So I was reading the less interesting bits of the paper and looked at a report on the price of oil which, as is pretty much routine, contained the suggestion that a shortage of refinery capacity was contributing to the high price of crude. Turning my brain on for a moment, it struck me that economics 101 suggests the exact opposite. Refineries and crude oil are complements in production, so a shortage of refinery capacity should lower the price of crude, while increasing the price of refined products such as petrol and distillate (easy thought experiment to show this: if there were no refineries at all, crude oil would be worthless).
A quick Google shows that I’m not the first person to notice this point, but the erroneous claim keeps on getting repeated.
How does an error like this get started. The obvious reason is that if the price of oil is driven by demand fluctuations (as at present) high prices for oil will be correlated with perceived shortages of refinery capacity. It will be easy to find specific instances to support an apparent causation going the other way. For a refinery working at maximum capacity, a breakdown will cause a supply interruption and will be very obvious. The same breakdown, occurring at a slack time, might be dealt with by rearranging operations and rescheduling maintenance and never reported to customers.
John Quiggin 
Cynicism tells me that the oil producers are keeping their prices up just because they can and nothing to do with what the situation actually is – but they get away with it because of the perception that supply is low. Im probably wrong (I hope I am) but its possible.
PrQ,
One of the problems is that oil is not just oil – there are many differing grades and a refinery has to be set up to take a particular grade. Most pricing (at least the stuff you see published) is done in Brent or West Texas Intermediate, the grades that suits the refineries in the US best. This is very expensive because it is in high demand. Saudi crude is generally heavier and so less suitable for petrol – it is cheaper. The differences only get large when refinery capacity is limited.
There are also distribution problems. Most of the prices are quoted for delivery to a certain place. During the long period of low prices up until recently the tanker stock was allowed to run down and the older single hulled vessels were retired. New ones take time and high prices – they are being built now. Tanker owners are demanding higher prices in the interim, though.
Give this a quick read. It may help.
One other point to note is that, yes, the oil producers are making a bit of hay here – it suits them to be producing at full tilt into a high-price market. This is likely to be a oil-hog cycle, though.
The point about grades of crude was mentioned in the link, but I don’t get the impression that the reports I’m reading have anything so sophisticated in mind.
John:
Seriously, there are many reasons why refined grades coude go up while regular crude remained unchanged. Reasons:
Both refinery capacity and crude extraction may both be working at maximum. In other words, what is being refined is been taken out.
You do not get all refined products from any particular barrel of crude. In other words crude is not generic. I have seen the price of various by-products zoom when there is a shortage without it effecting crude prices. In other words West Texas could stay at $X while jet fuel goes up in price as there are shortages of refined jet.
Investment banks and many other players are constantly trading spreads between all products. Players who think there is a shortage of say No.1 heating may buy heating 1 and spread the trade against Diesal, to use an example.
There are also lots of players in the market, both users and refiners that go to the swap market to hedge themselves. those selling these swaps could attempt to mitigate spot risk by only having basis risk. It is impossible to figure out what is going on by trying to look at the two markets, refined and crude, distinctly
A shortage or refined product does not necessarily affect the price of crude.
John:
I’ll give you another example of what can happen in markets, which makes the obvious answer fuzzy. Take the gold market as a good example.
There are several players in the gold markets. There are producers (miners), consumers (jewellery manufactures), speculators and central banks (large and small).
Gold can be traded physically or on paper.
One of the things miners can do is hedge their estimated forward production on the swap market. Without complicating it, miner x goes to his friendly investment bank shows them a schedule of expected production and asks the investment bank to quote on hedging the proceeds of future anticpated production. The investment bank then goes to a central bank and asks then to lease a quantity of gold for a period of time: probably matching the swap requirements by the miner. The central bank leases the gold (yes there is a daily lease market) to the investment bank who then takes the gold –the right to use it- and sells it in the spot market. There are times when the lease period doesn’t match the forward production of gold and you get a squeeze in the spot gold price. I have seen about a dozen of these squeezes in my life, which at times has sent to gold price up by $40 oz. This of course hasn’t meant the gold price was going up. It only meant there was a physical shortage in the spot market. This example shows that things are not always what they seem in the markets.
…suggestion that a shortage of refinery capacity was contributing to the high price of crude…
Maybe what they are trying to say is that demand for the refined product is so high that the refineries operate at full capacity, which means that demand for the crude is at its maximum.
In other words: shortage of refinery capacity is a proof of high demand for crude and high demand for crude is one of the reasons for high price of crude. Something like that.
