Manhunt Over…Crude Villains Found

Everywhere we go, we come ready to talk about the economy, interest rates, the stock market, and bank stocks (more on them coming soon).  But all people ask us lately is who’s to blame for gas prices, and when are they going to come down?  Not that it’s an unimportant subject.  Oil definitely affects consumer spending, corporate profits, and capital spending plans.

So, consider this Monarch’s think-piece on oil.  It is complete with both facts and opinions; we’re pretty sure the facts are right, but only time will tell if the opinions hold water.  This won’t morph into a weekly column highlighting all the week’s action in oil; it is a one-and-done.  Therefore, caution:  it is long.

If you step back and evaluate how American consumers feel about oil prices, it’s downright fascinating.  There are probably more lessons about Americans than there are about oil prices.  We’ve turned it into a virtual Hollywood script.  There are good guys (us, obviously) and bad guys (anyone involved in the oil industry).  There are winners and losers.  There are all sorts of investigations, some even criminal, into how this evil thing happened.  There’s a hunt for evidence.  There are twists and turns all along the way, from Hurricane Katrina to the Olympics to the price of rice in Vietnam.  Will there be a happy ending?

Who’s to blame?

The people have risen up and organized a man-hunt to determine who’s responsible for the mess that is high gas prices.  Many perpetrators have been identified:

  1.  OPEC
  2.  Oil producers
  3.  Refiners
  4.  Gas station owners
  5.  Gas station managers
  6.  The guy who changes the posted price of gas on the station’s sign
  7.  SUV drivers
  8.  Suburbanites and exurbanites
  9.  Middle-class first-time car owners in China and India
  10.  China’s insatiable appetite for industrialization and modernization
  11.  The U.S. trade deficit
  12.  The U.S. budget deficit
  13.  Investors
  14.  Speculators
  15.  The Fed
  16.  Alan Greenspan
  17.  George W. Bush
  18.  Dick Cheney
  19.  George H.W. Bush
  20.  Democrats
  21.  Republicans
  22.  Environmentalists
  23.  Congress
  24.  Prognosticators, like T. Boone Pickens
  25.  Hedge funds
  26.  Iran’s nuclear ambitions
  27.  The dollar (Uncle Sam?)

You could make a reasonable case for most of these, even those that are contradictory (Democrats, Republicans).  While the Monarchians certainly have our biases, like everyone, we’ll try to use as many facts as we can to support our opinions.

Actually, before we go too far, let’s at least clear the air of one notion: that high gas prices are attributable to anything but high oil prices.  The following chart shows the components of the price of an average gallon of gas recently:

image002 (5)

As much as you might want to deck the gas station owner, he and the guy shipping the gas to the station are taking only $0.04 per gallon of your cash.  The refineries had a long profitable run for a few years, but that abruptly ended in 2007, and now they aren’t making much.  The taxman has a nice take, but European drivers pay something closer to $5 per gallon in taxes (excise + VAT), a far cry from $0.67 here.  There’ll be no whining about high gas taxes, please.

So oil prices are the only variable we need be concerned with.  Unfortunately, there’s no one person in the oil business that deserves a split lip, and oil companies certainly do not control the price of oil – the market does that.

Econ 101

When in doubt, we always fall back on the basics of economics, notably the law of supply and demand.  Both supply and demand directly affect price – supply affects price inversely (when supply goes up, price goes down), and demand and price travel the same direction.

Think of a simple example, say, milk.  Consumers base their demand for milk really on two factors: 1) how much they like milk (its taste, its refreshingness, and its health qualities), and 2) its price.  Let’s assume that, today, demand and supply in your community are 1,000 gallons per day.  If there is a change in the consumer’s perception of milk’s health qualities, like if the community doctor said he’s seeing way too many osteoporosis patients and people aren’t drinking enough milk, demand might go up to 1,200 gallons per day.  Well, if supply is stuck at 1,000, how do the 200 new gallons of demand get satisfied?  In the short-term, they don’t.  Price must go up to the point that demand drops back down to 1,000.

But in the long-term, supply can increase.  Assume a dairy farmer in the community has 100 producing cows.  When demand and supply were in balance, he probably didn’t have much incentive to change his supply.  He knows that if he increased his supply, the market price would drop.  People wouldn’t suddenly get thirstier, but a few might drink more milk as a substitute for other beverages.  But, his sales could actually drop, depending upon the elasticity of demand for milk, while increasing his costs!

If demand goes up, driving prices up, the farmer suddenly has incentive to increase supply.  While new supply will drive the price back down, he hopes that at least the price stays above where it was before the doctor made his proclamation (let’s hope the doctor and dairy farmer aren’t in cahoots together).  So after increasing supply, the dairy farmer wants to increase both his per-gallon profit, and the number of profitable gallons.

