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Energy: The Market

This is the first in a small series on energy in the US, focusing on energy independence and renewables.

There is nothing more fundamental to the health of economy than energy costs, particularly the price of gasoline.  There are more important things in life, especially food, but that cost does not rise and fall as rapidly and unpredictably as the cost of the gasoline that keeps our whole system running.

The cost of gasoline is determined by a very open market that is functioning about as well as it can.  A critical analysis of this market shows that there are key trends that will constantly drive up the price in narrow bands.  The largest problems with this market are barriers to entry, in particular the available refineries, and the single source of raw material in the form of crude.  Opening up this system to new technologies and sources of energy is the only way it can be improved to produce more stable, reliable costs.

There is little doubt that the world is running low on crude oil.  That is not to say that we will run out of it tomorrow, but it does mean that the price of it will increase with time as sources become more scarce and expensive – and demand in the developing world ratchets up.  Here is the price of “West Texas Intermediate”, a benchmark oil price from the oil patch, since 1985:

Note that the price was rather stable until about 1998, when it started to take off dramatically.  The big rise has been since about 2005, which is worth highlighting in a separate chart:

Here we can see that the price rise is not a constant slope upward, but a ragged series of spikes and sudden, steep drops.  The peak, after the start of the official recession in 2007, is the brief “commodities bubble”. That was the last gasp of the stock bubble, credit bubble, housing bubble, and every other kind of bubble that worked through our economy.  It was caused largely by speculation in oil futures, a big part of the spikes.

But there is much more to it than that.  Note that recently the price has hit $110 per barrel in 2011, only to fall back to $80 before rising again.  This is explained at least in part by the fact that there are many oil wells, especially around Texas, that have had the easy oil that bubbles right out of the ground taken out of them.  What’s left behind requires advanced technology like angled drilling, high pressure steam, and so on – it’s a lot more expensive.  When oil hits $110 a barrel it’s worth it to bring these wells online, slowly, and the price drops.

Crude oil production in the US is up 24% since Obama took office.  The United States is now the third largest producer of crude oil, behind only Russia and Saudi Arabia.

Swings like this are supposed to be taken care of with oil futures, or the ability to buy tomorrow’s oil today with a long-term contract.  The fact that we have such a huge cycle shows that the futures market is not functioning as it is supposed to.  But the overall market for oil is operating about as well as can be expected, given the circumstances.

But that is not all there is to gasoline.  Crude oil has to be refined, or broken down to a chemical form easily handled and burned.  California keeps careful track of all these costs, and has found that of the $4.19 paid at the pump $2.85 is crude oil, with the refining process and profits, etc, adding about $0.68 to the cost.  The rest is distribution, retailing, and taxes.

As gasoline consumption in the US keeps dropping, now at a 15 year low, we have found ourselves with excess refining capacity for the first time anyone can remember.  Some of that is shutting down because it is not designed to handle higher sulfur oil, relying instead on more expensive grades of crude.  Refineries in the Northeast in particular have to rely on “Brent” crude from the North Sea, and they can’t compete.  Combined with sales of refined gasoline abroad, excess refinery capacity is being kept in check by market forces.

In total, the market for our motor vehicle fuel is defined by a few characteristics.  The price is constantly increasing, but subject to spikes when the price gets to a level where new resources are added.  Speculation appears to have over-run the potential evening out that the futures market should provide.  Running against these trends is improved conservation.

The market for oil is functioning about as well as can be expected, given that it all comes from one diminishing resource whose cost of production and worldwide demand are rising constantly.  The only thing that can fix this market are new sources of raw materials, provided by new technologies.  That is what we will examine next.

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18 thoughts on “Energy: The Market

  1. Interesting overview. Can’t wait to see where it goes next. Makes the case for alternatives very well.

    • Thanks. I wanted to present the reason why the market is failing as clearly as possible. It is working quite well, but it is not a truly “free” or open market because there are no alternative sources of supply and there are barriers to entry in the form of set investments in refineries, etc. But it is doing very well all the same.
      Alternative energy can, and will, improve the market.

  2. I want to hear more about alternatives. This is obviously the explanation as to why we need them but is there anything that is actually ready as an alternative? The real alternative is driving a lot less which we could do if we built up our rail infrastructure.

    • You are right about rail, etc, but there are alternatives that could be ready in a few years if we put our minds to it. More on that on Monday. :-) There isn’t anything quite ready for prime-time right now, but it can be done.

  3. OK, forget the futures market for a while because they seem like part of the problem. What about a lot of storage like our strategic reserve? If we know the price of oil goes between $110 and $80 it seems that someone could buy a lot when it is low and sell a lot when it is high and make a killing. Maybe storage is a problem but I thought the government had a lot in storage. Is it not enough? It would be great to see the government make a profit off of it if they could.

    • An excellent point, but I doubt it’s that simple. We can’t be sure it will bounce between $80-$110 because the price is being driven upward by increased demand. If we were to sell off enough to influence the market now we might be left with no reserves and a price that is still as high as it is now in a short time.
      But yes, a lot of “buffer” capacity would be the same as a properly functioning futures market. The latter is supposed to be the sophisticated answer to the problem, getting around the need for huge, idle stores of inventory with innovation. It does not seem to work as well as advertised.

  4. the markets are rigged in favor of big oil and goldman sachs – thats why there’s so much speculation – prices will always go up and they will always make more $
    the only way is renewable energy from sources they don’t control.

    • I agree with your conclusion, but while big oil and big speculators make a lot of money they only control so much of the market. The magic of the Koch Brothers is that they inherited (not invented themselves!) the tech and capacity to control much of the refining in the US. That is always the choke-point in the system. Crude oil itself is a different beast.
      There is a problem when it looks like speculators are making price fluctuations worse, and that does seem to be the case. They only can do that because all oil is priced in dollars and controlled by a small number of capital centers. Believe me, the developing world is as upset by this as anyone here – and that’s why they are going to challenge the status quo by paying in their own currencies whenever they can.

  5. I am confused. Oil prices keep going up. But they go back down when they hit a certain point? I understand that some oil is more expensive to get. But should that not limit how high the price goes?
    If speculators are the problem for the big spike than why is there nothing we can do about them? Is it politics again?

    • There does seem to be a ceiling around $110 right now, but that will not last forever. We can’t say for sure what that comes from, but old wells with a little bit left to extract is as good of a guess as any. At some point, that oil will run out – but there will be still some oil that is economical to extract at $115, $120, and so on. How much? We can’t say for sure.
      What can we do about speculators? I have yet to hear about anything big and obvious that will clearly work. But little things have been proposed that will affect it at the margins. Nearly everything is held up in Congress that can be (yes, it’s politics as we know it!) so the Obama administration is doing what it can with existing authority. It does not seem like much at all.

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  8. EriK:

    I’m not clear on why you keep saying “The market for oil is functioning about as well as can be expected.” while recognizing that speculation and defective futures markets are influencing prices.

    I really hate the term “renewables” because it has only a political, not a technical or ecological meaning. But it seems to be the case that most alternative sources of liquid fuels turn out to be more expensive than petroleum if one looks at real live cycle costs, even at $100 plus crude prices.

    • Given that there is one source of input and it is diminishing rapidly (ie the cost of production is increasing) I really don’t expect much from the market. Perhaps I should, and a greater than 30% up-down for almost no reason is pretty awful. Speculators know they have something that will go away in the future, and they are very hard to keep out of the market.
      Agree on “renewables”, but that is the term most people know. I couldn’t find a better one. As we discuss this some more I am open to any better term everyone comes up with.

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