March 7, 2005

Running on Fumes?

By Steve Feinstein

In light of the recent run—up in oil prices to more than $50/barrel, and the statement by OPEC Acting Secretary—General Adnan Shihab—Eldin that prices may spike to as high as $80/barrel within two years, it may be instructive to take a 35,000—foot view of the world oil market.

Few consumer commodities strike a bigger emotional chord in people than gasoline prices, probably because of the constantly changing nature of those prices. It's human nature to seek stability and consistency. When gasoline prices are relatively calm, people don't think much about them. When they rise seventeen cents per gallon between the time one drives to work in the morning and when that same gas station is passed on the way home, it's infuriating.

Analysts have said that for every dollar increase in the price of a barrel of oil, the retail price at the gas pump rises by three cents. If oil prices do indeed rise to $80/barrel, that would translate into an additional 90 cents per gallon, and we'd be well on our way to that dreaded psychological mark of $3.00/gallon.

Why are gas prices are so high now? There are four easily identifiable, specific reasons for today's high prices. There's really no mystery. Here they are:
 
1. Higher demand by the world's largest economies.
The demand for gasoline in the US is at record levels as our economy cruises along in high—speed overdrive. US productivity is way up, the housing and automotive markets are at or near record levels, consumer spending is at an all—time high, the unemployment rate is at historic lows (lower now than the average of the go—go 90's). The demand for gasoline in the US has never been higher than it is right now.
 
More than this, however, is the emergence of China and India as  major customers for oil. As the economies of the world's most populous nations wake up and step into the modern age, the demand for petroleum—based products in those countries is absolutely skyrocketing. Their demand for oil is running 20—30% higher than just a few years ago.
 
2. Political unrest in the oil—producing countries.
Venezuela, one of our largest suppliers, endured a crippling oil industry strike early in 2003, followed by a presidential crisis later that year. Major instability persists even today. Their production and exports are significantly lower than in past years, putting increased supply pressure on a market already beset by record demand.
 
The turmoil in the Middle East also contributes to the falling confidence of commodities traders around the world. Although Iraq's actual oil production is now about the same as pre—war levels (about 1.8—2.2m bpd) and the oil output of other Mid—Eastern oil—producing nations has been unaffected by the War in Iraq, the confidence levels of commodity brokers around the world is shaky because of the fears of a major catastrophe. Commodity and investment markets are as much about confidence and reaction to possible future events as they are about any reaction to present—day occurrences. Estimates are that this so—called 'terror premium' adds about $8—10 per barrel to the price of oil
 
3. "Regional" blends of gasoline.
Most consumers don't realize that gasoline sold on the coasts or in major metropolitan areas is different than the gasoline sold in rural markets, or that cold—weather gas is different than gas sold in warm climates. Because of increasingly tougher environmental/pollution regulations, each major climatic region of the US must have gasoline that meets the specific requirements for exhaust emissions in that particular area. Depending on average temperature, humidity, population levels, existing air quality, etc, the formulations of gasoline vary from region to region. There are eighteen such 'boutique' gasolines across the country.

While this might be good for the environment, it is hideously inefficient from an economic standpoint, since energy companies can't readily transfer gasoline inventory from area to area to meet spikes in local demand. Therefore, if there's a shortage of Mobil gasoline in metro NY and an excess in Topeka Kansas, Mobil can't shift their stock from Kansas to NY, because that gas is "illegal" in NY. Result? A shortage in NY, and a resulting price increase. This wasn't the case eight years ago, before regional blends became law. To make matters even worse, all the different formulations mean that US refineries (which take crude oil and turn it into gasoline) are stretched to their limits, overwhelmed, and constantly playing catch—up. There are simply not enough refineries in the US to keep pace with all the new gasolines that are needed (no new refineries have been built in the US in the last 30 years because of environmental restrictions), and when you throw in the dicey, roll—of—the—dice crap shoot that the refineries must play as to when they convert from producing summer gasoline to winter heating oil, it's no wonder we never have enough of anything at the right time.
 
4. Restrictions on drilling and exploration.
Despite new environmentally—friendly exploration and drilling technology, oil companies have been restricted in their ability to look for new oil reserves off the CA and Gulf coasts and in the Alaskan Wildlife Refuge. This last point is worthy of a separate treatise, but suffice to say, there are huge potential oil reserves that we just can't access. Therefore, commodity traders realize that the market's supply will remain restricted and this factors into their futures pricing activities.

What are the prospects for new countries to emerge as major players on the world's oil stage? Russia has huge oil reserves, but that country is politically unstable and therefore not entirely dependable. However, Russia desperately needs the hard currency that major oil exports would bring in, so the incentive to become a reliable, major oil supplier is there for them. Oil could prove to be their economic get—out—of—jail—free card. With several new oil pipelines scheduled to come on line soon, Russia could very well become one of the world's largest oil—exporting countries. Russia's potential gain from oil business with the US, given our desire to wean ourselves from dependency on Saudi and Venezuelan oil, could work in both countries' favor.

