Oil Prices - Some Basics

I am continually surprised at the lack of understanding exhibited by liberals and conservatives alike when it comes to the issue of oil prices. Even putatively educated people seem to lose all common sense amidst wailing and gnashing of teeth over perceived “gouging” of the public (note: there is no such thing as “gouging” in the free market – only government can force you to buy anything. More on this later).

But the oil business is not all that complicated. Crude oil is the basis for the many fuels we use – gasoline, jet fuel, diesel fuel, home heating oil, etc. Oil is also the raw material needed to produce a myriad of the products that we all use every day, like plastics, tires, synthetic fabrics, and so on. Oil, like energy, is largely responsible for our standard of living, which is the envy of the world.

Oil is a worldwide commodity – and one that is used by every modern nation on earth, and thus oil pricing is determined primarily by total demand and total supply. Demand goes up, prices rise. Demand falls (as it does during times of economic downturns), and the price goes down. Ditto with supply – something happens to dramatically increase or decrease the supply, prices change accordingly. Most people get that.

But there is another important influence on the price of oil that many forget – the need of oil producing nations to SELL their oil. After all, if the world suddenly stopped buying oil from, say, Saudi Arabia, their economy would collapse – oil is their mainstay. Thus there is a constant push and pull by the big oil producers like Venezuela and the Saudis to produce enough oil to keep their economies going, but not flood the market with oil so that the price falls below the level they need to make a minimal profit (somewhere around $40 to $60 a barrel, depending on the country). Likewise they don’t want to restrict the supply so much that prices go too high.

But why would OPEC be concerned about oil prices being too high? Well, it’s not because they’re nice guys – it’s just good business. Because when oil rises to levels of around $140 or more it results in recessionary pressures on the world’s economies, which causes demand to fall. When this happens, the oil producing nations make big profits PER BARREL, but because they are selling fewer barrels, they can end up with less total REVENUE. If this were not true, then OPEC would simply price oil at $200 or even $300 a barrel, and leave it at that. But they don’t – because they can’t. They need to keep the oil flowing.

Another factor that affects oil prices is the stability of the governments of the big oil producing countries. You may have noticed how even minor political tremors in oil producing nations cause immediate reactions in the oil futures markets, as well as prices today. This perplexes even very smart people, who demand to know “how can oil prices (or gas at the pump) jump up in one day when there has been no real change in supply?” But what these people fail to understand is that the biggest cause of changes in prices of any commodity is not what is happening today, but rather what the AFFECT is liable to be in the FUTURE.

The main reason that industry has an obvious interest in future trends is that every business needs one thing above all else: predictability. Thus all big users of oil-based products seek ways to protect themselves from unforeseen changes in their costs – a sharp up-tick in the cost of their raw materials can make their products uncompetitive, or, in the worst case, drive them to bankruptcy. One of the ways that businesses ensure predictability is to agree to a price TODAY in a contract for delivery at a FUTURE date.

For example, an airline cannot possibly determine what prices they will have to charge for their tickets next year, if they have no idea what their fuel costs will be AT THAT TIME. So they contract today to buy jet fuel that will be delivered in, say, June of 2012. Now, the price of that contract will be based on the EXPECTED price at the time of delivery, not on the current price. Both the buyer (the Airline) and the seller (the fuel provider) will look at the oil FUTURES market to decide on a price that is acceptable to both of them in terms of RISK. Because MANAGING RISK is what all “speculation” is actually about.

By the way, in the above example, both the airline and the fuel supplier are (yep, you guessed it) SPECULATORS. the airline is betting that the price will go above the price they got today, and the seller is betting that the fuel price AT THE TIME OF DELIVERY will be no higher than the price they agreed to in the contract. Heck, if you still have half a tank of gas, but stop in to fill up because you’re afraid the price might be 5 cents higher tomorrow, YOU too are “speculating” – just as you are a “speculator” if you’ve bought gold or silver lately. (Or if you bought a house a few years ago, hoping to “flip” it. How’d THAT work out for you?)

