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2008 Essays - June/July

"PETROMORPHOSIS" PART I: "PAY'N" AT THE PUMP

    * In 2008, crude oil and retail gas prices have hit all-time highs. This year's essay series, "Petromorphosis," will take a look at issues concerning gas prices and the future of petroleum and other energy sources, with a focus on fuels. The issues and the industry both are extremely complex - far beyond what can be covered in depth in a forum such as this one. What will be presented is a brief summary of basic ideas and topics, ones which hopefully will help illustrate and explain the current situation as it relates to your lives now and in the near future.

    The essay is interactive in the sense that links are embedded within the text. The article can be read as is, or one can click on a link to read more about the subject at hand, then return to the essay. (Please note: The links are included for information purposes only. No guarantees are made as to the accuracy of the materials presented on the sites, although every effort has been made to search out reliable and respected sources of information.) Footnotes and a bibliography also will be included at the end for anyone wishing to learn more about the subject. A glossary link for energy-related terms is provided as a reference for use as needed. Click here to reach the glossary. *

     Not long ago, $3/gallon gasoline seemed like a remote possibility. Today, after having become reality, it may become nothing but a memory. With average retail gasoline prices hovering at or above $4.50 per gallon throughout Southern California, the question everyone seems to be asking is "What next?" It is not an easy question to answer, especially when few forecasters or market analysts foresaw the rapid price escalation which has taken place over the last couple of months.

     In the last 30 to 40 years, spikes in the retail prices of gasoline were for the most part easily explained: the Arab Oil Embargo and Iranian revolution during the 1970s, the start of the Gulf War in Kuwait in the 1990s, and more recently disruptions in Gulf Coast refineries and other facilities in the wake of Hurricane Katrina. This time around, however, causes cited by experts and in the press are neither as cut-and-dried nor as immediately obvious to the consumer. Take the following two explanations, for example.

     In the May 2008 issue of the Oil Market Report (www.oilmarketreport.org), a monthly publication of the International Energy Agency, it was stated that, "NYMEX light sweet crude futures were double the levels of a year ago in early May, topping $126/bbl as strong demand from Asia and tight distillate markets pushed prices higher. Sentiment was further underpinned by crude outages, particularly in Nigeria and the North Sea. Refining margins rose in April, but remain volatile." (n1) The Automobile Club of California also reported on its website-based price summary information for June 13 that "California is the only state in the U.S. right now that is experiencing this painful level of price increases, and oil industry analysts say it is almost totally driven by fund manager investment in California wholesale gasoline futures." (n2)

     Speculation on the futures market? Demand in Asia? Nigerian supply disruptions? Demand for distillates? Peak oil? Refinery capacity? A weak dollar? All of these factors have been named as potential contributors to the rise in gasoline prices, with no one factor unanimously singled out as having exerted the greatest upward pressure or influence on prices to date. The remainder of this first part of the summer's three-part series will examine some of these factors individually and conclude with a few options for dealing with gas prices now. Before continuing, though, ask yourself how much you really know about the gallon of gas you're putting into your car's tank. If you'd like, you can click on either of the links below to take the American Petroleum Institute's five-minute Energy IQ Quiz before reading on.

*  * www.apitechtour.org, click "Energy IQ Quiz", or www.apitechtour.org/game_1.html *  *

Crude Oil, The Futures Market and Speculation

     The most significant portion of the cost of gasoline is the crude oil from which it is produced. In the first quarter of this year, crude oil made up about 70% of the pump price of gasoline, with refining and retailing costs at about 17% of the total and taxes accounting for the other 13%. (n3) The term "light sweet crude" refers to high quality oil with a low sulfur content, the type most preferred for refining into gasoline. Thicker crude oils are generally considered to be of lower quality, and oils with a higher sulfur content are referred to as "sour." (n4) Crude oil futures are traded on the New York Mercantile Exchange, or NYMEX (www.nymex.com), and NYMEX is regulated by the Commodity Futures Trading Commission (CFTC, www.cftc.gov). The CFTC is an independent agency of the U.S. government with "exclusive jurisdiction over futures trading in all commodities." (n5) The international benchmark price for a barrel of crude is set based on contract prices for light sweet crude on the NYMEX.

