atomic_fungus (atomic_fungus) wrote,

Energy Costs

Lately there's been a discussion in the Fiero forum over whether or not high gas prices are the result of high crude prices, or a reduction in refinery capacity in the US.

I've been throwing in my $0.02 every once in a while, but I think I may as well shout at the wind. People have no desire to understand why energy costs so much; they are happy just to curse the oil companies and complain about how much money they're making. They apparently need a troll to curse; and "the oil companies" form the kind of monolithic-seeming faceless machine that is easy for the average person to hate.

I think much of the problem stems from the fact that economics is not a required subject in school. It should be; macroeconomics at a minimum--because if people understood why the law of supply and demand works, they would be less easily fooled.

The oil companies are making record profits!

...always implicit in this statement is, ".... Those BASTARDS!" But oil companies exist to earn profits by selling a product; they are not in it for warm fuzzy feelings. The companies are obliged to earn dividends for their stockholders, because the stockholders expect a return on their investment. A failure to capitalize on favorable market conditions would get the corporate executives replaced with executives who would work to maximize profits; they cannot decide to sell their product for less out of sensitivity for the plight of the common man.

But there really isn't all that much profit in the production of fuels--certainly not "record profits", not even at today's prices. Oil companies do it because they have to have a market for their product. No one but other oil companies can use crude oil; crude oil must be refined into products which the consumer can use.

The production of crude oil is separate from the refining of crude oil and the selling of refined petroleum products. The signs may all say "Exxon" or "BP" but they're subunits of a conglomerate. The company which drills for oil, and pumps it from the ground, has only a name and a CEO in common with the company which refines the oil into gasoline and heating oil and plastic base stocks. The company which pumps oil from the ground sells its product to the one which refines the oil, even if the transaction is merely entries in a ledger. (And the gas stations which all have the same name on them must buy the gasoline and diesel from the refinery, the same as "Joe's Gas-n-Go" must. But gas stations are generally franchise operations, anyway.) Even so, the stockholder in the typical oil company owns a piece of all of the subunits.

Most of the profit made by oil companies comes from the sale of crude oil. As of this writing, crude oil trades for about $70 per barrel on the open market; but the cost to produce a barrel of oil has been steady at around $15 per barrel for quite some time. That means that an oil company earns around $55 profit on each and every barrel of oil it sells, at current prices. The "record profits" statement only crops up when crude prices are high.

So: all the units of the oil company must be profitable to one extent or another; this is why US domestic oil production is so low: for many years, the world price of crude was below $15 per barrel, and US companies could not make a profit on selling the oil they'd pumped out of the United States. If it cost $15 per barrel to produce, but it was only selling for $15 per barrel, they would not make any profit; and since shareholders expect a dividend, US oil companies started to produce their oil in (or buy it from) foreign countries where the cost of production was lower. (By the way, this naturally put many people in the domestic oil industry out of work.)

During times when the price-per-barrel of crude is low, the oil company makes a certain amount of profit. None of their operations are losing money; there is a certain amount of profit to be made on every stage of production, on every product which is produced.

When the world price of crude oil rises, however, things change.

At $20, $30, $50, $70 per barrel, the production company makes very large profits on every barrel it pumps from the ground. The other units of the company are still profitable; the refinery has to raise its prices because its raw material costs have risen so dramatically, but it still generates profit. Taken as an aggregate, the total profit of the company becomes enormous.

With the price of crude oil today, as I said, an oil producer makes around $55 per barrel. That's roughly 367% profit on each barrel of oil. Just to put it into perspective, Ford made around $15,000 on each Excursion it made. That's something like 36% profit, and they were very happy...and people who don't like SUVs were outraged.

So, every time the price of crude oil is high, the oil companies will make "record" profits; but it's not because they charge so much for gasoline; the high price of gasoline is dependent on many factors, including the price of crude oil and the availability of refineries to make the fuel.

So why does crude oil cost so much?

Well, because the world has a certain supply level of crude oil--a rate at which oil cannot be pumped from the ground any faster. The supply is limited by this; but further, the supply has artificially been limited by other factors. For example, political pressures have reduced the output of oil from some countries. For another, Saudi Arabia has a lot of excess capacity which is going unused due to a lack of demand for medium- and heavy-weight crude oil. But the world supply has stabilized at this level.

At the same time, world demand has increased. China is drawing more from the supply in order to feed its booming economy--Chinese manufacturing is at an all-time high, and that requires raw materials and energy. Other countries are expanding their economies, and as they do, their demand for crude oil increases. With world supply at its limit, more money chasing a fixed supply increases the per-unit price. This is basic "supply and demand" at work. There is plenty of crude oil available at $70 per barrel--there is no shortage!--but there need not be a shortage for high demand to raise prices. The fixed supply and high demand are sufficient to lead to an increase in prices.

But, just try to make people understand all this. It's too complicated. The prices are high on a commodity that everyone needs; therefore the rules of supply and demand don't apply and the government should do something about it. *sigh*

Even people who ought to know better--people who should remember the disastrous application of price controls in the 1970s--are starting to complain that the government should do something about the price of gasoline. What can the government do? Every time the government gets involved, costs increase. Ask the people in the computer industry if they are better off today, after the Clinton Administration took on Microsoft and got it declared a monopoly. The Dot Com Bust can be directly traced to the Justice Department's case against Microsoft in the late 1990s. Who was helped by that? The politicians: before all that, Microsoft didn't have a lobbying arm; now it does, and makes contributions to all sorts of politicians.

As I said, the Federal government tried to enact price controls in the 1970s, and the result was a reduced supply and rationing. Gas stayed cheap but there was a lot less of it around. Look at any city which has rent control, and compare the availability of housing in those cities to cities which have no rent controls. There are many examples, in history, of what has happened when government has tried to artificially limit the price of a commodity; and in every case, it has ended up limiting supply. EVERY TIME. It's inescapable.

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