See Rand Corp report mid 2002 on refining capacity in US. Utilisation up from 60% to 95%. “Boutoque” products for CA AZ push up costs. No percentage in beoing overstocked on refined products, no new refineries for 25 years because of environmental lobbies, improved technology increases yields. Big stopper is use of PETCOKE which is the shit left after refining, burnt in cement plants, v dirty not suitable for steam generation unles mixed with coal.
Refining is the key in N America, don’t know in Australia / Japan.
If I was a terra wrist I would go for the Texas / Louisiana coastal refineries – or put dirty plutonium in an oil tanker.
Even more curious is the weekly at the pump price of fuel at service stations. I always just put this down to “what the market will bear”. Stations on busy roads with many service stations have lower prices than those without passing traffic and competitors. Prices are higher on Fridays, Sat and Sun when ordinary punters fill up but lower Tuesdays and Wednesdays when demand is lower. However I hear Oil companies justifying the weekly / daily fluctuations etc on the basis of their input prices. Surely this can’t be correct?
abb1 probably nails what is really being said here. As I understand it the oil refining industry was operating for many years on uneconomic long term refining margins of about 4c/litre. Australia was importing petrol from Asia as a result and Adelaide’s Mobil Port Stanvac refinery closed early last year(It was also an aging plant) More recently world demand for fuel has seen refining capacity pushed to the limit and refining margins double to 8c/litre, which will cause more capacity to be built in the long term. The same thing has happened with steel, with about 6 price rises in the last 18 months, pushing steel prices up by about 50%. Bluescope Lysaght and Onesteel(previously BHP ) are enjoying a lack of domestic import competition from Asian steel-makers now because of demand from China, albeit they are all paying higher resource input prices. Same with petrol from Singapore. Processing capacity restraints(and shipping)have been added to resource demand price hikes, to feed overall final product pricing. It’s probably difficult to isolate the various components at work here.
As an aside I know a mate in the meat export shipping game who has experienced reefer cargo rates to the US West Coast rise by 50% in the last year. With Maersk swallowing P&O recently, the shipping cartel is getting smaller and playing increasing hardball with exporters. They’ve dropped reefer shipping from Fremantle to put a shot across the bows of the Productivity Commission’s report to Treasury. Basically, don’t mess with our oligopoly profits Oz, or else!
Given that at current rates of consumption there is only 30 years of oil remaining. And given that there a couple of largish countries who are still planning to grow their economies from here on in, the current daily oil burn will increase from 85 million bdp to god knows what.
Refineries at near continual capacity signal that demand has jumped to a new level. This screams out that oil is still under-priced.
wbb,
There has only been 30 years’ worth of oil left for the last 50 years – and there is still only 30 years’ worth left. Makes me think there is some basis error in the calculation.
If Prof. Quiggin insists that the high price of crude is a simple (“Crude”?) supply and demand phenomenon, how can high inventories in the US coexist with high prices? There is a revealing graph of US crude oil stocks at
http://www.petromatrix.com/Us%20tables.htm
which shows stocks currently above the usual range for March-June, not below, as a shortage would imply.
Andrew:
don’t you get it. It’s a perpetual thirty year supply from to start of the next day. It reminds me of the Brits “perpetual entry into the Euro”. Everytime they talk about entry, someone says it will happen in the next five years. However the starting point is from that point on.
Brid – that is the point I was making. I would also contend that, by the time we wean ourselves off oil we will still have about 30 years’ supplies left. Of course, once demand drops to zero we will then have an infinite number of years’ supplies left. That is where the basis error steps in – we know (roughly) our usage, but the estimate of the recoverable reserves keeps shifting so we compare a known to an unknown.
Andrew:
I am not an expert in this area; however, one stat has bothered me particularly with regard to the Refined/ crude question. If crude was going to run out in 30 years time as some people are stating, I would expect the COST of extracting crude to be going up as well. And this is where I encounter a problem. Middle East crude is still being extracted at 2 bucks per barrel. Generally, when wells start to die off the cost of extraction begins to rise, but this hasn’t happened in the places where the world’s biggest wells are.
Of course, no one is taking account the fact that if there were a shortage coming up, the cost of extraction would be the price signal for substitutes to begin entering the market; or at the very least you would begin to see more activity in “cutting” shale oil in Canada. Although, some oil is produced from the absolutely massive shale supples in Canada, they are doing so only at the margin because investors are concerned about the Saudi sledgehammer coming down real fast. I think the cost of making this oil is around 15-20 bucks per barrel. This is an enormous differential to the cost of Saudi and hence the reticence, as it would place the whole exercise at an enormous danger to the Saudis.
