Oil Price Out of Control As World Pumps at Capacity

This was published on Scoop last week, I forgot to also publish here - here it is.

Powerless NZ
27 April 2006

As consumers around the world baulk at US$75 oil (per barrel) suspicion sets in that the oil companies are price gouging even when a few seconds rational thought informs us that oil is traded transparently on the open market to the highest bidder. Hilariously leading this crusade is President Bush himself. “Bush has ordered the US Federal Trade Commission to investigate whether the price of gasoline has been unfairly manipulated in any way since the hurricanes struck last year.” (Washington, April 25, 2006, AFP).

Interestingly in 1971 around the time US oil production peaked, the oil production regulatory agency announced that it would allow US oil companies to produce at 100% capacity. Prior to that oil production had been strictly regulated to prevent the price falling too low. After that event in 1971 the concept of marginal price for crude became irrelevant, oil became a tradeable commodity in the US on the open market, sold to the highest bidder. Shortly after this event oil production in the US peaked. Today the US produces less than 50% of the oil it consumes.

A similar event occurred in 2004 when in an attempt to quell volatile oil markets OPEC announced it would pump at capacity. At that point a marginal price for oil was no longer under OPECs control. Any first year student of economics could inform President Bush that the long run marginal cost means any additional costs or cost savings per barrel of additional or reduced production. Once the margin is gone and you are unable to increase production the marginal cost as a pricing mechanism or indicator of the same becomes irrelevant — it is simply sold to the highest bidder. The fact that the marginal cost of (Saudi) oil production is estimated to be between US$1.50 — US$3.00 per barrel must make consumers squirm (Littlejohn, 2004., Kudlow, 2001) but this is how the market works. If you don’t like the price you always have the option to purchase an alternative product, or simply not purchase at all.

OPEC has continually argued since late 2004 that they are pumping at capacity and are therefore unable to drive the price down. According to BP’s Statistical Review of World Energy, OECD oil is currently in decline to the tune of -1.9% per year. Since it seems the world is producing oil at maximum capacity or very close the concept of a marginal cost of crude is no longer relevant and because there are no swing producers, that is, no producer has the ability to control the price by flooding the market with cheap oil. Oil production is no longer at a margin of the total produced — result, the price cannot be controlled by the producer. Thus the market is sending a very clear signal that production is at a peak. Once over the peak we are on a declining trajectory forever, things are not going to get better.

OPEC’s official price range in 2005 was $22-$28, obviously with a marginal cost around 3 dollars a nice profit would have still been made. However the current price of oil is determined by free trade on futures markets with buyer knowledge that there is no excess capacity, and no one wants to miss out. The price is at the mercy of the market, surrendered to the whims of speculating traders and hedge fund managers who are increasingly fidgety due to an increasingly imaginative array of externalities such as production shutdowns in Nigeria, Iran, Iraqi civil war and Hurricanes or indeed any other perceived risk. It’s a bit like selling roses where everyday is Valentines Day.

There is currently enough oil to meet consumer demand, that will however change over the coming year or two as demand continues to grow and existing supply slowly but surely depletes. The price will remain highly volatile so long as the valves remain open at capacity. Economics relating to marginal concepts or a “fair price for oil” are no longer relevant because we are not producing a “margin” of the total producible; we are producing at the maximum, familiar market rules are out the window.

Steve McKinlay
Powerless NZ
27 April 2006