Iraq is roughly 75% unexplored for oil, yet the known 25% has yielded the second highest proven oil reserves in the world, behind Saudi Arabia (source: Oil and Gas News Online). That is an incredible fact, and it takes a moment to fully digest it. Only 2000 wells have been drilled in Iraq, compared to almost one million in Texas (source: The Independent Petroleum Association of America). Obviously, Iraq's potential upside is tremendous.

A stable Iraq could deliver enough oil to the world market to help satisfy demand for quite some time to come. A domestically—secure Iraq, maximizing its oil production potential, represents a huge economic threat to its oil—rich neighbors such as Saudi Arabia and Iran, quite apart from the sobering political effect a democratic Iraq will have on the rest of the Arab world. This is certainly not lost on the theocracies and monarchies of the Middle Eastern oil states, who have every reason to 'hope'—or worse—for a US failure in the effort to promote a Western—sympathetic (or at the very least a Western non—hostile) Iraqi government.

It's therefore apparent that worldwide crude oil reserves aren't the problem. Political instability, refining capacity, environmental opposition, and distribution inefficiencies are the factors that limit the amount of oil and gasoline actually delivered onto the world market.

However, we should take heart, because there is light at the end of the tunnel. Technology is on our side.  Consider these facts:
 
1. A few decades ago, oil more than a few hundred feet below the surface was thought to be inaccessible. Now, modern drilling techniques easily reach down many thousands of feet.

2. Furthermore, it's possible to drill 'sideways' first, then down, minimizing the surface area that would be disturbed during the exploratory phase. (The enviro—politicians, more intent on using 'oil exploration' as a political issue, are fully aware of this, but they conveniently ignore the facts, preferring to put party wedge issues above the good of the country.)

3. Offshore drilling and production, previously regarded as impossible, is now routine.

4. Heretofore untapped oil reserves are becoming recoverable with new technology. In the western U.S., the amount of crude in oil shale—literally oil—infused rock—rivals the proven oil reserves in Saudi Arabia. Alberta's Athabasca tar sands hold even more oil. Right now, it's too expensive to retrieve that oil on a large scale, but as the technology advances, the US will benefit from an ever—increasing domestic and North American oil supply, free from Middle Eastern geo—political circumstances.

One additional factor promises to have an agreeable effect on America's oil/gasoline situation. There is a sea change on the horizon in regard to gasoline consumption in the US market because of the automotive industry's impending switch to 42—volt electrical systems, from today's 12—volt—based systems. The number of automotive accessories has increased dramatically in recent years, as DVD video systems, navigation screens and ever more elaborate HVAC and multi—channel music systems place increasing demands on a car's electrical capacity. Accordingly, as reported in the trade magazine Automotive Industries, manufacturers will be converting future production (starting around the 2007 model year) to higher—capacity 42—volt electrical systems to handle the increasing demands for electrical power in the automotive environment.

But there is an added benefit to this switch: Not only will car stereos play louder, but several ancillary systems, such as power steering and air conditioning—which used to be fuel—robbing parasitic drains on the engine—will now be electrically powered. The exact same 4000—lb SUV with a 42—volt electrical system will now get 15—20% better fuel economy than before, and with lower emissions to boot. All without having to shave as much as one ounce off the curb weight. This is not some 'what if' fantasy—42—volt vehicles are on the way. And the first recipients of this new pumped—up voltage muscle? High—priced luxury SUVs—not because manufacturers set out to increase their mileage, but because their auxiliary systems need the added electrical power. The gas mileage increase is just a by—product of the change, but a very welcome one, nonetheless.

The emotional effect of rising gasoline prices on the average consumer is actually far greater than the real financial impact. First, some perspective: Adjusted for inflation, gasoline prices remain low in historical terms, and an upward spike is more of a psychological annoyance than a real financial hardship. For the average driver who uses about 50 gallons per month (assuming 12,000—15,000 miles driven per year, in a car that gets 22 real—world MPG), a 50—cent run—up in gasoline prices amounts to a 'whopping' $25 per month. In truth, hardly noticeable. People pay more when they switch from dial—up to broadband, without even flinching.

The economic significance of the world's oil market obviously a huge topic, influenced by many additional factors not discussed here, such as CAFE, the Strategic Petroleum Reserve (SPR), and alternative fuels. But for now, there's plenty of oil around, and there's even greater incentive for the countries that have that oil to deliver it to the market. We're not running out any time soon. Those 25—50 cent—per—gallon price fluctuations may be emotionally unsettling to individual consumers, but that's about it.