Understanding $100 $200 Oil

Back in Spring (March 2008), I made an attempt to grasp and lay out in 500 words or less the factors influencing the $100 world-market oil price in “Understanding $100 Oil.”

Mine remains a crude understanding, but I was right about the basic components:

• high and increasing global demand;
• prospective supply limitations (though no immediate supply shortage);
• a 25-year underinvestment in production;
• regional political unrest & nationalization of oil production; and
• intertemporal financial factors (including the weak dollar [gluttonous US consumption + Iraq!] and record funds flows into commodities, including oil derivatives).

Meanwhile, the oil expert’s expert and author of The Prize: the Epic Quest for Oil Money & Power, Daniel Yergin, took the chance to catch us up on his read of the oil situation …

Daniel Yergin | “Oil has reached a turning point” | The Financial Times | 27 May 2008.

Yes, it’s another oil shock, he says, but one that’s different in character from our experience in the 1970’s. This one is a demand shock. And oil supply is slow in responding for several reasons: prices haven’t been that high for all that long and the cost of getting crude out of the Earth and refining it has more than doubled in the last four years!

Yes, the current high oil price may be a demand shock triggered by what had been several years of excellent global economic growth, and thus more benign than supply shocks caused by 1970s-style disruptions. It is amplified by a dollar shock caused by the fall in the dollar and by the embrace by financial investors of oil (and other commodities) as an asset class.

Mr Oil continues …

Oil supply, one might think, should be responding [to record-high prices]. Yet there are three obstacles. The first is time. These high prices have not been around all that long and development of new supplies takes many years. The second is access to new resources. And the third factor is what is happening to costs. The public focuses on the price at the pump, but the oil industry is preoccupied, and indeed somewhat stymied, by how rapidly their own costs are rising – far exceeding the rate of general inflation. The latest IHS/Cambridge Energy Research Associates (Cera) Upstream Capital Cost Index – the consumer price index for the oilfield – shows that costs for developing a new oil or natural gas field have more than doubled in four years. Some costs have risen even more: a deep-water drill ship might have cost $125,000 per day to rent four years ago. Today it goes for more than $600,000 per day – if you can find one.

A pause.

I would like people to understand that beating up on the oil companies — which are making record profits at present — is not a helpful or productive response, as attractive a reflex as it may be. We in the United States consume about 20 million barrels of oil a day, of which almost 7 million we produce ourselves. This leaves the rest, which we get either from people who don’t like us or from people who take more dollars US than they used to for the same horse blanket (or both; the long overdue Oil Security movement is predicated on these bedrock facts). Oil companies are our best friend, Kimosabe. Why? Because they produce oil. We use a lot of it … more than anybody else, in fact.

They are not the bad guy here. In this flick, they are the love-interest. It is not clear whether the oil companies are gouging at the pump or if they may be pricing even lower than before relative to the new challenges and higher costs of gaining supply. (For example, it is not clear if the $4.79 I spent this week on Regular fully reflects today’s $144 crude price or some blended lower price based on the older, lower-cost inventory in the production chain. We’ll need to ask our friends at Exxon Mobile or Royal Dutch Shell to help us toward a better understanding of the liquid’s odyssey from the ground to the filling station. It is entirely likely that the $144 barrel would cause a $5 – $8 pump price if the global market persists for a long time.)

What the oil companies will do with high prices is invest … and innovate. That’s why the Peak Oil theory — so appealing to the the bolshy tree hugger or those of limited sensibility seeking faith in a reason for all this chaos in the markets — is questionable.

The idea of a fixed oil supply is a misunderstanding; there is a difference between Total Oil Actually Present and Total Oil We Can Get With Current Means. The history of the oil industry is a sequence of new approaches to sourcing oil in clever ways which have either reduced the cost of certain processes or enlarged the definition of In-Ground Reserves by increasing yields with new techniques (steam injection is one that comes easily to mind). The amount of oil “in the ground” “increases” over time because we are enterprising, competitive & thinking beings coming up with new ways to access what had been inaccessible before. This confuses the heck out of people who’s understanding is limited to the idea that the Earth is running out of oil. Of course it is! But sometimes it’s not, depending on oil company grit, resources & fortunes.

The ideas of windfall profits taxes (arbitrary penalties slapped on oil companies) and summer tax holidays (a temporary halt in the 18.5% federal gas tax) have come up in the primary elections. McCain made the holiday proposal and Hillary followed up in support. Luckily Barack Obama has a compass:

“This isn’t an idea designed to get you through the summer, it’s designed to get them through an election.”

It surprises people no end when I tell them that the high oil price makes OPEC and the oil companies more nervous than anybody. It’s the demand, stupid! They don’t want to see it go down. But it is, already.

It’s far better to beat up on ourselves than on the oil companies (riding the bike more at these pump prices is hardly flagellation): use less oil and less of other non-renewables and do whatever is necessary to replace imported oil first with renewable sources.

As Daniel Yergin points out, the new higher costs of oil production are an important factor in today’s startling price; this additionally makes the $200 barrel seem plausible, even likely. And cost pressure will sustain fuel prices for a long, long time — at least several years.

The silver lining — there is always a silver lining — may be that high non-renewables prices is precisely the thing to support a strong move into the best renewable sources of energy and out of what Massachusetts Governor, Deval Patrick, called today “the fossil fuel age”.

It’s up to us. Think of oil as the reference price we need to beat. It won’t always be so easy, but the path is clear for now.

Mr Yergin concludes …

The break point is already here. Oil is in the process of losing its almost total domination in ground transport. It is not going to fade away soon – such is the scale of its use and convenience, it will retain a dominant position for many years. But it will share the transport market with other sources as never before, reinforced by a new drive for fuel efficiency.