Posted by
Doug Van Duker on Friday, July 25, 2008 3:35:14 PM
Drill, Drill, Drill – A Case In Studied Ignorance
Increased Drilling Will Affect Consumer Prices next to Nil
It’s as if the political mavens are intentionally setting the American consumer up. The ploy is to use slogans to divert the public from the obvious.
“Supply and demand” is an effective force in mitigating prices that are unreasonable to the market, but it is only a small factor and needs to be kept in a proper perspective. Trouble is, consumer pricing, particularly on gasoline, has never been driven by supply and demand. The correct adage for establishing consumer pricing is: “What the market will bear.”
If exploration and new drilling results in a doubling of the amount of oil availability to the international market, it won’t have a significant impact on the amount of available gasoline supply in the United States...or, our price at the pump.
Only a little bit of logic, common sense, and a look recent market history all say that I’m right.
First: There is only a general relationship between the price per barrel and the bill at the pump.
A few years ago, OPEC were being blamed for an unexpected and significant jump in the price of petroleum products to over $60 per barrel. When production was increased, the per barrel price dropped on world-markets back to roughly $40; about where pricing had been before the spike. US consumer fuel prices however, moved only slightly in response to reduced crude prices. While the cost of raw materials was demonstrably reduced in the production of fuel & heating oil, somewhere in the market chain of oil companies, oil transportation dealers, oil refineries, wholesalers, distributors and finally gas stations, the cost reduction was transferred from a cost to a profit. As US markets had demonstrated a willingness to pay $2.00+ per gallon, the price was maintained.
In the same context. Now that crude oil futures are closing in on $160 per barrel (current spot markets are still only half of that price) the pump price doesn’t demonstrate a direct correlation to price per barrel. It does show a fairly significant relationship to the value of the dollar in the present international currency market and a general adjustment for inflation. So adjusted, fuel costs are roughly the same adjusted percentage of the consumer’s total disposable income as it was about ten years ago.
Initially, we moved to more economical cars. Even today’s SUVs get better gas milage than the average station-wagon of the 1970s. As we moved from vehicles that got 12-14 miles per gallon to similar vehicles today that get 20-24 miles per gallon we pump prices static...which was actually a reduction in our percentage of total household incomes. The market steadily adjusted.
If one tracks CURRENT spot-market pricing for oil with pump prices, a given cost of oil seldom provides a strong correlation to pump pricing. When crude prices go up, pump prices go up. When crude prices go down, pump pricing eventually goes down...but not anywhere near the prior pricing levels for the same cost per barrel of crude oil. Even when oil prices are static, every few months pump prices are tested with higher pricing. Once a noticeable drop in consumption is demonstrated, pump pricing drops a few cents, but very seldom to the pricing prior to market testing.
When a “crisis” occurs...a hurricane, an embargo, et. al., the market testing is accelerated, but even if the crisis is avoided, the margin still moves up as a factor of the prior public acceptance, even temporally, of higher pricing. Remember a few years ago when a hurricane “endangered” a single oil derrick in the Gulf. Pump prices quickly jumped 15¢ per gallon in the anticipation that the derrick would be badly damaged or that nearby refineries would be damaged. The public was mollified with the explanation that today’s higher prices resulted from the anticipated higher “pipeline replacement price.” In the end, the derrick wasn’t damaged and was producing at pre-crisis rates within a week. No refineries were damaged.... Pricing SLOWLY began to adjust towards the “pre-crisis” price–over the next several months. In the end, the price settled down to just about 3¢ above the “pre-crisis” price.
It is only when domestic consumption drops to below the economic threshold of refinery profitability that there is pressure to either reduce–or at least slow the rate of increase to consumer pricing.
Another set of examples.
Gasoline used to have a performance additive of lead. An unleaded gasoline was produced and then a small amount of lead was added to the fuel. In the 1970s, it was mandated that all new domestic cars run on unleaded gasoline. In response, the price for unleaded gasoline almost immediately became MORE expensive than leaded gasoline...and continued to be more expensive until leaded gasoline was totally phased out.
Diesel requires significantly less refinement than does unleaded gasoline. Because it is cheaper to produce, world-wide diesel fuel is the less expensive standard for transportation...except in the US. Here, domestic consumer prices for diesel have been more expensive at the pump than gasoline for the last 10 years. The corporate explanation...they have not been accurately able to estimate the domestic need and continuously the available supply is less than consumer demands—yeah,...right.
Most folks have failed to notice that truckers, railroads, and other high consumers of diesel fuel pay roughly 20%-50% less than the retail consumer price. The argument is that businesses obtain lower pricing as a result of quantity purchases coupled with long-term contracts that fix pricing for future fuel consumption needs. Strange, no diesel fuel wholesalers or distributors have similarly been able to give themselves a competitive edge to pass along reduced prices to their customers.