This is where the fatal mistake comes in. People see the price of oil zooming to 55 bucks per barrel and immediately think we are going to run out of oil. That doesn’t signal anything like that. It merely means either there is an imbalance in the market or Opec for a short while has the world by the short and curlies. The problem for the Saudis and Opec is that higher prices will eventually cause lower prices because the price signal if kept high for a long time will attract new entrants.
The only time we ought be alert (not concerned) to crude supplies going south is if the cost of extraction goes much, much higher in real terms, not nominal. I personally think it is not even going to happen in my grand kids lifetime although I wish it would to at least cut the legs underneath the Saudis.
So the Middle East will have us over a “barrelâ€? for a long time yet, or so it seems. It is not the price of extracted crude that signals resource scarcity, it the cost of extraction.
Well, OKay, so demand is high. However, the supply mechanism is deliberately designed to manipulate the price regardless of what the demand is. Obviously (assuming enough crude production/delivery capacity) the suppliers could flood the market and bringing the price down to $30, $20, even $10/barrel.
This, it seems, leaves only two possibilites:
1. conspiracy to keep prices high, which seems kinda plausible or
2. not enough of the crude production capacity, which would kinda contradict this announcement: Saudi oil minister: kingdom has enough oil to meet global demand
abb1,
The Saudis are about the only ones not pumping at full tilt at the moment – apart from Iraq. The reasons we are having problems at the moment is not because there is not enough oil in the ground (see S Brid above) but for many other reasons, including because there is not enough productive capacity.
During the long period of low oil prices that is only just ending (prices are still only half in real terms what they were in 1973) many countries, including those with the best quality crude, allowed their capital stock to degrade as the Saudis could always out price them if they tried to meet them on price. They could cover the cost of pumping, just not the cost of rebuilding capital stock and exploring. It takes time to turn that around – see my link on the oil-hog cycle above.
S Brid is broadly correct – Middle East crude is plentiful so, apart from market manipulation and cycles we should just get a gradual increase in prices as supplies dry up, causing a move away from the use of oil to other replacements.
The reasons we are still using oil is that:
1. it is still relatively cheap;
2. we are set up to transport and store oil – the capital stock is in place; and
3. we can source it from several locations, not all of which are entirely odious.
Read the article on the oil-hog cycle at post 2 – while not entirely correct it is more than close enough.
I would not necessarily believe everything in the South Bend Tribune.
abb1
1. Yea, everyone ought to be pissed with that pic, but it doesn’t explain the steadiness of extraction costs.
2. The Saudis are what people call he swing producers in the market. They are the ones who swing the quantity around to try and meet price targets set by Opec. Of course all them cheat on their promise.
If I was the Saudi oil minister I would be saying the same thing as well. The reason is that you don’t want oil exploration platforms going out and looking for the black gold. Why, because at 50 bucks a barrel they are making out like bandits ( 2 bucks for getting it out of the ground) but it is also a scary price for them because it will invite exploration. That’s why deep down the Saudis as the largest and cheapest producers don’t really want a very high oil price. They know they will get hit with new entrants sooner or later sending the price plummeting.
As the cheapest and largest producer with the largest reserves, it is not in the Saudi’s interest to keep crude at a very high price for too long. The ideal situation for them is a substantially lower oil price without the threat of new entrants.
I am not pissed, I think it’s funny.
Of course all them cheat on their promise.
They cheat by producing more, not less, that’s the nature of their cheating.
So, again, does the OPEC have enough capacity to bring the price down to $25 or not? If they do, then it’s a conspiracy, if they don’t, then it’s the lack of capacity.
abb1
Of course all them cheat on their promise.
That comment had really nothing to do with the topic. I put it in to illustrate waht they are like.
does the OPEC have enough capacity to bring the price down to $25 or not?
Depends how much time you will allow for various processes to occur.
Extraction isn’t the only problem. As someone said earlier shipping is a problem. It takes time to build ships. It takes time to add new refining capacity. It takes time although a little less to build pumps to get it out of the ground.
If they do, then it’s a conspiracy, if they don’t, then it’s the lack of capacity.
It doesn’t have to be either. As someone said earlier the add on demand (China and India) wasn’t anticipated and the market does what it does best which is to react to price signals.
I wouldn’t exactly call it lack of capacity when Iraq, the second largest producer is to a large extent out of the picture and has let it’s capital stock run down since the sanctions- 15 years ago. The Saudis also aren’t producing at max.
It all depends on what your defintion of full capacity means. Do you include or not include Iraq. Do you inlcude or not include Saudi at full production. Do you include or not include ANWR for instance when that comes on stream in the next 6 years or so. Do you include or not the expected future production tied to the probabilities assiciated with increased exploration. If your question was leading to the idea that we are running out of oil, no we are not any time soon. At worst ( or best) we have billions of reserves in shale.
