News and commentary

It Is All Their Fault

By Jim Brown
Updated: Friday, April 04 2008 02:04:AM

If you listen to consumers or the government you would believe the major oil companies were controlling the price of gasoline. Nothing could be farther from the truth. The witch hunt on Capitol Hill is a bureaucratic process where only the faces change with the seasons.

Record prices at the pumps has put the oil industry on the defensive again not only with consumers but also with lawmakers. The assumptions that oil companies set the price of oil is as false as the idea that the sun revolves around the earth. Oil prices are set by supply and demand as reflected in the futures prices. Refiners are the main buyers of crude and they would much rather be buying it at $60 a barrel than $110. They go to great extremes to pay the lowest possible price.

Exploration companies want the highest price possible for their oil so they can take the profits and spend more on exploration. When the oil bust hit in 1998 and oil fell below $20 per barrel the oil companies would have had the power to sell it for $50 if what consumers are saying now was true. Unfortunately for big oil they can't set the price and are at the mercy of supply and demand just as much as the consumer.

An oil company faced with spending $3-$5 billion to build out a deepwater field in the gulf has to decide at what price they would have to sell their oil 10 years from now in order to decide if the field should be built. If they could set the prices then they would build them all and just charge what they needed to make a profit.

The futures market determines the price of oil, not the oil companies. At any given time there are over 10 times the number of futures contracts outstanding than the amount of oil available to satisfy those contracts. This is refiners, production companies, investors and speculators all voting on what they think the price of oil should be at any specific point in time. You can buy a futures contract as far out as 2012 today or as short as May 2008. This extremely liquid market is what sets the price. If there are more buyers than sellers the price goes up and more sellers than buyers and the price goes down. Companies have no more control over the price of their own stock then they do the price of oil.

To be fair they can throttle back production in times of excess to avoid a crash but most companies can't afford to do this. They are too leveraged to the daily dollars coming out of the ground and the need for that cash to buy billions in equipment, pay salaries and taxes. They can't just stop producing or their business would grind to a halt. That is the limiting factor on them controlling the price of oil. If you are Exxon and pumping 2.5 million barrels per day then you could cut off a 100,000 here or there but then the shareholders would get mad that your production did not meet the projections and you stock would suffer. They really don't play games of this magnitude.

The American Petroleum Institute (API) says the cost of crude accounts for 70% of the price of gasoline. The next biggest chunk is taxes for state and local government leaving the retailer with 5-8 cents per gallon in profit. Add in competition among stations and that margin sometimes drops to only a penny or two.

Gasoline inventory levels are at the highest point in 15 years due to slowing demand. January demand fell -2.2% or 445,000 barrels per day. That was the weakest month since April 2005. Chief API economist John Felmy said last week that the cost of gasoline had only risen 75 cents per gallon over the same period in 2007 compared to a 94 cent per gallon increase in oil.

Last week Valero, the nations largest refiner, said they were running its fluid cat crackers at 73% of capacity because of the excess gasoline inventories. They are running out of places to store it.