     Many have blamed speculation in the futures market for driving up the contract price of a barrel of oil and therefore the ultimate cost to consumers at the pump. In OPEC's Monthly Oil Market Report for June 2008, a report on the oil market outlook for the second half of 2008 says that ". . . this strong [price] volatility reconfirms the view that current price levels do not reflect supply and demand realities but are strongly influenced by future market activities and the prevailing bullish sentiment. A review of prospects for the remainder of the year also shows little support for prices to remain at current levels." (n6) At the same time, however, others have expressed different opinions on the current situation. The Economist magazine has reported that Jeffrey Harris, chief economist of the CFTC, "does not see any evidence that the growth in speculation . . . has caused the price to rise . . . Investment can flood into the oil market without driving up prices because speculators are not buying actual crude. Instead, they buy contracts for future delivery. When those contracts mature, they either settle them with a cash payment or sell them to genuine consumers . . . The contracts are really a bet about which way the price will go and the number of bets does not affect the amount of oil available." (n7)

Resources, Reseves and "Peak Oil"

     So what does affect the amount of oil available? Before discussing the global growth in demand, three terms with particular importance to the industry will be defined: resources, reserves and "peak oil." A resource is a concentration of a naturally-occurring material, such as oil, that is considered to be potentially recoverable. Resources can be identified (located and measured) or undiscovered (thought to exist based on theory or broad geological knowledge). A reserve is the portion of an identified resource from which a usable commodity (such as oil) can be economically and legally extracted. (n8) "Reserves must satisfy four criteria: they must be discovered, recoverable, commercial and remaining based on the development technologies currently applied." (n9) Proved (or measured) reserves are reserves for which tonnage and grade (the amount and quality) can be computed and judged within certain limits. (n10) The chart below may help you visualize the distinction between resources and reserves.

Chart sources: Statement of Dr. Vincent E. McKelvey, Director, U.S. Geological Survey, Department of the Interior, in Market Performance and Competition in the Petroleum Industry, Hearings before the Special Subcommittee on Integrated Oil Operations, Committee on Interior and Insular Affairs of the U.S. Senate, January/February 1974, p. 1542, and National Petroleum Council (NPC), Hard Truths: Facing the Hard Truths About Energy, Washington D.C.: NPC, July 2007, p. 96.

     One of the most common phrases used in discussions of the oil industry is that of proved (or proven) reserves. These "reserves are concentrated in the Middle East and North Africa [which] together [account] for 62% of the world total. . . [It is estimated that] the world's proven reserves, including non-conventional oil, could sustain current production levels for 42 years." (n11) Forty-two years? Does that mean that the world will run out of oil at that time? The answer is not exactly. To begin with, data on proved reserves is closely held by the countries and companies owning the oil. Though estimates are widely published, precise, exact figures are not known. Also, the current reserve figures don't take into account new discoveries of oil.

     Still, as a fossil fuel, oil is a finite resource. Whether the amount which can be extracted is sufficient to last another 50, 100, 150 or more years is a matter of intense debate. More important is the fact that at some point reserves will be depleted. On a broad historical scale, the age of the use of petroleum - sometimes called the hydrocarbon age - is a relatively new phenomenon, as shown in the graph below. It was primarily in the 20th century that oil and its byproducts came to fuel the world. As demand for oil continues to grow, however, some estimate that "non-OPEC production of conventional crude oil and natural gas liquids is to peak within a decade." (n12)

     But what do forecasters mean when they say production will "peak"? The phrase can be applied to both individual oil fields and overall global output, and it refers to the point at which half the oil available has been produced. After that production levels begin to fall, and oil can become more expensive to extract (think of the resources/reserves chart). The diagram below illustrates what is known as the "Hubbert Resources Curve." The curve in essence depicts the lifespan of fossil resources. M. King Hubbert, a geologist, physicist and economist, "first shocked the oil industry in 1956 with his accurate prediction of a peaking in domestic (lower 48 states) oil production between 1966 and 1971 at a time when the consensus view called for infinite growth potential. Hubbert's prediction was proven out when U.S. crude oil output peaked . . . in 1970" [excluding Alaska]. (n13)

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