The Global Oil Market

Why the price of oil has little to do with the "fundamentals" of supply and demand.

By Paul Cummings

This article is from the July/August 2008 issue of Dollars & Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org

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This article is from the July/August 2008 issue of Dollars & Sense magazine.

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Since the United States-led coalition invaded Iraq in March 2003, the price of a barrel of oil reached a high of around $135, nearly quadrupling in five years. With U.S. oil imports currently totaling 4.5 billion barrels a year, this translates into a staggering $600 billion annual oil bill. Many energy economists predict that oil prices could top $200 a barrel in the near future, particularly if U.S. opposition to Iran's nuclear enrichment program leads to a confrontation, either directly or through surrogate states.

Why are oil prices skyrocketing? Many economists and business analysts like to talk about "the fundamentals": supply (constrained) and demand (strong). They point to rapid economic growth in China and India driving demand. On the supply side, it's the OPEC cartel limiting production while tree-huggers in the United States block the development of new offshore and Alaskan oil supplies.

But other analysts claim the so-called fundamentals tell us little about why oil prices are rising rapidly. Recently the London Times's economy and finance commentator, Anatole Kaletsky, noted that over the past nine months, as the price of oil has doubled, none of the basic determinants of supply or demand has changed much. China's demand growth is in fact slowing, as is the world's demand growth overall. Iraqi oil production is back up to prewar levels. Kaletsky views the current price spikes as symptoms of a classic financial bubble during which, typically, "prices end up bearing almost no relation to the balance of underlying supply and demand."

For now, the experts are displaying a remarkable lack of consensus on whether it's the actions of commodities traders and other financial-market movements or real supply and demand factors that explain the current oil price spike. In any case, the terms "supply" and "demand" are supposed to conjure up images of a free market. But the global oil market is anything but. Even leaving aside the role of financial markets in setting the price of oil, the supply of and demand for oil are heavily shaped by the actions of mammoth multinational oil companies and of governments in both the consuming and producing countries. And while the price of oil is rising fast, causing real pain to consumers, those extra dollars are going straight to the governments of the oil-rich countries and to the major oil companies—not to offset the tremendous costs that oil imposes, chiefly on the environment but in multiple other arenas as well.

Supply Management

From the very beginning of the modern oil industry, the supply of oil has been managed by powerful oil companies and the magnates who run them. The first was none other than John D. Rockefeller, who founded Standard Oil in 1870. By 1878 he had gained control of 90% of U.S. oil refining. In the 1880s Rockefeller used his strategic control of refining to build the first vertically integrated oil company, with oil fields, tankers, pipelines, refineries, and retail sales facilities under one corporate roof. By mercilessly undercutting competitors until they were near bankruptcy, and then buying them on the cheap, Standard Oil gained control of over half of the world's then-known oil supply. By the turn of the century Rockefeller had become the richest man in the world, with a fortune valued at around a billion dollars. Then, in 1911, the Supreme Court ruled that Standard Oil was a monopoly and, to create competition, split it into 34 companies, including Esso and Socony, which eventually became Exxon and Mobil, respectively.

Instead of competing, over the next 50 years Exxon, Mobil, and five other giant oil companies (the "majors") essentially formed a cartel. Leveraging their superior technology, production experience, and control of the retail market, the majors engaged in oil colonialism: they pumped and sold oil from a number of developing countries under highly favorable terms, earning vast profits.

In the 1950s, oil-rich countries began nationalizing their oil and training domestic oil technocracies to run the business. The advantages of collusion were no secret to them. In the 1960s Venezuela and Saudi Arabia organized OPEC (the Organization of Petroleum Exporting Countries), a cartel whose explicit purpose was to control the price of oil by regulating supply. By acting together, the oil-rich nations leveled the playing field with the majors and gained a larger share of oil profits.

With this context in mind, let's consider how oil gets to market today. Currently, around 75% of the world's oil is nationalized, managed by state-run oil companies that are monopolies in their own country. These state companies are often their country's largest employer, largest exporter, largest source of hard currency, and largest contributor to state revenue. State oil executives report to political authorities instead of a corporate board, and local political considerations can trump economic factors in their business decisions. For example, state oil companies may site new facilities in poorer communities to spur local economic development. More importantly, nationalized oil earns the money to pay for hospitals, schools, sanitation systems, and roads, projects rarely funded by Western oil corporations. The downside is that oil money all too frequently has been stolen by corrupt rulers or siphoned away to buy expensive weapons—Zaire's Mobutu Sese Seko and Iraq's Saddam Hussein were just two in a long line of oil-funded despots.

