Who's to blame? Oil companies or the market?

After Hurrican Katrina hit in 2005, and it became clear that petroleum facilities in the Gulf of Mexico were badly damaged, the price of oil spiked to around $70 per barrel. In 2004, The Economist assured its readers that the recent oil price hikes (which had just risen above the unheard-of level of $40 per barrel) were not as bad as those which occurred during the 1970s supply crises. For that to happen, The Economist assured, prices would have to get to around $80 per barrel.

Now as I write this, oil prices are hovering at $73.85 per barrel. Today's oil price is higher than it was when Hurricane Katrina hit - and has maintained its price despite the fact that petroleum facilities in the Gulf of Mexico
have been repaired (more or less), despite the fact that no hurricane is bearing down upon these facilities as I write, despite the fact that there has been no recent inflammatory speeches coming out of Iran, and despite the fact that it is Summer in the US, which means that the demand for heating oil is at a seasonal low.

Faced with high oil prices and higher bills at the bowser, many people have naturally turned upon oil companies. When I used to work at a service station, drivers would sometimes blame me for upturn in price - as though some lowly console operator in a dead-end job is deliberately getting his kicks out of hurting ordinary motorists.

There is no doubt that oil companies are making massive amounts of profit at the moment, but it is simplistic in the extreme to blame them for our current woes. But it is easier for us to believe that oil companies are indulging in price gouging and profteering and collusion than it is for us to accept any other explanation.

Take this step of logic with me - if the price of oil is high and if the oil companies are to blame, then surely when the price of oil was low it was because these same oil companies were generous, likeable and self-sacrificing. In September 2003 - less than three years ago - the price of oil was $25 per barrel, which means that the oil companies were really nice to us back then.

Of course, such a notion is completely ridiculous. Oil companies are driven by profits and back in September 2003 they were just as profit-driven as they are today.

Let me make this very clear - it is not the oil companies that are to blame for the current price of oil, but the entire market. And when I say "market" I mean the market in general, not the oil or petroleum market.

When presented with false information, people make ridiculous choices. When people have colds they often turn to Echinacea, despite the fact that it has no positive effect upon their health. People have bought the lie that Echinacea can help, and are willing to spend money to justify it. In England a few years ago, a mob of vigilantes looking for a supposed pedophile living nearby managed to attack the offices of a pediatrician, thinking they were the same thing.

When it comes to oil, the market has been given false information. I mentioned The Economist earlier. In early 2004 a page in that magazine was given over to a current discussion on oil supplies, which conlcuded that places like Iran, Iraq and Saudi Arabia had between 70 to 100 years of oil reserves left.

Since then I discovered that the facts it was reporting were simply not true.

Maybe you've seen the episode of "The Simpsons" where oil is discovered under Bart's school. Both the school executive and Mr Burns then set up oil drilling platforms to tap this oil supply. During the process we see what an oil reservoir supposedly looks like - a gigantic underground cave flooded with liquid oil, with the oil platforms sucking up the oil via pipes that act as straws.

I won't blame this on The Simpsons, but I fear that the market somehow thought that oil extraction was a simple process of sucking up the oil until it was dry. It's not.

The fact is than an oil reservoir is actually oil and gas co-existing in the same place with permeable rock - rock that has microscopic holes in it that allows the liquid and gas to pass through it. This geological fact may sound rather unimportant - but it is of vital importance because it affects the way in which an oil reservoir functions when oil is extracted from it.

Essentially, when oil is extracted from an underground reservoir, it follows a "bell curve" throughout its functional life. This means that oil is extracted faster and faster as time goes by, but, when the reservoir is around half full, the speed of extraction declines.

Think of your bath. It would be like turning on a tap full, and then watching as the liquid from the tap slowly increased in speed. Then, as the liquid reaches its fastest speed, it begins to slow down. Have you ever turned a tap on full and watched in annoyance as only a small amount of water comes dribbling out? That is the situation with oil reservoirs.

This process - known as "Hubbert's Peak" - is a geological fact that has been, for whatever reason, ignored by the marketplace. What are it's implications?

Economics is simple. If the supply of the product increases beyond its demand, the price drops. If the supply decreases below its demand, the price increases.

The current price of oil is due to the fact that oil cannot be extracted fast enough to cope with demand. It is simply a fuction of the marketplace - the market wants a certain amount of oil but the oil reservoirs can't extract that much. To cope with the shortfall, the price increases. This is the beauty - or the ugliness if you like - of how markets operate.

