The recent spike in oil has caused political nonsense from both the Right and the Left to reappear about US energy. I’ve seen incorrect (boilerplate) characterizations on how the oil markets work and what oil companies and our government can and can’t do about high prices — from both sides. The Right resorts back to tired anti-environmental memes – the President is in thrall to the Liberal wing and if only oil companies were allowed to drill unfettered in a “Free Market”, oil prices would go down and all would be well. The Left is quick to accuse oil companies of gouging consumers, if not being the sole controller and cause of rising prices themselves. At the very least, the Left accuses oil companies of taking usurious advantage of high gas prices to a premeditated and evil degree. I am here to tell you that both characterizations are confused and wrong.
It should be obvious to anyone that oil companies would always like oil prices to be very high through all market conditions, and if Exxon and Chevron could force gas prices to be $5 a gallon or more, they’d certainly do it all the time. Even recent history of $30 oil and $2 gas should prove that the oil companies have far less influence over prices than the Left would like to believe.
Similarly, high oil and gas prices are a political nightmare for Democratic administrations, perhaps even more than for Republican ones — and believe me, they know it. There is a long list of Administration action, both from the Democrats and the GOP of using every tool at their disposal, particularly in election years, to bring oil and gas prices down as low as they possibly can, environmental instincts to the contrary. Joe Biden is no different, disbursing oil reserves from the SPR, having his Secretary of Energy jawboning with oil companies and the Press and traveling personally to Saudi Arabia (as George Bush and Trump did, for example), all trying to move prices lower before the midterms. It should be obvious at this point that his efforts have had very limited effects on prices — and that the President, whether he is Democratic or Republican, has far less influence over gas prices than the Right would have you believe.
So, how do the global oil markets actually work?
Here follows my simple analogy using one of the last remaining open outcry marketplaces, a Turkish Bazaar. With it, I hope to simplify a bit this very complex system enough for anyone to grasp at least the basics, and understand the real mechanisms of global oil pricing. If we can approach this subject honestly, with real information instead of memes, we have a better chance of moving towards correct energy solutions — for us and the rest of the world.
Imagine a big Turkish bazaar – an old-fashioned open market where sellers come to peddle their wares and buyers come to purchase them.
No one comes knowing what the prices of their products are going to sell for; that’s why we have a market, after all. All we know is that the sellers would obviously like to get the highest prices they possibly can, and that the buyers want to pay the lowest prices they can.
Now, imagine the sellers come from all over the world and only sell one product – let’s say woven baskets. Some of these sellers can make baskets for $5 a piece, some have to do it more expensively perhaps for even $40 a piece, or more. Our sellers, to complicate matters, are often limited in how many baskets they can bring to market on any single day. While some of them may have nearly unlimited access to cheap wicker and weavers, Others may need specialized technology or labor to compete, or be in debt with interest rates on the rise, or be in a war that limits production, or a hundred other factors. But no matter how these baskets get to market, let’s say that they are exactly the same in quality – no matter where they come from won’t matter to our bazaar buyer — one basket is as good as the next. (Oil is fungible)
Our buyers also come from all over the world, and while they each have different numbers of baskets they may want to buy, they have a minimum number of baskets they simply must buy every day. Further, that number, again collectively, is increasing year after year. (Global oil demand continues to grow) Now, there is definitely an incentive for many of these buyers to purchase a few more baskets if prices are low, as well as a similar need to limit the number of purchases if prices are very high. But — and this is important – for the most part, our bazaar shoppers have a bare minimum number of baskets they must buy and surprisingly little leeway either in the extra they’re likely to purchase even if baskets are very, very cheap, (storage is expensive) or, alternately the number they are able to forego, even if the price of baskets is very expensive indeed.
