Friday, September 28, 2012

High Oil & Gas Prices -- The Real Issues.

For decades, politicians have been promising America oil independence AND lower gasoline prices. But instead of more promises, we need some straight talk on expectations, global realities, and the tough choices we face. The real policy issues that drive today's high oil prices are the consequences of war and a suffocating federal debt -- anything else is a diversion.
Can We "Drill Baby Drill" to $2 Gas?: A major diversion used in campaign rhetoric on high gas prices is supposedly simple Econ 101 -- Supply and Demand.   Under this argument, if U.S. environmental regulations were reasonable allowing more oil drilling, the increased supply would reduce the price of gas to a $2 range. FACT CHECKing this claim should be really easy by just looking at Canada -- as they have historically produced much more oil than Canadians consume. But Whoops! -- gasoline prices in Canada exactly track those in the U.S. (as they also do in other free market "net oil exporting countries" such as Norway).

On the flip side of political rhetoric, President Obama is taking credit that U.S. oil production is now the highest since 1998. Is this credit deserved?

Of course not. As an article from the Canadian "Oil Patch" explains, the reason oil exploration and production is currently booming in North America is because of high prices. For example, extracting oil from tar sands (the source of the Keystone pipeline project) and other unconventional sources can cost up to $40 a 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).

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

The Real Price Drivers: 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 oil demand from developing economies; and possibly
(4) The unprecedented levels of money flowing into oil futures speculation.

A picture can be worth a thousand words. As the above chart illustrates, there have been dramatic consequences from 10 years of war, bad behavior on Wall Street, and the accumulation of massive debt under President Bush and Obama (devaluing our currency). These are the true drivers of high oil prices, not environmental regulations.

War in the Middle East:: Many oil market analysts believe a war between Iran and Israel would immediately send oil prices to $150 per barrel (and already creating a significant risk premium in oil prices). If an Iran/Israeli conflict were to spread throughout the Region (which supplies ~60% of the World's oil market), the consequences on prices would be catastrophic. With the possibility of $6, $8, $10 U.S. gas prices (fill in the blank as your guess is as good as anyone else), foreign policy is very much a domestic economic issue in the U.S. Presidential campaign.

Devaluation of U.S. Dollar: Beginning with the Bush Administration (in 2002) and continuing with Obama, a significant devaluation of the U.S. dollar has occurred. While there are numerous reasons for this, they are generally linked to Federal monetary policies to finance huge federal budget deficits and to spur a weak economy.

With currency devaluation the cost of imported goods (such as oil) increases as the purchasing power of the U.S. dollar is less. In simplistic terms (all things equal), ~33% of the increase in the price of gasoline since 2002 could be explained by currency devaluation. Many market analysts argue that as a result of world central banks flooding the market with money (to finance budget deficits), its not that oil is expensive -- but its money that is cheap.

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.
[British Petroleum (BP) has an excellent 2 minute picture overview of what's occurring in world energy markets on YouTube.]

Oil Futures Speculation & Oil/Gas Prices: Typically, a belief in whether excessive market speculation is causing a significant rise in oil prices depends on what "Political Tribe" you belong to. Democrats believe oil futures markets should be regulated more -- and are raising the current price of gas between $7 (small car) to $14 (truck) when you fill up. Republicans believe this is paranoia and oppose additional regulation (Dodd-Frank).

Thankfully, there is an Easy Button to resolve this. Even if financial market speculation is adversely impacting oil prices, its an "effect" not a "cause". If the issues of war and federal debt were resolved, this would pretty much eliminate the conditions that drive excessive financial speculation.

The Final Question: After listening to all the campaign rhetoric and attack ads, everyone should ask the question:   "What do environmental regulations have to do with war and the Federal debt level, the true drivers of high oil prices?" The answer is simple -- they don't.

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