Monday, May 12, 2008

So Oil Prices are High, Here’s How It Should Work

Oil Prices have been on a steady incline specifically since Hurricane Katrina gave us our first dose of $3.00 + gasoline. That was a capacity issue, which eventually was resolved. There are a number of factors involved in how we got to the price of $126 per barrel including:
  • Industrialization of China and India
  • Political strains with Venezuela
  • Speculative buying of oil futures
Now some commentators, more ideological than myself, will claim that the price really shot up after the Democrats took control of the House and Senate in 2007. While a great way of shifting blame, the most immediate wag of the finger is not necessarily the correct one.

The way economics works, as I have learned at the dinner table every day growing up by my father the Economist, as well as 5 semesters at a private Liberal Arts school in Northwest Ohio, is there are two basic factors: Supply and Demand. As supply goes up or down, demand goes the opposite. Ergo if supply is high, there is little demand. If supply is low, there his high demand. These two factors meet at a point called equilibrium.

Right now the oil demand is high, this is represented by the price of $126 per barrel. This is the equilibrium point as the supply and demand have come together at a price that benefits both the supplier and demander.

Now oil has been around for a while. It wasn’t that long ago that oil was only $10 per barrel. So if it is possible to drill for and extract oil for $10 per barrel, it must be extremely profitable to do this at $126 per barrel. Exxon-Mobile shareholders know this is true.

Under normal circumstances the oil companies would then take their profits, knowing that it is still financially worth their while to drill more wells to get more of this $126 per barrel oil on the market. When prices are high for a particular product, it behooves you to sell as much of it as you can.

The consequence of this is when you increase supply, the demand suddenly goes down and all of a sudden your $126 per barrel oil may only be worth $80 or $90. It may seem silly for a company to do this, but by not doing it they run a risk of pricing themselves out of business. Then we would have no oil at all.

Some argue that the supply side of the equation had dwindled to the point that we must seek alternatives. They are half right. The blame for the lack of supply falls on our government. Passed by multiple congresses, and signed by Presidents Clinton and Bush 41 there is a moratorium on US off-shore drilling.

A recent report states that there is enough domestic Oil to run 60 million cars for 60 years. I’m sure Exxon-Mobile, Chevron and Valvoline would love to help provide us with more than enough oil. The free market demands they do it.

However while the invisible hand guides the free market the invisible foot of government trips it up!


Anonymous said...

Yup, supply and demand.
BTW: you wrote, "I’m sure Exxon-Mobile, Chevron and Valvoline would love to help provide us with more than enough oil. . ."
I work for the Valvoline division of Ashland Inc. and Valvoline is a motor oil marketer, not an integrated oil company such as the ones named. Valvoline buys base stocks from the big guys, then blends with additives to make premium lubricants.

azoric said...

Thanks for the update, B. Bronson. Earlier this year I did a little freelance work for Valvoline and thought I'd be nice and throw them a plug.

Speaking of which. I read a recent aritlce stating that the oil companies are not betting on sustained high oil prices. How do we know this. Because they're not looking to expand drilling, thus the profit in getting crude oil isn't going to be there for long.