Back to Oil

All the arguments and opinions about oil fall on one or both sides of the law of supply and demand.  If you think George W. and the Iraq war are the reasons, then you could defend it by saying oil supply has been reduced directly in Iraq (which hopefully won’t be true for long) and indirectly in other producing countries because they hate us now and want to stick it to us (Venezuela, Iran).  In fact, most debates likely take place on the supply side.

There’s no question that demand has risen in China, India, and the Middle East, and to a lesser extent in other emerging markets.  That’s fact.  Industry is producing more, requiring more energy, and more people are driving instead of biking it.  Ironically, demand is dropping in developed countries, as consumers try to reduce fuel consumption by buying higher-mileage cars, carpooling, riding mass transit, and even biking to work.  What does it say when Americans jump on the bike at the same time that Indians are parking their bike?

That 70’s show

Obviously the 1970’s were a generation ago, and therefore a lot is different now.  But it’s still instructive to examine how the 1970’s oil boom started, and, even better, how it ended.  Demand for oil had been increasing steadily in the 1950’s and 60’s as the world industrialized, and supply had risen to match it.  But the formation of OPEC and the absolute economic power it quickly amassed was the fire that ignited the oil price crisis of the mid-late 1970’s.

In other words, there was growing demand, but the boom happened because of supply.  OPEC kept their grips on the market as oil-consuming nations tried repeated bad ideas to combat higher oil prices, such as rationing.  Hmm…. Oil supply drops, prices go up, let’s fix that by withholding supply.  And it didn’t work?!  Below shows oil prices going back to 1946.

image004 (1)

Imagine you were an OPEC oil minister then.  You know you could pump more oil and if it was a small enough increase, you might not cause prices to drop.  But, like the dairy farmer, why take the risk?  Especially when prices keep going up, and all your other OPEC buddies keep telling you it’s because of your supply discipline, you probably would start to believe it.  So you would have NO incentive to increase your production.

But the problem for you is that OPEC doesn’t control the whole world’s oil supply.  Now imagine you’re sitting on top of 10,000 acres of scrub brush in West Texas in the mid 70’s.  The oil was too far below the ground to make any money when the price of oil was $1 per barrel.  But at $10, suddenly you could be the Beverly Hillbillies.  So do you withhold production in order to keep the price of oil up?  HECK NO!!!!  First of all, you’re so small that any change in your supply could not possibly affect the price of oil.  Second of all, you’re not pumping anything right now, so you’re not making a cent off the oil boom.  So it’s time to bring in the rigs!

Also, many people believe it was conservation efforts, especially in America, which drove down demand for oil, and therefore finally drove down prices.  While initiatives like carpooling and smaller cars certainly helped tip the scales, the problem with this logic is that any drop in demand can be offset by a drop in supply via OPEC.  Unless…..non-OPEC supplies are increasing.  And that’s exactly what happened, in a nutshell.  Suddenly, OPEC’s control was slipping, because supply started rising at a time when demand was falling.  OPEC couldn’t cut supply fast enough because non-OPEC supplies (like in the U.S.) were soaring.  So that was the tipping point.  The towel got thrown in when OPEC member countries started to cheat.  When they saw that their reduction in supply was only resulting in lower prices, they started—one by one—to raise production in defiance of their own agreements with their OPEC buddies.  Instead of selling fewer barrels of oil, at a lower profit per barrel, at least they would sell more barrels and try to “make up for it with volume” as the saying goes.


Which brings us to today, finally.  Before we render our verdict, one more group of perpetrators that we can rule out as the problem are investors.  This group, which includes “speculators” and average Joes buying any oil ETF they can find just because it’s in an upward trend, can’t be blamed for rising oil prices.  They can be blamed for exaggerating it, we believe.  But they aren’t the problem, or the solution.  Investors shouldn’t be punished for making profitable trades.

As you could probably guess, we come down firmly on the side that non-OPEC supply is both to blame, and is the solution, maybe the only solution.  Demand destruction will certainly take place with oil at $139 per barrel, not just in the U.S., we believe, but even in developing countries.  Emerging market consumers can’t afford it, and their governments are going to be pinched if they continue to subsidize fuel consumption in their countries.  But changes in demand alone won’t end this cycle.

OPEC certainly shoulders a lot of “blame” too.  Countries like Venezuela and Russia have taken over fields from oil companies, or changed the terms to make producing oil much less affordable for the oil companies (and much more profitable for themselves).  This has seriously reduced the incentive of oil producers to take any risk of trying to find oil in those countries.  And OPEC’s supply growth has been absent during this oil boom, as it was in the 1970’s.  Whether that’s because they don’t have much more capacity to pump more oil out (as they say) or whether they’re lying and just want more profits, is unclear at this time.  What hasn’t helped is violence in places like Nigeria and Iraq.  But blaming OPEC for profiting off of rising oil prices is a non-starter.  OPEC’s business—its sole reason for existing—is to maximize profits.  Kind of like blaming Satan for your sins.  You can blame him, but he probably won’t feel too bad about it.