State oil ministers set oil production targets taking into consideration both economic and political factors, including current global economic performance, OPEC member production quotas, long-term contracts with oil corporations, International Monetary Fund debt repayment schedules, domestic revenue requirements, the desires of greedy and corrupt rulers, and the cost of oil extraction compared to oil's market price.

Of course, most of the state-owned oil across the globe lies within OPEC, whose policies fundamentally shape supply. The eleven member states of OPEC control over 50% of the world's oil. After both the 1973 Israeli-Arab war and the 1979 Islamic revolution in Iran, OPEC cut oil production, oil prices skyrocketed, cartel members earned hundreds of billions of dollars in windfall profits, and the world economy slid into recession.

Then, in the 1980s, a weak economy and more efficient cars cut oil demand, while newly discovered non-OPEC oil increased supply. OPEC tried to prop up plunging prices by cutting production. In particular, Saudi Arabia cut its output by nearly 8 million barrels per day. When other OPEC members began to cheat on their lower production quotas, the Saudis enforced market discipline by flooding the market with cheap oil, driving many suppliers out of business. With oil supply back under control, prices rose to around $20 a barrel, OPEC's market share was restored, and OPEC production quotas were honored. John D. Rockefeller would have applauded.

In 1990, the first "oil war" was launched when Iraq invaded Kuwait and seized its oil fields. With Iraqi troops poised to attack Saudi Arabia, a U.S.-led coalition drove the Iraqi army out of Kuwait. The Saudis once again demonstrated their market power by pumping enough additional oil to offset the loss of Kuwaiti and Iraqi oil production.

The cartel aims to keep the price of oil high, but it also seeks reasonable stability in the oil market. After all, the lion's share of the petrodollars that OPEC members earn are plowed back into the United States and the other wealthy consuming countries in the form of investments. If oil price volatility begins to damage the U.S. and other industrialized economies, those investments will likely suffer as well. But OPEC's ability to manage supply for the twin goals of profitability and stability is limited. In recent years conflicts in the Middle East, rapidly growing oil demand in China and India, and OPEC's own tendency to overshoot or undershoot planned production levels have all contributed to a more volatile oil market than OPEC perhaps intended.

The remaining 25% of global oil supply comes from fields owned by the majors or by Russia's ostensibly private energy giant Gazprom. This production is more responsive to market signals, but is still influenced by non-price factors such as government tax and environmental policies and Wall Street pressure to report high quarterly earnings.

Perhaps the clearest indicator that the supply of oil is managed and not a simple response to market signals is the curious fact that much of the oil that is brought to market is relatively expensive to produce because of high extraction costs (for instance, deep sea oil), transport costs (Alaskan oil), or refining costs (some of Africa's oil). At the same time, oil that could be brought to market far more cheaply—much of the oil in the Arabian Peninsula, for example—is left in the ground. Saudi oil costs just $1.50 per barrel to produce, while the average production cost of oil outside of the Middle East is $22 per barrel. In a free market, competition would cause the lowest-cost oil to be sold first, since cheap oil can undercut expensive oil. However, in the case of managed supply, producers of cheap oil can hold back their oil, allowing the market price to rise until it exceeds the production price of expensive oil. This means very high profits for the producers of cheap oil, while many energy analysts stimate that consumers are paying twice as much as they would if oil markets were free, Paul Roberts writes in The End of Oil.

Retail supplies are influenced by vertically integrated global oil delivery systems—pipelines, supertankers, refineries, delivery tanker trucks, assorted retail sales facilities—which are controlled by the Saudis, Venezuela, and the super-majors (the six largest private oil companies: ExxonMobil, Shell, BP, Chevron, ConocoPhillips, and Total S.A.). Every day 85 million barrels of oil flow to consumers around the world. The massive oil delivery systems are worth a combined $5 trillion dollars and create a large barrier to entry for alternative energy suppliers. Supply can be constrained for other reasons as well, for instance, environmental or other regulations that block expansion or construction of oil pipelines or refineries.

Occasionally a geopolitical or extreme weather event breaks the oil supply system and retail oil prices go through the roof, creating outrageous profits. For example, in the aftermath of Hurricane Katrina, U.S. gasoline prices doubled overnight. The oil industry denied using Katrina to fleece customers, but a 2006 investigation by the Federal Trade Commission found multiple examples of price gouging at the refining, wholesale, and retail levels. Coincidentally, in the last quarter of 2005, the accounting quarter following Katrina, ExxonMobil earned $9.9 billion, the largest quarterly profits ever reported by a U.S. company.

