensus, corporate regulation has gone out of style. Therefore, on a fairly frequent basis, you get these news events - like the seizure of the British sailors - that the popular media say are the causes of rising prices, but, in reality, are only distractions, diversions that condition consumers to accept higher prices. The real issue is the continuing uncompetitive nature of these essential markets.
It Happens Every Spring had a happy ending. Ray Milland, who had been playing baseball secretly to earn money to marry his fiance (faculty salaries apparently as lucrative then as they are now), is worried that, if his future father-in-law, the college president, finds out, the wedding will be called off, baseball players apparently being then seen as rather rough individuals. Not to worry, his future father-in-law already knew, and was totally accepting.
He need not have worried. It's not like baseball players were then, or are now, inherently corrupt, dishonest and morally bankrupt.
Like ... oil company executives?
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved. )
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