There are many opinions as to what has caused the spike in oil and gasoline prices. Some opinions are based in fact, while others simply echo media-biased sound bites. Where’s the truth? The issue of oil and gas prices is complex. Why are prices so high? Is it due to the Russian invasion of Ukraine? Biden? Is it the oil companies? What about OPEC? Exactly how are prices for these commodities established? We are not getting the complete story from the T.V. news media.
The price of oil is the most important factor in determining gasoline prices. Moreover, the relationship between the price of each is highly correlated, with causation, meaning they tend to move in the same direction, and for good reason. Both are currently priced well above their long-term average. While the price of oil is an important factor in determining the price at the pump, there are other critical factors to understand.
The Price of Crude Oil: The Producers
Globally, there are two groups of oil producers, categorized as OPEC and non-OPEC. OPEC is comprised of thirteen countries: Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi Arabia, UAE
The other group, called non-OPEC producers, consists of investor-owned oil companies or IOCs. This group, which produces about 60% of total global production, includes publicly traded companies, all of which are focused on increasing shareholder value. They operate independently, without central coordination.
Production Capacity and Focus
OPEC members are focused on bringing value (employment and revenue) to their country while non-OPEC producers focus on increasing shareholder value (profits). Because each group has a very different focus, the issue of capacity differs. For example, in the IOCs, with a focus on increasing shareholder value, they typically operate at full capacity, meaning, there is very little room to increase output. NOCs usually do not operate at full capacity. Therefore, if more oil were needed, OPEC members could increase production.
Most of the lower cost conventional oil is located in OPEC countries. Thus, OPEC members can produce high-quality oil cheaply. This has led IOCs, especially in the U.S., to develop new, but more costly methods of extracting oil, such as deep water offshore and unconventional sources like oil sands.
Oil prices are also influenced by OPEC’s capacity. If OPEC is operating near full capacity, which is rare, a risk premium might be added to the price of oil since an increase in production is not attainable. But again, OPEC does not usually operate near full capacity.
Crude Oil Inventories
Inventories are another important factor affecting the price of oil. When production is higher than consumption, inventories rise, creating what we know as oil reserves. Also, when the future price of oil is expected to be higher than the current price, inventories tend to rise as companies store more oil to resell later at a higher price. Remember, IOCs focus is on increasing shareholder value (profits).
Financial Markets and Oil Prices
The price of oil is also affected by the financial markets. For example, oil producers and airlines have a significant commercial exposure and hedge their risk through energy derivatives. Airlines may buy futures or options to help lock in a lower price, whereas oil producers may sell futures and options to help secure higher prices. This is one of the many factors that contribute to the global price of oil.
It would be a mistake to focus solely on the U.S. oil production as oil is priced globally. But for those who are seeking more information, we will discuss it. The following chart shows the level of oil production in the U.S. from January 2000 through March 2022. Production trended higher during the first six years of Obama, only to decline in the last two. When Trump became president, oil production increased until the pandemic hit, when it fell in dramatic fashion due to low demand expectations. Enter President Biden.
It’s no secret that President Biden is anti-fossil fuels. In his first full month in office oil prices fell, perhaps due in some part to his stance on the subject (there is a psychological effect). However, oil production under Biden has increased in every month except February and September 2021. The chart below also shows the current level of production as of March 2022 and a horizontal red line to compare current production to the recent past.
Because oil is a global commodity subject to global supply-demand forces, U.S. production is relevant, but a smaller part of the picture. In 2021, U.S. oil production represented about 20% of total global production. It is significant, but not the main driver of global prices. The U.S. is also the largest consumer of oil, followed by China.
The price of oil is determined globally. It is an extremely complex issue, which does not lend itself to media sound bites. Although the far right- and far left-wing media outlets are putting their own spin on the issue in an attempt to stir up their listeners for higher ratings, neither side is portraying an accurate picture of the whole. Moreover, this problem was not created by a single individual or political party. It was created by global forces. Granted, politicians and the extreme media have made it worse, but they are not the sole architect of the problem.
I expect high prices will remain for quite some time.