Tuesday, May 27, 2008

Speculators And A Falling Dollar The Primary Fuel For Rising Oil Prices; Oil Companies Not Necessarily The "Bad Guys"

According to a very informative article published May 27th, 2008 in the Anchorage Daily News, speculators attracted by the decreasing value of the dollar are the primary factors fueling the steady rise in oil prices.

The article is basically a short but informative tutorial on the methodology behind oil pricing. It is complex mix of factors, from the cost of turning oil into gas to taxes to marketing costs to the competitive whims of a local gas station owner.

Here's the basic sequence: Once oil is pumped from the ground, it can be sold on the spot market, a last-minute trading arena where oil companies and distributors buy and sell to each other, or straight to refiners. After it's refined into gasoline, the product can again be sold on the spot market, or directly to wholesalers, who in turn can supply their own stations or sell it to other retailers. At each step in the sequence, buyers and sellers negotiate a price until, finally, drivers pay the ultimate tab at the pump. At the starting point of all this is the wellhead price of oil.

But the oil companies are NOT the villains. In fact, it's hard to characterize any one entity as a "villain", since no one, in principle, is violating any laws.

The primary cause are the investors and traders in the futures market. Prices are a function of the open market, the result of futures contracts being traded on the New York Mercantile Exchange, or Nymex, and other exchanges around the world. Buying the current July crude oil futures contract means you're buying oil that will be delivered by the end of July. But most investors who trade futures have no intention of ever accepting the underlying oil: Like stock investors who frequently buy and sell their holdings, they're simply betting that prices will rise or fall.

But why are oil futures continuing their steady rise? Blame the falling dollar. Oil is priced in U.S. dollars, and the weaker the dollar gets, the more attractive dollar-denominated oil contracts are to foreign investors -- or any investor looking for a safe haven in the turbulent stock market. Consequently, the rush of buyers keeps pushing oil futures to a series of new records, and the rest of the energy complex, including gasoline futures, has followed. That pushes up the price of gas that goes into your tank. Supply and demand. The increase in the supply of speculators helps push up the value of the futures. And as long as oil prices remain high, there will be NO relief at the pump.

A secondary factor behind rising oil prices is the Organization of Petroleum Exporting Countries (OPEC). Because they control 40 percent of the world's crude oil, they swing a big stick. Many OPEC countries are located within politically unstable areas or suffer from political volatility themselves; conflict can curtail production, which in turn increases the value (and price) of the product. The answer to this problem is to reduce our dependency on OPEC - initially by opening up ANWR and some offshore areas to development, coupled with a long-term strategy of developing and integrating alternative energy sources into our national grid.

Another factor, not mentioned in the article, is insufficient refining capacity. The virtual moratorium of new refinery construction, driven in part by environmental objections, causes delays in refining crude, and, if one refinery becomes inoperative, can exponentially increase delays.

Oil companies say they're not to blame for spiking fuel prices, and their earnings, measured against revenue, are in line with other industries. Additionally, rising oil prices have sharply cut profit margins for refining, and that hits the major oil companies -- which both pump oil and refine it for use as gasoline. CEO Jim Mulva said Conoco Phillips, the second-largest U.S. refiner behind Valero Energy Corp., buys about 2 million barrels of crude a day at market prices to refine into gasoline and other products. "If oil costs us $30 a barrel or $40 a barrel or $120 a barrel, that's why the cost of gasoline is what it is," he said.

A giant like ExxonMobil can handle the blow. Its refining and marketing profits for the first quarter were down 39 percent from a year ago, but Exxon still banked a nearly $11 billion profit because of the hefty prices earned on crude it pumped out of the ground. The so-called "windfall" profits earned over a particular cycle then tides them over during leaner cycles.

But smaller refiners aren't so fortunate. Sunoco Inc.'s refining and supply business lost $123 million in the first quarter, hurt by lower margins. Tesoro Corp. lost $82 million for the same period. But in any event, huge profits at big oil companies like Exxon Mobil and Chevron aren't because of high prices at the pump. Their massive profits are tied to their exploration and production arms, which are benefiting from record crude prices.

