“Getting crude oil wrong” by Mike Luciano

Mike Luciano reacts to a recent Lowell Sun editorial on domestic oil production:

Tuesday’s Lowell Sun featured an editorial about how America can control and drive down the cost of oil and gasoline by producing more oil domestically. But like many Americans, the Sun’s editorial writer does not understand the nature of commodities markets, as indicated by this passage:

“While pushing more domestic oil into the U.S. market will offset huge price swings, it’s not enough to drive costs lower. For that, Obama should also relax offshore drilling regulations that have prevented oil companies from tapping into known reserves off the Gulf Coast and elsewhere.

“America has relied too long on foreign interests to solve its energy problems. That dependency must end. Obama would be wise to use our reserves and offshore deposits to control U.S. costs…”

Tapping America’s strategic reserves because a barrel of oil costs $105 is not prudent by any stretch of the imagination. There is only enough oil in the SPR to power the country for about a month and a half at current consumption levels. These reserves should be left alone in case of a real national emergency.

More than that, the writer seems to think that if only the US produced more oil, the price of oil in America would decrease; hence the suggestion to tap the SPR and approve more offshore drilling applications in an effort to increase supply and “control US costs.” But the price of crude oil—even crude pumped from American soil—is traded internationally on commodities exchanges such as the New York Mercantile Exchange. This means even the price of domestically produced oil is affected by what goes on in oil exporting countries around the world. For example, one American petroleum brand, West Texas Intermediate crude, was trading around $105 a barrel today. Now that’s American oil, and what’s going on in the Middle East is having zero effect on the supply of WTI, and yet the price for WTI has been rising along with Middle Eastern petroleum brands, North African brands, Brent Sea crude, and every other kind of crude oil in the world. And that’s because they trade closely with one another on global commodities exchanges.

This is important to understand, though few people do. They hear about cheap gasoline that’s sold domestically in places like Saudi Arabia and Iran, and assume that being an oil-producing country automatically means cheaper fuel costs for the domestic population. That is simply not the case. In such instances, domestic gasoline is subsidized by the government, which means it can be sold at prices that are often well below market value.

In most cases, however, the price of oil is left for the global market to decide. On commodities exchanges, speculation reigns supreme. Most of the people who buy oil contracts will not actually use or even see the oil they’re buying, but will instead try to sell it at some opportune time later. During the seismic 2008 oil spike to $150 a barrel, the average barrel of oil was traded about thirty times by speculators, before it was actually delivered and consumed. Furthermore, traders are allowed to trade on margin, meaning they can buy more crude oil than they otherwise could with the principal in their accounts.

Given the immense volume of trading activity in crude oil in 2008, it is not surprising that its price went sky-high. This is the downside of an unfettered speculative commodities market. The basic idea behind speculation is that it allows industrial consumers of particular commodities to enter into futures contracts now at a locked-in price, even if it means paying higher than current (spot) prices, as a hedge against future price spikes.

But in this age of global casino capitalism, most speculators have no use for physical delivery of the commodities they’re buying. They buy and sell oil, corn, wheat, cocoa, etc. with no intention of holding on to them for any lengthy period of time. These exchanges occur on internationally traded markets that are open most of the time. So while Americans sleep tonight, a commodities trader sitting at his home or work computer in Singapore could sell his counterpart in Moscow 10,000 barrels of West Texas Intermediate crude for May delivery, thereby helping determine, along with the activities of every other trader of WTI at that moment, the price of a barrel of WTI.

Because oil and other commodities are traded globally, domestic supply and demand cannot be considered in isolation. This is the mistake the Sun editorial writer and so many others make. Imagine for a moment that overnight America magically doubles its oil production (to about 20% of world production) for the foreseeable future, but at the same time, OPEC announces that its member states have run out of oil altogether. That’s about 40% of the world’s oil supply suddenly gone.

Given this scenario, are oil and gasoline going to be cheaper in the US? Of course not! The price of WTI and every other brand of petroleum would hit the stratosphere. The amount of crude being pumped out of American soil may have doubled, but overall global supply will have plummeted with OPEC drying up. Where the Sun goes wrong is its assumption that “pushing more domestic oil into the U.S. market will offset huge price swings” that result from unrest around the globe. But there is no American oil market. It’s a global oil market that determines prices. That’s why the price of crude has gone up in America in response to the upheaval in the Middle East and North Africa—not because the US gets most of its oil from those countries (it doesn’t) or because supply in America has significantly gone down or because demand has significantly gone up (they haven’t), but because the unrest has conjured fears of an interruption in oil production in those places that could substantially decrease global supply.

As you can see, the Sun’s recommendation that the government tap the SPR and allow more drilling would likely do nothing to affect the price of oil now, and do very little to affect it later unless the oil reserves discovered were incredibly abundant and actually recoverable. On that front, there was a related letter to the editor in the Sun that same day that contained wildly inaccurate information about oil reserves in the US.