But what about those who only act as intermediaries in the transaction – the “brokers” of oil, gasoline, jet fuel and other such commodities? Well, they are no different than commodity brokers who buy and sell futures contracts for pork bellies, orange juice, corn, wheat, sugar and just about everything else we consume. They are not the “greedy financial types” portrayed by the media talking heads – they simply fill a need. If they didn’t, they wouldn’t exist – that’s how free markets work.

What third party speculators actually do is to contractually take on the risk for both the buyer and the seller. If they guess right, the buyer gets the commodity at the price they agreed to pay for it, the commodity producer got the price they accepted, and the broker made a profit on the difference between what the buyer agreed to pay them and what the broker will have to pay the producer for the commodity AT THE TIME OF FULFILLMENT.

The press of course blames the “speculators” for “artificially” raising prices by “trading paper” – but the press leaves out the fact that if the “speculators” are wrong, they stand to lose a lot of money. And they often do guess wrong. But more importantly, in the real world of markets and business, there is no such thing as an “artificial” price, because in every case, BOTH PARTIES AGREED TO THE CONTRACT. If the bottom falls out of the market by the time the contract comes do, that was the result of the financial decision they made, rather than rely on blind luck, or hope that the price of oil (or bananas, or sugar, etc.) declines by the time you have to purchase the commodity.

Likewise, suggestions (oddly, by both liberals and conservatives) that the American government should somehow “regulate” so-called speculation are dangerously misguided – futures trading would continue everywhere else in the world anyway. But the larger issue is that to regulate such things always results in disastrous consequences. Price controls ALWAYS result in shortages.

By the way, there is no such thing as “gouging” in the private sector. If a hardware store in Florida prices a flashlight at $20 the day after a hurricane hits, you don’t have to buy it. But if you failed to take the simple step of buying one BEFORE the hurricane (when it was only $1.98) you have no business whining to the rest of us who had the good sense to prepare in advance. Because the VALUE of any product is determined by how badly you want it, AT THAT TIME. How much is a gallon of water worth? Well, if you were trudging though the Sahara desert, it would likely be worth a lot more to you than it would be to an ice fisherman in Minnesota.

So you may not like paying $4 or more for a gallon of gas, but would you rather have all the gas you want at $4 a gallon, or pay a little less, but be limited to “X” gallons a week? Or you can ride your bike to work. Or walk. Your choice. Now, you may not like the choices you have, but you do have them. Because no one can “force” you to buy their products – only government has the power to do that. Public school funding is a perfect example – even if you do not use the school system because you have no children, you are forced to pay.

But no matter how expensive anything gets, price controls are never the answer, because the result is always the same – shortages. Because commodities will always follow the best prices. If America ever instituted government price controls on oil, we would find ourselves with a shortage that would make the gas lines of the Carter years seem tame by comparison.

Finally, the single biggest threat to oil prices today is the looming possibility of the American dollar losing its status as the world’s reserve currency – and oil prices are currently traded in U.S. dollars. But with our skyrocketing national debt, and the reckless printing of money by the government (to pay for out of control spending), the real possibility exists for the U.S. dollar to be replaced by the Euro, or even more likely, the Chinese Yuan, and soon. And if that happens, it will without question cause a drastic devaluation of our currency – in which case we could very well be looking at $200 or more for a barrel for oil, and $10 a gallon for gas. Disturbingly, Obama and more than a few of his advisers have openly supported such high gas prices – in order to advance their “green” agenda.

No one owes you cheap gas for your car, or cheap oil to heat your home. We can, however, do things as a nation that make the situation better…or worse. And since we cannot do much to control the likes of Jugo Chavez or the Saudis, the only way to ensure that we can meet our present (and future) energy needs is to immediately (and drastically) cut government spending, stop printing truckloads of paper money, reduce the national debt, repeal the stacks of insane energy limitations we have placed on ourselves, and proceed at (excuse the metaphor) full throttle with drilling, refining, and exploration on every square inch of land and sea that is within our control.

John Caile