Actually, while consumers are paying $4.70 a gallon for diesel at the pump, market pricing for railroads, and similar quantity consumers is about $3.20 a gallon. US retail diesel drivers represent a small nitch market...which has demonstrated a willingness to pay between $4.65 and $4.80 a gallon. As long as consumers are willing to maintain current market consumption at the existing prices–costs at the pump will never go down.
Large consumers, such as railroads in particular, get lower prices because as an aggregate, they have refused to pay higher prices. They represent a large enough market that if domestic suppliers fail to provide fuel at competitive prices, foreign fuel sources, for which diesel is a primary market, are ready to step in.
Consumer purchase patterns have more to do with retail pricing than does the production cost, or availability of product.
Second: More drilling will mean more crude oil will be available for refining into consumer products. BUT...where the crude oil goes will be driven by world markets. Chevron, Exxon, Mobil, Shell (a Dutch company) and BP (British Petroleum) ship world-wide to the customer offering the highest price per barrel. The fact that Mobil drilled a high producing well in the ANWAR doesn’t mean that the oil will be sent to their refinery facilities in Benicia, California. On the contrary, most existing US refineries are already operating at their optimum economic levels of production. Send them more oil to refine will result in more oil sitting in the facility storage tanks for longer periods of time...not in higher rates of production of consumer products.
Effectively, more US drilling will not result in increased US supplies of gasoline, heating oil, or diesel fuel.
What will?
Well, if oil companies were incentivized to construct more US refineries, then there would be more oil products in the US. The cost of shipping refined products would make selling to US consumers, at lower prices, more profitable than shipping the product to markets in Europe and Asia...even at significantly higher prices –most notably, domestic and foreign taxes are generally based on gross sales. Increase domestic refineries would result in enhanced domestic supplies of consumer products.
So, why don’t we push for more domestic refineries?
One of the biggest issues of any plan to expand domestic refineries curtailing the current empowerment of the “green” political interest group.
Environmentalist don’t just oppose energy development of oil, they have an active history of being in total opposition to the development of any and all known sources of energy in the US. Nuclear, coal & coal gasification, oil & oil refineries, hydro-electric, wind (aesthetical unsightly), geothermal, exploration of facilities for mass power generation from solar have been attacked as a blight. Finally, even passive power generation from tidal flows is enmeshed in a protracted court battle...at the possibility of fish being confused.
Environmentalists oppose US drilling 90 miles off the coast of Florida...but have shown total indifference to drilling on the same site by the socialist governments of Venezuelan, Chinese, and Cuban state oil companies. There has been a significant “green” opposition to drilling in ANWAR...but no protests of Russian exploration and drilling in the nearby Bering Strait. So for many, it isn’t the drilling they oppose, but rather US drilling.
While environmentalist present themselves as individuals and groups concerned about maintaining the world ecology, their own actions have definitively demonstrated that environmentalism is simply a fancy way of expressing the blatantly selfish position of, “Not in my back yard.”
Okay, presuppose that consumer interests could trump environmentism and US oil companies double the existing number of refining facilities to 1970 levels, would that result in lower consumer prices?
The best we can get is a qualified “yes.”
Another obstacle to overcome is the self-interests of the oil companies to limit refineries to levels lower than saturation...something sightly less than current and foreseeable demand. For all the reasons consumers want more refineries in the US, increased supplies to below current market demands, without an outside stimulus, the oil companies have no market incentive to boost production to the point that supplies exceed demand. More US refineries would mean more gasoline would produced domestically.
Currently, US oil companies are willing to expand US refinery operations...but only to a level where current market profit levels can be maintained. Twice the product at half the price results in equal gross sales. Unfortunately, in this economic model, the profits on gross sales would be negatively impacted by the significantly increased operating expense to double production.
Limited short-term tax incentives for significant short-term gains could induce construction of a sufficient number of refineries such that a level of production would be required to off-set the operational expense–pushing oil companies to sell US refined products domestically to recover the refinery operational expense at minimum levels of profitability.
Will a significant increase in the amount of available gasoline drop the pump prices?
Again, the best we can get is a qualified “yes.”
If the market demonstrates that it is willing to pay $4.00+ per gallon, then even significant increases in supply won’t push prices down. Where the oil company and refinery lower costs, there is every likelihood that other member in the supply chain will absorb reduced costs with higher profit margins.
We saw an excellent example of this just two years ago in Utah. Remember the hurricane that endangered the oil derrick in the Gulf? Well when national gasoline prices began to drop, Utah prices stubbornly refused to move. Prices in the greater Salt Lake City area, where a lot of gasoline is refined, was notably more expensive than pricing in localities where Utah refined oil products where shipped to. The Lt. Governor launched an investigation and held hearings. In the end, it was very clear that product availability from local refineries had little to do with retail pricing. The drop in national prices reflected a drop in pricing from the oil companies and refineries. Reduction in wholesaler, distributor and retailer expense were converted into increased profits until such time as pump prices needed to be reduced to re-attract sales.