(I’ve just described a product that has an unfixed, swinging supply, but with a mostly fixed demand that continues to increase. Fixed demand in economic-speak is called ‘inelasticity’, that is, there isn’t either much less or much extra that each buyer, or nation, or economy absolutely requires, no matter what it costs. Oil is the classic market with a variable supply and inelastic demand that has steadily increased for decades (outside of a short-lived global pandemic, or global economic meltdown)
Back to the bazaar:
The seller who has produced baskets for $5 will happily take a $20 profit and offers his cart full of baskets for $25 (OPEC Nations) – no one can compete with this low price, and all the buyers rush to his stand – he is quickly sold out for the day and goes home to weave more baskets. The remaining buyers who weren’t able to get $25 baskets go to the next cheapest seller, and the next and the next, until the demand runs out and everyone has been satisfied with the number of baskets they absolutely must have. On this day in the market, we’ll say that demand was satisfied with the last few baskets from a $55 producer, who priced his supply for $75. At this point our market price is $75 and any buyers who might want to buy baskets have decided that $75 is more than they’re willing to pay for baskets. (core demand is satisfied)
Let’s total up all the sales that happened in the bazaar today and publish them. (price reporting) , after all, this is a global market that people from all over the world rely upon to tell them what baskets are costing at any time. (Oil markets are transparent)
The next day, all our buyers and sellers return to the bazaar to buy and sell more baskets. But today, not surprisingly, our $5 seller isn’t willing to sell his baskets for $25. Why should he? He knows that baskets were selling for $75 when the bazaar closed the previous day. We’d call him a fool if he somehow took pity on the ‘poor consumer’ and continued to sell his baskets for so much less, wouldn’t we? Would we even ask him to do it with a straight face? (Maybe, if we were the Secretary of Energy) Similarly, the sellers whose costs required more than $75 for their baskets to be profitable might not even bother showing up today to the market. Why should they waste their time? They have a more difficult choice to make too — If the top price for baskets stays below $75 for very long, they’ll need to slow or even stop weaving baskets — and maybe even shut down their shops. (consolidate/take on debt/ go bankrupt) But If they can, they’d much rather try and wait (and even sell baskets at a loss! ) until the market prices come up and tell them it’s worth it to go back to full-time weaving. Weaving can be a very good business (latest Exxon $200b quarter!) when the market is up. – (that’s when Liberal Senators want to hit them with a windfall basket tax!)
In any event, the price swings from day two of our bazaar aren’t as big as they were on day one; everyone now has a good idea of what baskets are going to cost. By the third or fourth day, you can imagine that the price has become pretty much set, and you won’t find baskets selling for $25, nor will you find anyone trying to get $100 for baskets from even the most unsophisticated buyer either. Our bazaar buyers and sellers have established a BENCHMARK PRICE.
This is NOT to say that prices for baskets don’t change. Benchmark prices change all the time, and often by a lot. The costs of wicker can go up, the number of weavers changes, the demand for baskets can suddenly increase or decrease. Weavers from certain parts of the world can suddenly be at war or defending an invasion and can’t either get to work or get to the bazaar. Benchmark prices are often very volatile.
But no matter what happens to the benchmark price – the important point is that it is still UNIVERSAL (or nearly so!) in the bazaar itself – no individual baskets are sold for much more or much less than that benchmark price, whatever that price happens to be that day.
Everyone is tethered to the benchmark, whether they are buyers or sellers, and even though they all participate in finding those prices, they individually have very little influence over them. (god knows they wish they did!)
This concept of benchmark pricing using ‘price discovery’ on the open oil and gas futures markets is by far the most important fundamental input into how global oil and gas prices are derived.
Two last points, trying to continue to puncture Right/Left memes: 1 – You’ll notice nothing inside my analogy mentioning how basket weavers get baskets to the bazaar (Keystone pipeline). Transport is a minor player compared to production — you’d easily find an alternative truck, a barge, a railcar or a donkey cart willing to carry baskets to the bazaar (for the right price). But first — you need the baskets. 2 – You’ll also notice there is no mention of the Turkish government and their inevitable efforts to control the bazaar. In Turkey, just like everywhere else, money is the driving force in the marketplace, and not governmental policies, nor political rhetoric.
NEXT BLOGLETTER SUBJECT:
OIL COMPANIES ARE GOUGING CONSUMERS WITH HIGH GAS PRICES (not)