The problem is that the market is only just now realising that increasing oil supply is easier said than done. In ignorance the markets assumed that oil supplies would last at least another century. Now they are realising that, while the supply of oil isn't going to "run out", the fact is that oil supplies will be unable to meet current demand and, more crucially, future demand.

It wasn't always so. I remember when I first encountered Hubbert's Peak I simply didn't believe it. I quoted articles from The Economist to assuage myself that this was just another theory from the same people who advocate Tin-Foil hats. As I discovered, those who were pushing the theory actually had PhDs and experience working in the oil industry.

The world is running out of cheap oil. That's why oil is $73.85 per barrel now and likely to increase (especially if another hurricane hits the Gulf of Mexico). It's the reason why we are heading for a protracted, international recession and a gradual, but irreversible, change in our lifestyle.

Don't blame the oil companies. Instead, blame the market for being so stupid - and remember that you're part of the market too.

© 2006 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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Craig Schwarze said...

The market isn't stupid - just inevitable. It doesn't have a mind - it just responds to the stimulus it is presented with.

One Salient Oversight said...

I love that description. Very apt. Moreover it is helpful because it is able to show both its strengths and weaknesses.

Which is why, of course, I can never ever call myself a Communist.

Tommy B at the news desk said...

Hi Neil

I have an alternate explanation as to a contributing factor regarding the higher oil prices. Please forgive me when I repeat stuff you already know.

When a graph reaches the top of a bell curve and begins to come out the other side, demand exceeds supply. So more people want to buy the product than the amount of the product that is available. Hence, prices increase.

However, initially this price increase is reasonably gradual. It becomes more violent the further we travel along the bell curve. Now the explanations given regarding hurricanes and wars and the boss's day off can further contribute to the greater price increases that occurred around fifteen monthe ago, and at various times since, but usually these prices will return, more or less, to the price they were prior to the crisis.

However, in this case, that didn't happen. Of course we still have a war going on and we may have reached peak oil, but I want to suggest that the oil companies are being greedy in this situation as well.

In a post you did several months ago, you noted that prices increased into the high $1.30s - and people started reducing the amount of fuel they consume, as the price rises were having such an impact on disposable income. Consequently, prices went down as demand decreased.

However, we are now further down the track and people are accepting the higher prices, which exceed where they were when people reduced their consumption, more readily. Why?

I'm glad you asked. Because they had time to adjust their budgets and lifestyles to the previous price rise - so this new price rise doesn't seem quite as large as it did last time, because there was a greater increase last time.

Oil companies have had the opportunity to test how far consumers will go in terms of price, and what explanations they will accept for increasing oil prices.

Oil companies are, of course, part of an oligopoly. An oligopoly, by its very nature, is an extremely competitive market. Unless representatives of the oligopoly decide to collude.

The market for retail vehicles is an example of an oligopoly. The car manufacturers, quite some time ago have colluded to keep car prices approximately the same, regardless of the company they represent.

This is because of our demand and supply graph. If one member of the oligopoly reduces their prices, then demand for their vehicles will increase. However, because they have reduced their own prices to do this, the point of equilibrium for the graph will move down and to the right. Even if supply increases to meet demand, the price needs to stay the same. Otherwise, demand is reduced again.

However, if one car manufacturer tries this ploy, what happens? All of the other car manufacturers also reduce their prices, so they get their share of the market back, and all of the demand and supply graphs settle at a new point of equilibrium - one in which they are all receiving the same market share, but all of their prices, and consequently profits, are reduced.

Once collusion has taken place, there is little benefit in reducing prices in an oligopoly. So car manufacturers try to maintain competitive edge through other means - features, customer loyalty, extras, new technology - but not price.

Now, to the oligopoly of the oil companies. They are dealing in a primary resource - one that, unlike vehicles, has little difference regardless on from where it is purchased, and is irreplaceable. They do not have the flexibility to maintain competitive edge through other means, so the best way to increase their profits is to collude, and agree to increase the prices.

World events and perhaps peak oil are contributing to the higher prices. But I would suggest that the combination of being able to test the market through world events, and the ways in which prices have jumped that seems out of proportion with the beginning of a downhill slide of a bell curve, combined with the apparent huge profits oil companies are currently making, suggest that the oil companies themselves are also using the current prices to gouge the customer.

What are your thoughts?

byron smith said...

If you haven't already seen it, Four Corners had an episode on Peak Oil this week.