Okay, S Brid, fair enough.
At the risk of calling down the wrath of most of the posters here on me, I don’t think people should be so dismissive of the idea that we only have 30 years of oil supplies left.
First up lets deal with the claim that we have had 30 years worth of supply for 30 years and it just keeps being extended. In the early 1970s calculations were done suggesting there was 30-40 years supply, but this was based not only on the usage a the time *but on the rate of growth*. In other words consumption was growing fast and on that basis we were likely to use up the supply in 30-40 years.
Along came the oil shock and two things happened – everyone went out and looked for more oil, and conservation measures kicked in making cars more efficient etc and the growth in demand dropped right off.
As a result its thirty years later and we are not about to run out.
But the crucial question is, which of these two factors had the main effect. If we found heaps more oil then that suggests that there is no problem with supply – as soon as prices rise enough people will go looking for more, and probably once again find it. However, if the main effect was from conservation then we are in trouble, because absolutely no progress will be made in this regard in the US as long as Bush is in power, and American culture in general these days is pretty resistant to making any major changes.
If you look at the record, very little new oil has been discovered since the late 70s. Some old fields have turned out to be bigger than expected, either becuase they have more in them than we realised, or because extraction technology has improved, but the notion that there are all these new fields out there waiting to be found looks likely to be false.
The Persian Gulf fields are a natural freak (a bit like Olympic Dam having a quarter of the world’s uranium). The fact that oil can be dragged out of them at some incredibly low cost indicates that there is plenty more there, but says nothing about supply anywhere else. And even this massive field has to end sometime.
I have no idea how soon, but long before our grandchildren’s time we will find that the only source of cheap oil is the Persian Gulf, creating a hideous political situation, followed some years later by the point where even those fields are starting to dry up.
Stephen,
If that happens the price will start to rise for reasons other than taxes, and substitutes will move into the market. It has happened before with many other products and there is no reason to believe it will not happen this time as well.
Stephen, I discussed peak oil here
Thanks JQ, and sorry, I wouldn’t have made such a long comment if I had realised you had discussed it already.
However, I’m not convinced by Andrew Reynold’s arguement that substitutes will simply move in. Of course this will happen eventually. However, given the wild fluctuations oil undergoes for various reasons, and the long lead times required for many of the alternatives to hit the market there could be a very unpleasant transitionary period, where supply is inadequate, but alternatives are not yet available.
Government foresite could help avoid this, but is hindered by unrealistic estimates of how long supply will last.
With a Texan in the Whitehouse and a former Haliburton CEO as VP, why does anyone here believe that the executive branch of the US government wants a lower oil price? Clearly the elimination of a $ 2,000 tax credit next year (2006) for buying vehicles such as a Prius, Honda, or Ford Escape Hybrid etc.,etc. is a GOVERNMENT decision!
When is the US government going to get it right? Does anyone really believe Bush wants us all to have a hybrid? Seeing as how the USA is the world’s major consumer of petroleum I would hardly think that the current price of over $56 a barrel would be long-term sustainable if every major automobile producer was grinding out hybrids at full tilt. The tax credit should actually be set to $ 3,000 next year if the US government was serious about moving in the right direction.
I find it amusing that everyone assumes that oil companies can purposely cause oil prices to move in one direction or another. If that were the case, when the Asian economic downturn of 1997-98 came along and supply overwhelmed demand, why did those companies allow the price to drop below $10/barrel when it cost $12-15/barrel to extract? Oil is a world commodity, priced every business day by an open auction process in New York, London and Singapore. There are too many bidders in those markets to believe that they all work for the oil companies alone make the price move one way or another.
The biggest reason oil prices have risen is the strength of the Chinese and Indian economies that have grown more rapidly than the world could accomodate presently. Speculators and commodity brokers may exaggerate peaks and valleys, but they merely ride with the wave as commodity prices move up and down relative to how much of the commodity there is and who is willing to pay for it.
Secondly,the world didn’t run out of rocks at the end of the stone age, man just found a better way of using his resources. The same will be true of the petroleum age. We won’t run out, we just won’t be able to buy it as cheaply as we once did. At some point, mankind will be forced by economics to adopt a new way of life.
As world’s largest concentrated reserve of oil, the Saudis want to moderate the price of oil to keep it low enough to discourage alternative energy sources. The Saudis have told the Bush administration that they are now limited on what they can produce until the invest in drilling more wells, etc. that will take 2-5 years to bring on line. But they now believe that their maximum production level is just a few million barrels of oil per day above where they are producing now.