Since I get a plethora of questions about the oil industry I decided to expound about it. Why are gas prices so high?

Gas price is governed by the economic law of supply and demand. Much of the world’s oil is in politically unstable countries (Saudi Arabia, Iraq, Venezuela, Libya), making for inconsistent and volatile supply patterns. According to the API, OPEC lowered production 4% since December. China is developing a strong thirst for energy, especially fossil fuels to power its developing middle class. According to the API, China’s oil imports grew 36% in 2003. Since global oil supply is restricted and worldwide demand is at record levels, price must increase to ration this limited commodity.

Many people believe we can just crank the valve open and produce more barrels of oil in the upstream arm of our business. This is false. Most wells in the world today are operating at maximum capacity. For the past decade we were fortunate to have Saudi Arabia be a swing producer. That is, Saudi Arabia had excess capacity to tap when supply was short and brought this to market to help match supply with demand. With increased global demand, and consequently Saudi Arabia’s increased production, its available swing production is fast approaching zero. What does this mean? It means that very soon there will be no more existing valves to turn to increase production. Saudi Arabia is currently producing well above its OPEC allocation making for interesting politics, and even causing some to question the viability of the OPEC cartel. Add terrorism with a goal of $100 / BOE to the upstream equation and supply could be especially volatile.

Some would argue that the solution is just search for and find more oil. This is much easier said then done. Many oil companies are having a difficult time just finding enough oil to replace their reserves. For example, Shell has reduced its reserves four times this year. Unless an oil company replaces its reserves it will produce less oil in the future and its business will shrink. Currently, oil companies are spending huge amounts of money on exploration and production. Some companies are replacing reserves, but many are falling short. Finding oil isn’t the only trick, it must be economically recoverable (meaning it doesn’t cost more to produce than it can be sold for). Consequently, many wells are drilled to find emptiness or unrecoverable reserves.

Overall, oil reserves in the world are mostly mapped out. When was the last time you heard of a huge oil find in a new area? Has oil production peaked in the world? It peaked in the US during the 1970s. (More on this in a later blog entry).

Lets assume for a second that our upstream problems were resolved by huge elephant finds in our own back yard. It would be many years before the infrastructure surrounding these finds could be developed and oil brought to market. There are still many downstream issues that need to be addressed. The downstream arm entails the refining, marketing, and transportation side of the business. When and where was the last refinery built in the U.S.? MAP’s Garyville Louisiana plant built in 1974.

Many refineries have closed in the U.S. since 1974 and no new refineries have been built. However environmentalists have scuttled quite a few attempts. Therefore, our existing refineries are pushing their limits each and every day to bring gasoline to a station near you. Many refineries are old and some were even built during World War II. According to the API, the U.S.’s refineries are producing 3.7% more than last year, but have limited capacity for further growth.

Therefore, we have become an importer of refined product. New environmental regulations governing fuel specification have recently gone into effect and consequently gasoline imports have fallen 8% since last year. Some foreign refiners choose not to spend billions upgrading their facilities to refine fuel for the U.S. market, and instead ship their current products to countries with increased demand (i.e. China). This fall in gasoline imports has left U.S. inventories at low levels, making it difficult to match supply with demand. Environmental regulations governing fuel specifications have required the U.S. refining industry to perform $49,000,000,000 in upgrades in the last 10 years.

The next time that you are paying at the pump remember that refiners have seen an average rate of return on investment of 5.5% for the last 10 years, which is much lower than other investment opportunities. If there were price gouging and price collusion, wouldn’t refiners make more money? During a good year refiners make 3-5 cents / gallon in profit.

What does it take to make a gallon of gas?
98 tons (~196,000lbs) of prehistoric, buried plant material.

This entry contains my own personal thoughts backed up with API statistics. This entry doesn’t reflect the thoughts of my employer.