What hurts the oil companies is the seeming outlandish compensation packages for oil executives. The basic salaries are high enough, but the extra aristocratic perks appear obscene on the surface. Unfortunately, conservative columnist Dan Fagan defends high CEO compensation. In his latest ADN column, published on May 25th, Fagan slavishly defended Lee Raymond's compensation package awarded during his tenure as Exxon's CEO:

The media whipped everyone into a frenzy when it reported Lee Raymond was paid $686 million during his tenure as Exxon's CEO. But what they didn't tell you is under Raymond's watch, Exxon's market value increased fourfold to $375 billion. Under Raymond, Exxon's net income soared from $4.8 billion to almost $70 billion. For the shareholders of Exxon who took their hard-earned money and then invested in the company, Lee Raymond undoubtedly earned his salary.

Undoubtedly, Raymond's contribution to the company's profitability was important. But how important? Where's the objective or empirical data justifying this level of compensation to just one person? Raymond didn't do this all by himself - he had the help of an army of lesser executives, managers, and workers to implement his decisions. Had they not implemented his decisions successfully, Raymond's vision would have remained nothing more than a pipe dream. What Fagan is doing is justifying this "winner-take-all" casino economy that has been imposed upon us. And it's not just "progressives" who object; many ordinary Americans take umbrage as well.

Here's how the typical price of a gallon of gas breaks out. After paying for the wellhead price of oil, these are the additional surcharges:

- Refining costs take a bite. The cost of refining added 27 cents to a gallon in the first quarter of this year, a nickel less than what it added in 2004, according to the Energy Information Administration.

- Marketing and distribution costs take another bite. The tab for delivering gasoline from refiner to retailer -- were 27 cents to start the year, only 6 cents above the cost four years ago.

- Taxes take a bigger bite. Federal and state taxes added an average of 40 cents to a gallon of gas in the first three months of this year, roughly the same amount as four years ago. California's 63.9 cents of tax is the nation's highest, Alaska's 26.4 cents the lowest. How the money is used varies from state to state, though the federal take helps to build and maintain highways and bridges.

- Gas stations may actually take the smallest bite of all. Stations pay tens of thousands of dollars for each gas shipment before they see a cent in the register. Eventually, many make only a few cents on a gallon of gasoline, a margin that can disappear altogether when credit card fees are added in. Consequently, since only five percent of gas stations are owned by the oil companies, station operators have turned many of their facilities from classical "service stations" into convenience stores which also sell gas. They make up the difference through the sale of other products. Here's a typical example from the Daily News article:

In the Philadelphia suburb of Havertown, PA., earlier in the week, Sunoco station operator Steve Kehler received a load of gasoline -- 9,000 gallons -- which, at a wholesale price of $3.729 a gallon, cost him 4 cents a gallon more than the previous load. That left him in a sticky situation: Should he raise prices right away to recoup some of his higher gasoline expenses, or should he hold off for a couple of days in hopes his competitors will also have to raise their prices?

"I'm surrounded by $3.89's, and I'm already at $3.91," said Kehler, referring to his prices and those of some nearby competitors. "I'm going to play a little waiting game right now."

The $33,600 Kehler must pay for his overnight gasoline delivery won't be debited from his bank account for a few days. That gives him a little breathing room, time to hold prices steady. Hiking prices too quickly will hurt sales. "I'll probably change it tomorrow night, at closing," Kehler said. "I'll go up 4 cents."

Commentary: The short-term solution is to increase the supply to correlate with the demand. Prices will continue to rise, thanks to the declining dollar, but the rise will be much slower. This means opening up ANWR and some offshore fields for exploitation. This would also increase our own internal energy autarky and economic sovereignty.

But this must be accompanied by a long-term strategy to develop alternative energy and integrate it into the national grid. In some areas, this must be accompanied by the creation of a refueling network. The lack of such a network has prevented wholeslae acceptance of electric-powered vehicles, which also require a considerable amount of time to recharge. One example of alternative energy available right now is compressed natural gas for motor vehicles. This alternative is taking off in Utah, where it can be had for 64 cents per gallon. But what makes it possible is a refueling network in Northern Utah. This makes CNG-powered vehicles a viable commuter alternative along the Wasatch Front. Unfortunately, there is no such refueling network in Alaska.

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