Thursday, April 12, 2012

Oil: Then Why is the Price Skyrocketing?

The previous chapters have talked about oil availability from a geological and engineering perspective.

First, the good news: potentially risky new technology, including deep ocean drilling, reservoir conditioning, and fracking have all opened a new door on the future availability of oil. In July 2008, the price of natural gas in Louisiana was close to $14 per MMBtu. There is now such a glut in gas supplies in the United States that it has driven the price down below $2 per MMBtu. Companies are running out of places to stash the excess gas.

Steep oil prices from several years ago have had two predictable - but very different - effects:

  1. These prices brought to our public awareness in an unmistakable way that carelessness (a single small person driving a giant SUV from home to the grocery store and back) had a very real consequence.
  2. These prices motivated energy companies to pour financial resources (which you and I ultimately pay for) into greater technology development and greater exploration. Already more hydrocarbons are coming on line, and the United States appears to have a rare, if very small, energy surplus in 2012. 

Q: ...Then why is the price of oil skyrocketing?
Mark M.

Now, the bad news: that prices keep climbing and will probably keep ON climbing. The reason oil prices keep climbing really have more to do with some ugly aspects of both uncontrollable demographics and controllable economics - specifically, commodity futures regulation.

The first driver is demographic: it includes countries with huge populations - China and India come to mind - who have rapidly expanding economies as they surge forward to live life like Europeans, Japanese, and Americans do. That means having many more cars, and dramatically increased power to grow their industrial base. Cars require oil - but so do chemical companies, growing navies, and a host of other things. To try to cut oil-import costs, China is bringing online one new coal-fired power plant every week.

There are unintended but inevitable consequences, of course. Burning coal has carbon footprint consequences, along with carbon black soot aerosols and sulfur dioxide. When sulfur dioxide gas touches the mucous membranes of your nose and lungs, it converts quickly to sulfuric acid. The black soot particles generally remain in your lungs - I'm sure you've heard of Black Lung disease. The pollution consequences in Beijing are already worse than they have ever been in southern California before anti-pollution controls kicked in. Air pollution in Beijing is already as bad as famous Bangkok, and getting worse.  Breathing my car-exhaust is safer.

Ultimately supply-and-demand says that when demand grows, supply must grow at least as fast or prices will rise. China, with a population of 1.35 billion people, has an economy expanding at a rate above 8% annually. Back-of-the-envelope calculations indicate that it will be very difficult for production to more than momentarily meet the consequent demand with such a huge growth rate driving it.

Bottom line: the price of oil will rise as countries compete for what will always be a limited resource.

The second driver is economic - or more correctly, the a dark side of unregulated economies.

Some basic facts:

  1. The average production cost today for a barrel of oil in 2012 is $11.
  2. The price this morning for a barrel of oil was $103 and change.
  3. Today, total world oil production is about 85 million barrels/day
  4. But speculators in the oil futures market routinely trade more than a billion barrels a day

Wait. WHAT? That makes no rational sense at all. 

Indeed. What this all means is that speculators are exchanging more than ten times as many "paper barrels" of oil than are actually being produced. Some companies - airlines, for instance - use these futures to lock up their cost for oil for a long period of time - they may pay extra to "hedge" their bets, in an effort to avoid huge price swings that could potentially bankrupt them. That could be considered a legitimate hedge: there is a rational, comprehensible reason for it.

But make no mistake: whether paying for oil futures or for a barrel being pumped from Ras Tanura terminal, the price is the same... so a bidding war will drive the price up - both "paper" oil and "wet" oil at the same time. Let's say I need oil desperately because my airline must keep operating to keep everyone in it employed. Well, you don't say! That desperation is going to cost you.

Only now instead of legitimate cost-hedging, it has become a case of the tail wagging the dog. A dog (you and I) is being wagged by a tail (the speculator) that is ten times bigger - and is wagging just as hard as it can.

But speculation means you can win - or you could lose. Right? It certainly means someone is making a bet on something... but people don't make a business of losing bets... or it isn't a business. You can always win your bets if the deck is stacked in your favor. What if, say, you bought some oil futures at $96/barrel, and then arranged (for a percentage of course) for someone in the news media to create rumors that Israel was about to strike Iran's nuclear facilities... which would then close the Straits of Hormuz... which 35% of the world's oil must transit.

This isn't hard to do - you only need to spread a threatening rumor about the uranium concentration facility in Natanz, Iran, going up to 20% pure U-235. The leaders of Likud in Jerusalem will ever-so-predictably react, and make dire threats of an imminent strike. Legitimate users get spooked, because this could mean life or death to an airline, and they jump in. The price of oil 30 days out just jumped in the same news cycle to $108/barrel. You've just made millions of dollars - overnight - without having to do any work. Well, you may have had to lift a hand to make a phone call or two.

It's just that easy. Has it actually happened this way? What do YOU think?

You have to admire these guys. Greed is so predictable.

Some history is in order here. Congress created the Commodity Futures Trading Commission (CFTC) in 1974 as an independent agency, with the mandate to regulate commodity futures and option markets in the United States. The agency's mandate has been renewed and expanded several times since then, most recently by the Dodd-Frank Wall Street Reform and Consumer Protection Act. In 1974, the majority of futures trading took place in the agricultural sector. The CFTC was created to control the wild swings in futures in corn and pork bellies.

Now the ugly part. In 1991, a company named Goldman Sachs (does this set off alarm bells yet?) argued with the CFTC that big Wall Street dealers making big bets should be treated a legitimate hedgers - and were granted exemption from the normal regulatory limits on their trading. That happened near the end of 12 years of a Republican president in the White House. The CFTC commissioners were mostly Republican appointees by then. Note the timing.

By 2008, just eight investment banks accounted for 32% of the oil futures market. Only 30 percent of oil futures traders are actual oil industry participants - legitimate hedgers.

As Joseph P. Kennedy II, writing in the New York Times put it (11 April 2012): "These middlemen add little value and lots of cost as they bid up the price of oil in pursuit of financial gain. They should be banned from the world's commodity exchanges, which could drive down the price of oil by as much as 40 percent, and the price of gasoline by as much as $1 a gallon." 

We all remember the 2008 financial crash - where ordinary folks started losing their jobs and homes, and people on Wall Street - the poster child of greed being Goldman Sachs - paid themselves obscene, multi-billion-dollar bonuses.

Where do you suppose the money for those bonuses came from? Reach around behind you and check your hip pocket.