2007/12/01
What is the true price of oil?....or any form of energy for that matter? What is the true price of anything? And why should we care?
Let's start with the easy question first. Why should we care? Because how prices are set for the resources and services we depend upon have a direct impact on our personal wealth and well being. When we think the process is rational, even as the result is offensive, we may "suck it up and deal with it". But when we think we're being "SCREWed" (a technical acronymn for Subject to Cronic Rapacious Ethical Wrong-doing) we are then motivated to look for options,....if there are any.
The November 19th issue of the Wall Street Journal published an article entitled Oil Officials See Limit Looming on Production created a new and interesting context for the question of the true price of oil. But first, a little background.
At the end of 2006, the price of oil was just a few hairs below $60 per barrel. At the beginning of the year, talking heads were debating where oil would be by year-end. Some industry pundits and investors, among them T. Boone Pickens, staked out a claim for $100 by year-end. Others argued that the "true" price of coverage was between $30 and $40, and the excess was the "risk premium" from 'temporal' threats such as political chaos in Nigeria and Iraq, the possibility that Iran or Russia might do something nasty, hurricane and other natural disaster threats to the supply chain, and occasional shutdowns of critical facilities due to maintenance problems.
The fundamental truth about oil prices as they have been is that they are driven by a short term time horizon of three to six months, and the exposure to events that may affect them in that time frame from well-pipe to tail pipe. Let's review again the factors that affect this short term perspective on pricing:
- intrinsic value of the asset being depleted from the ground
- hard costs to extract, refine and transport the asset from source to market
- political risk factors affecting the above costs and availability of supply to meet current demand
- environmental (principally weather) risks affecting the above costs and availability of supply to meet current demand)
- supply chain disruptions or constraints due to failure of facilities or other constraints in production capacity.
- a fair and competitive return on investment to investors (profit).
Many people assume that the escalating cost of oil is due to the rapacious greed of the oil giants. But analysts who follow the industry with far more expertise than I note that, although the absolute profits generated by the oil majors are record breaking due to the volume of sales, the relative profit in relation to capital deployed and risk assumed is mediocre. This notion is reinforced by the fact that the majors are spending in many cases as much in stock buy-backs as in exploration-- a sign that they cannot, in their own judgment, effectively deploy the returned capital to continue their alleged rapacious ways at an appropriate profit.
So if the escalation in prices is not a result of pure unbridled greed, what is the cause, and where are prices likely to go? Few if any of the political risks facing oil production at its major sources - Russia, Saudi Arabia, Iraq Iran, Kazakhstan, Nigeria, Venezuela -- are likely to diminish in the near future. So although the oil markets treat each day's headlines as a new and exciting, if temporary, event, the truth is that all these political risks are likely to be intermediate to long term in nature (i.e. 3 years or more ) and therefore semi -permanent elements of the price structure which may get yet worse.
What about costs of production and distribution? The easy stuff has already been sucked out of the ground at the nearest and safest points of source. Everything else becomes more, shall we say euphemistically, 'problematic'.
Environmental factors: 2005 showed us what the future could be like. Hurricane seasons of the past two years may lure the market back into a sense of complacency. But digging a deep hole for the newly announced Jack well at 15,000 feet in the middle of Hurricane Alley has got to be giving a few people at Chevron reasons to pray. And as the industry is learning on the Caspian Sea, you don't need hurricanes to produce very expensive environmental headaches.
By this autumn a new factor emerged in the price of oil that had not been prominent previously: the declining value of the dollar. This has possibly done more to drive up the price of oil in the past few months than any other factor listed above. And it was precipitated by financial events (the sub-prime fiasco) which have no direct relation to oil or energy.
But there are three factors that are not listed above, and they need to be, going forward.
- the availability (supply of oil)
- the long term demand of oil relative to that supply
- the cost of "pollution control" assignable to this product.
The Wall Street Journal article cited above touches on availability. Interestingly, it speaks of a production plateau in oil supply relative to near term demand. This approaches, but does not yet embrace, the concept of "Peak Oil", which has been dismissed by much of the oil industry establishment until recently as a fringe issue. You know, kinda like Climate Change. But the fact that the Wall Street Journal is now reporting this is in my view a sign that it can no longer be hidden under the blanket. It reinforces Mr. Greenspan's observation that Iraq "was about oil" (see my earlier blog of 2007/11/03: It IS About Oil. Thank You, Mr. Greenspan). Incidentally, is there a distinction between an oil peak and a production plateau? Well, the first has a pointy top, and the second has a flat top; but the important commonality is that, once you've climbed to the top of either, the other side is a decline. The only remaining questions are: how soon, and how steep?
Now, if our demand were to increase not one wit beyond today's levels, the prospect of a 'plateau' (a peak by another name) should be troubling in itself. But in a world that is projected to go from 6.5 billion to 9 billion people by the end of this century, the prospect of a peak in supply against growing demand should cause us more than a little pause. Yet that prospect does not yet appear to factor into the price of oil, or our strategies to conserve it or find alternatives. If it did, we would now be pricing oil in a context more similar to another carbon product: diamonds- scarce and precious.
The third factor is a little harder to get our heads around for philosophical reasons that are still evolving: pricing oil for the attributable costs of its pollution. Any other industry whose processes generate scrap or regulated pollutants must bear the cost of controlling and disposing of those factors as a cost of production, and pass that cost onto consumers in the price. Unregulated pollution, the generation of conditions that are harmful to society or the environment, is in effect a cost of production which the producer passes on, not only to the consumer of its products, but to society as a whole and generally without its informed consent. Oil, and all other hydrocarbons which contribute to human generated CO2 are in essence contributing pollutants which are not being contained at their source, and are arguably contributing to negative consequences that society at large must pay for.
If the oil industry were to be assessed those reasonably assignable costs at the point of final production and distribution, as would be the case with any other regulated pollutant in any other industry, the cost of oil would be significantly higher than it is today. That's the carbon tax. Industry is looking for all kinds of ways to wiggle out of it. Cap-and-trade is a palliative that seeks to induce cooperative effort through market mechanisms, but it is a delusion of convenience. Market pricing has gotten us where we are today, and it has failed to allocate a precious resource as if it were a precious resource. So we might as well begin thinking long and hard and fast about a meaningful carbon tax, because it will get us closer to where we need to be: a price of oil that more nearly, if not perfectly, reflects its true costs and real value in an age of diminishing availability, and a means of generating funds for dealing with the emerging consequences.
But you haven't heard the best! Do you know what's going to save the economy from Peak Oil? Coal! It's abundant and cheaper! That is, if you don't take into account that it is more environmentally damaging than oil, and should logically bear proportionately greater cost for dealing with those consequences. But if you read the Wall Street Journal Article there is a very disturbing quote by Matt Simmons, an observer of the oil industry who warns about Peak Oil but appears clueless about Climate Change:
" 'Peak oil is likely already a crisis that we don't know about. At the furthest out, it will be a crisis in 2008 to 2012. Global warming, if real, will not be a problem for 50 to 100 years,' he says."
His perspective on oil could be quite correct, but if his solution is coal, he will compound one disruption with another of equal magnitude. Climate Change is in progress now, and it will steadily escalate. But if coal is introduced at an accelerating rate over the next twenty years to fill the oil gap without the necessary mitigating technologies, the next fifty years will see, not the beginning effects of Climate Change as Mr. Simmons suggests, but the attainment of the upper reaches of impacts that scientists are warning us to avoid.
So, as you fill your tank next time, rejoice at the low price, for we are not likely to come this way again.
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