Friday, June 22, 2012

Why Oil &Gas Prices are High in 5 Pictures (Updated)

Update: British Petroleum (BP) has released an excellent 2 minute overview using pictures of what's occurring in world energy markets on YouTube. Also, World oil prices (Brent) have dropped to $89 per barrel. (1)

History: After decades of stable oil prices, beginning in the early 2000's the combination of several drivers have fundamentally changed global oil markets: (1) Ongoing war and political unrest in the Middle East; (2) Devaluation of the U.S. Dollar; (3) A dramatic increase in world oil consumption from developing economies; and possibly, (4) The unprecedented levels of money flowing into oil speculation markets since banking deregulation.

Devaluation of U.S. Dollar: Beginning with President Bush's Administration (in 2002) and continuing under President Obama, a significant devaluation of the U.S. dollar has occurred. With currency devaluation the cost of imports (such as oil) increases. In simplistic terms (all things being equal), ~33% of the increase in the price of gasoline could be explained by currency devaluation.
Increased Demand for Oil from Developing Economies: A major driver in higher oil prices is/will be the continuing dramatic increase in oil demand from developing countries such as China and India -- something that no President has any control over.
Oil Futures: If you don't understand financial futures/derivatives, don't feel alone. When Warren Buffet was asked about what he thinks of derivatives he responded, "I don't understand them". For most people, an opinion on futures trading will depend on which Tribe they belong to (Democrats believe they should be regulated better, Republicans are anti-regulation). While the impact on oil prices from futures trading may be unclear, one fact is crystal: Their use exploded in the early 2000's after banking de-regulation (where now ~60% to 70% of trading volume is by financial institutions).
But the above chart is just the tip of the iceberg, where the vast majority of futures trading is unreported (OTC markets). The problem is the lack of transparency/disclosure -- nobody really knows or can know if excessive speculation is occurring.

Can We "Drill Baby Drill" to $2 Gas?: A central theme in this year's election campaign rhetoric on high gas prices is supposedly simple Econ 101 -- Supply and Demand. Under this argument, if environmental regulations were reasonable allowing more oil drilling, the increased supply would reduce the price of gas to a $2 range. Since the economics are so simple, we should be able to just look at the pump price savings in Canada -- as they produce much more oil than Canadians consume. But Whoops! -- gasoline prices in Canada exactly track those in the U.S.

Conclusion: While there are numerous benefits of increasing domestic oil production (e.g., creation of good jobs, greater energy security, improving the U.S. trade deficit) -- expectations of meaningful reductions in oil and gas prices isn't one of them. Simply stated, gasoline prices will always be driven by the world price of oil (an internationally traded commodity).

Extra Credit: If you want to be an A+ Student on market drivers for oil and gasoline prices, read this article from the Canadian "Oil Patch". The reason oil exploration is currently booming in Canada and the U.S. is because of high prices. For example, extracting oil from tar sands (the source of the Keystone project) can cost up to $40 per barrel. Without high oil prices, tar sands would not be economic compared to Middle Eastern oil (which costs 50¢ to $2 per barrel to extract).

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