Written by Michael Carpinella, the letter is nothing more than a regurgitation of a chain email that first surfaced a few years ago about the vast untapped potential of the Bakken oil field in the northern US and southern Canada. Taking a cue from this internet rumor, Mr. Carpinella asserts that the field contains 503 billion barrels of crude oil based on an incomplete Energy Information Administration. But the very EIA he cited also noted that that report had not been peer reviewed and that the United States Geological Survey would conduct another survey.

About a year and half later, the USGC announced, “North Dakota and Montana have an estimated 3.0 to 4.3 billion barrels of undiscovered, technically recoverable oil in an area known as the Bakken Formation.” Naturally this information was missing from Mr. Carpinella’s letter, but to the previous estimate’s credit, it was off only by a factor of 117.

Then, citing a dubious and self-serving investment newsletter called the Stansberry Report, Mr. Carpinella claims that under the Rocky Mountains are two trillion barrels worth of crude oil. But that claim has been called into serious question, as well as the feasibility of extracting whatever oil is actually there. (Scroll to the bottom of the link for the Rocky Mountains assessment.)

Regardless, why hasn’t the US exploited these allegedly vast untapped reserves in the Rockies? According to Mr. Carpinella, “Environmentalists and other small interest groups are allowed to block our way to independence.”

There you have it. A bunch of tree huggers somehow forced undue government restrictions on oil exploration, meaning that the likes of Greenpeace and the Sierra Club somehow managed to outlobby the oil industry. That’s like Bambi slaying King Kong. But I guess when you get your news from chain emails of questionable origin, anything is possible.

4 Responses to “Getting crude oil wrong” by Mike Luciano

  1. Steve says:

    Very interesting. On a related note, an e mail sent to me by John Lumbard, of Lumbard investment Group.

    The Saudis have guaranteed that they will offset any shortfalls in the export of Libyan crude oil. Yes, their crude is heavy and can’t be used by some refineries, but many or most US refineries have recently been upgraded to accept crude much heavier than anything that comes from the Middle East. The Saudis have also been building modern refineries, so this is probably a red herring thrown out by oil bulls. Saudi crude can indeed drive prices down.

    Demand is also feeling a pinch. The friend who just bought a Prius is not indicative of a trend, but lots of Americans are getting serious about energy conservation. There will be conservation, and there will also be substitution—anybody with a heating-oil furnace who lives near a natural gas line is making calls to dealers right now.

    In the intermediate term we’ll be seeing increased production from the Gulf, from the start-up of deepwater Brazil, from Iraq, and from shale fracking in the US (which will quickly spread all ‘round the world). There’s a big new oil-bearing shale in Ohio that probably overlaps the Marcellus, and a very large one under development in North Dakota. All the above are the big and obvious new sources of supply, but a lot of other things can happen at the margin. There’s no reason why Canada can’t ramp up its oil sands further. Russia is #8 in the world in terms of reserves, but in 2009 it was #1 in production; so the top 7 can produce more. There’s been a lot of demand from commodity investors that could ease off or even reverse. There might be a disruption in oil deliveries from yet another Mideast nation, but there could just as well be a resumption of deliveries from Libya. All Libyans suffer when the oil stops flowing.

    In the longer term we can expect large new deepwater discoveries, and further substitution of other energy sources for oil. There is a glut of natural gas and coal, and Israel has embraced electric cars (and a national grid of recharging stations) with an eye to nearly eliminating the import of oil and gasoline. China is working on the same idea. Using nuclear power to charge the cars is particularly appealing, because nukes like to run flat out 24/7, and there’s never been enough night-time demand for their power.

    All of these things can be overwhelmed in the short term by Mideast turmoil or a Saudi production cutback, but the key point is from economics 101; when the price goes up supply increases and demand shrinks. There’s a lot of argument about the oil price that is necessary to justify further oil sands production, or the use of carbon dioxide to force more oil out of old wells; but the combatants are arguing over prices in the $30 to $70 range. We’re above $100, and the cost of production in many places (such as shale or deepwater) is falling, not rising.

    When the oil stocks started this run they looked cheap, so we’re reluctant to take profits right away; but we already know that they will still look cheap (their PE ratios will be low) when they top out. Other options are to sell oil short via SZO, an exchange-traded fund that moves inversely to West Texas Intermediate, or buy emerging-market stocks and funds. The latter have been doing poorly this year because oil and food comprise a much-larger share of third-world spending than they do for us; falling oil prices, conversely, will be a boon for these nations and their stock markets.

  2. Michael Luciano says:

    “All Libyans suffer when the oil stops flowing.”

    And here I thought that all Libyans suffer when their dictator guns them down in the streets.

  3. Dean says:

    ww.opec.org tells it’s member countries what to pump for the year. When Ecuador joined OPEC. OPEC told Eduador to drop their production.