Oil 101 – Part Two
We’ve recently heard this mostly from the Left, on just about every news media. Even President Biden warned oil companies recently about gouging. This accusation of oil companies isn’t new. It’s almost always carted out when gas prices are high, and it stems from the wrong assumption that oil companies set the prices for their products, like gasoline.
First of all, if oil companies could set gas prices, why would they ever be below $5 a gallon? Or, below $8 or $10?
That’s the obvious refutation – but let’s go further.
Most people think oil companies set prices, given that they daily buy products in stores from producers that have the ability to charge whatever they want – Apple gets $1000 for an iPhone, BMW gets $50,000 for a new SUV. If you want an iPhone or a BMW, you either pay their price or you have to walk away. iPhones and BMW’s are unique products where no one else makes one quite like it. Oil companies do not sell a unique product and cannot price their products however they want. They are subject to the prices set on global markets, both here in the US and in London. In addition, gasoline is not something that most people can walk away from, so they hope to be protected by government when it comes to high prices.
I’ve already outlined for you a very simple (but accurate) model of how the global oil markets work, with our analogy of a Turkish bazaar. (Please see here if you missed it).
One thing to recognize from that model is that the sellers of our phantom product – our woven baskets – come from all over the world, but wherever they come from, their baskets are essentially the exact same. In other words, unlike with Apple, you can get an iPhone from anyone who makes phones. However, even though everyone’s product is essentially the same, they each can have very different costs of production. As I said, some of them can weave a basket and bring it to market for $5 a piece; for some the costs are much, much higher.
Oil is like this – there are fixed costs associated with every barrel that comes out of the ground. Some producers, like Saudi Arabia and most of the rest of OPEC, have core assets that yield oil in a very old-fashioned but cheap and reliable way, and their costs per barrel are not more than $10. Other complex plays, like many shale plays here in the United States, cannot produce oil for less than $75 a barrel and sometimes much more.
Here’s another very important point to make: Oil producers need very careful planning, money and time to bring oil barrels to market. They don’t have a magic switch where they can ramp up – or ramp down for that matter – the amount of oil that they are producing. These plans must be made normally years in advance – although many modern shale plays can currently yield new barrels in a bit more than 6 months after drilling begins – but that’s by far the shortest timeline of any oil production.
So, to go back to our basket market analogy, the sellers who are in the bazaar on any particular day are those sellers who planned to be there several years ago – even though they had little idea what the benchmark prices would be when they arrived.
That’s the oil business – a bit of a crapshoot on planning how much to take out of the ground, dependent of course on what it costs to get out of there and what you think the price you’re likely to get once you get it out of there will be.
I don’t cry for oil companies, and you shouldn’t either – in times where the ‘bazaar’ is short of buyers, like we just went through with a global pandemic, oil companies are forced to borrow, either with bond issuance or stock dilution or dividend reductions in order to survive. If they can’t borrow enough to keep the lights on during tough times, they need to either consolidate by selling themselves to larger, stronger oil companies or go out of business altogether – and more than 500 oil companies have gone out of business since 2017.
But if they get to the bazaar and there are a lot of buyers and not so many basket sellers, like we’re at now – well, the oil business can be very profitable indeed. This is when they get accused of ‘gouging’, which means they’re charging more than they should. We now know they’re only charging what the market says they can charge – which is, for the moment at least, quite a lot. What the Left should accuse them of is making outsized profits – which is true – and not gouging, which is not true.
The oil companies would rightly counter this accusation by saying that no one was looking to support them when they were losing money and being forced to go ever deeper in debt in order to survive – and shouldn’t therefore be punished when the markets are more favorable and they can now make a very healthy profit (and pay back all of those bondholders that lent them money during the bad times).
If you look at gas prices at gas stations, you’ll find that they don’t vary too much between stations, whether it’s an Exxon or BP station or your local BJ’s gas or Speedway. Those differences are all the oil companies can get in terms of their gas being ‘special’ and drivers wanting to specifically have their iPhone as opposed to just any phone. When Exxon can get $1.00 more a gallon than Speedway can for a gallon of regular, we can definitely accuse the oil companies of gouging.
Until then, it’d be more appropriate to accuse Apple of gouging consumers for their latest iPhone.
NEXT NEWSLETTER – OIL 101 – Part 3 – Don’t Drill, Baby, Don’t Drill – Why the US Never was and Never Will be Energy Independent