So, where’s the non-OPEC supply growth today?  Where are the 1970’s wildcatters now, punching holes in the West Texas scrub land?  The answer is that there is a lot of drilling suddenly in places that haven’t seen drilling in decades, like Louisiana, Pennsylvania, and West Virginia.  Extracting oil from “shale” has only been profitable at recently high oil prices.  Similarly, the tar sands of Alberta have quickly ramped up production in the last few years.  Producers who have operated in these high-cost areas have seen their stock prices skyrocket in the last couple years.  New frontiers are being opened up, like offshore Brazil, and in the Arctic above Norway and Russia.  Then there’s ethanol, which has slightly added to gasoline supply.

But the incremental supply so far has served only to offset lost supply from declining fields in places like the North Sea and in Mexico.  While the new sources will grow in importance, what is needed to throw a counter-punch at OPEC, like non-OPEC was able to do in the 1970’s, is a handful of major new oil patches.  Tupi in Brazil is very promising, and Kashagan in Kazakhstan has a lot of issues, but is promising.  However, more are needed.

(Un)fortunately, in our opinion, by far the #1 contributor to high oil prices has been, and will continue to be, the decision by our federal government to not open new drilling areas in Alaska, offshore in the Atlantic and Pacific, and (less so) on protected lands in the Rockies.  You can thank Congress, Bush, Clinton, and environmentalists alike.  True, it’s easy to make this assessment in Fort Wayne (not our backyard), not having visited the “virgin land” of ANWR (Arctic National Wildlife Refuge) in Alaska.  But at every point in time, our lawmakers are implicitly making an assessment of the importance of new oil supplies to our economy, versus the welfare of Alaskan caribou.  While that may sound a little harsh to caribou lovers, let it be known that, according to Wall Street Journal columnist Daniel Henninger, the U.S. might be the only country still holding on to these “values” at the expense of our economy.  How did we earn the reputation as a country of capitalists?  Link to Wall Street Journal article: Drill Drill Drill!

While opening up new lands might be a simple, sign-of-the-pen solution to our oil mess, it’s wishful thinking that it will happen anytime soon.  If it couldn’t get done with Republicans in control of Washington, it’s a much longer shot now.  That leaves America with the marginal ideas of demand conservation, jawboning OPEC (always successful—not!), and alternative sources of energy.  To the latter point, we are encouraged that numerous alternative energy sources are being developed, which means that the model of supply and demand still works.  But it might be a long time before they are economically efficient enough for the mass market, without government subsidies.

As for the major oil companies, surely they are partly to blame for not spending enough on exploration.  Having gotten burned in the 1980’s, the world’s largest oil companies adapted to a world of lower oil prices in the 1990’s by becoming tighter stewards of capital.  In calculating project profitability today, they can’t assume that oil will be $135 forever.  In addition to our government’s restrictions on drilling, the majors have been continually screwed by foreign countries that signed long-term contracts at lower oil prices.  Countries like Russia and Kazakhstan have ripped up contracts and forced the majors to sign new ones that pay higher royalties.  Other countries like Venezuela and Bolivia have kicked foreign oil companies out and made off with their assets.  Finally, the costs of exploration and production have skyrocketed, thanks to tighter markets for raw materials and for skilled personnel.  In other words, it’s tough for the majors to find new places to drill where they can be assured of some profit, so it’s hard to fault them for not throwing money around like drunken sailors.  The world must still hold out hope for the majors to find new fields, and, ironically, hope that oil prices stay high enough for them to come online.

Bottom Line

So where are oil prices headed?  Let’s ask the prognosticators.  The CEO of Gazprom, Russia’s largest natural gas producer, believes that we’ll see $300 per barrel in 2009.  This is just the latest “moonshot” prediction in the last 3 months.  Predicted prices have been climbing even faster than actual prices.  Where were these predictions 1 year ago, at $70?  You couldn’t find anybody to predict that prices by now would be over $100.  So everybody was wrong???  At least we can say that any price prediction is based on predictions that may or may not come true.  The market’s price is the best guess of where the price will be.

The following picture shows how the price of oil, whether in a bubble or not, looks a lot like the bubbles of Nasdaq in the late 1990’s, and the homebuilders of this decade.  Notice that each boom had a last-gasp moonshot into their peaks.

image006 (1)


It’s very difficult to be optimistic that falling prices are near at hand.  The trend is not our friend.  But it’s also hard to ignore that prices are so high that demand destruction is almost necessary.  When Americans can’t even afford to pay for gas anymore, what does that say about the Indian who’s earning $2,000 per year?  OPEC is powerful, and can offset any drop in demand with a drop in supply.  The only hope is non-OPEC supply.

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