In 2007 oil prices were exploding along with much of Iraq. That year ExxonMobil earned $40.6 billion in profits on $400 billion in revenue, the highest yearly profit ever earned by a public corporation. Amazingly, even this record profit pales in comparison to the 2007 Saudi net oil revenue of $194 billion.

Captive Consumers

The demand for oil is no more a simple result of free-market forces than is the supply. To begin with, energy demand is not created directly by consumers: we do not desire gasoline the way we might desire a new house or a new pair of shoes. Instead, demand is "pulled" by the economy, whose mix of technologies and rate of growth determine how much energy, from oil and other sources, is required to power it. Oil heats tens of millions of homes, offices, and factories and powers 30% of the world's electric generation. Oil is also used as an input in the manufacture of petrochemicals such as plastics.

And, of course, oil moves mountains of raw materials, tons of finished goods, and billions of people every day. The world's armada of oil-fueled vehicles consists of nearly a billion cars, trucks, buses, tractors, bulldozers, ships and airplanes. The troubling reality is that this armada runs only on oil; there is no viable alternative fuel today, and oil companies intend to keep it that way.

Every year the armada grows, moving more people and more stuff over greater distances. Globalization has spread out the production and sales processes over ever-longer international supply chains. U.S. and Canadian commuters drive more and more miles as suburbanization moves home and work farther apart. And the average fuel efficiency of U.S. passenger vehicles fell by 5% during the past 20 years, due to aggressive marketing of SUVs and trucks.

Oil companies use their political clout to stop government efforts to increase fuel efficiency. Over the last 20 years, the oil industry has given $200 million to U.S. politicians, mostly Republicans, who believe in free markets but regularly give an invisible helping hand to the oil companies. During those same 20 years, oil lobbyists have rolled back gas mileage standards and created tax subsidies for buying eight-ton Hummers that inhale gas. Oil lobbyists have redirected funding from alternative energy technology to road and bridge repair.

Oil companies have also used their wealth and political power to crush electric powered transportation systems. In the 1920s city-dwellers commuted on electric trolleys, but oil and auto companies wanted to sell them buses and cars. Standard Oil, General Motors, Mack Truck, and Firestone Tire funded a dummy corporation, National City Lines (NCL), to replace trolleys with buses. It didn't matter if NCL lost money; its goal was to create demand for buses, cars, tires, and oil. If it could do so, its parent companies would make a fortune. By 1929 NCL had established its business model and when the Great Depression deepened, over 100 electric utility companies, located in most major cities, were forced to sell their trolley lines at a sharply discounted price to NCL, the only buyer with cash. Once NCL had control, the trolley systems were sold for scrap and within days a new fleet of buses arrived, followed by a tidal wave of cars. In the late 1940s, NCL had served its purpose and was failing. Government lawyers had been investigating NCL, and in 1949 they successfully prosecuted its parent companies for collusion to destroy the nation's trolley system. Each parent company paid a $5,000 fine, which wasn't too bad considering they had made on the order of $100 million in profits from NCL's illegal actions.

By 1990 the Los Angeles basin faced a serious public health problem due to smog from car exhaust. The state of California issued a mandate requiring car companies to develop a zero emission vehicle, or ZEV. Oil and automobile companies launched a full-fledged political campaign to overturn the ZEV mandate, including TV and magazine ads, direct mail, and thousands of calls from phone banks. The ZEV mandate was never enforced and, in 2003, was replaced with a minimal requirement that car companies sell a few gas-electric hybrid cars by 2008. That same year, in a remarkable episode chronicled in the 2006 documentary "Who Killed the Electric Car?," GM was taking back the hundreds of EV1 electric vehicles it had leased to U.S. drivers beginning in 1996. The carmaker assembled most of the EV1s at a site in Arizona where it proceeded to crush them—despite very positive feedback from EV1 lessees, many of whom wanted to purchase and keep the cars. Explanations for GM's decision to halt the EV1 program and destroy the cars vary. GM says it determined the venture could never be profitable, in part because hoped-for breakthroughs in battery technology did not occur. One thing is certain: the car did become less marketable once California gave in to pressure from the oil and auto industries (including GM) and lifted the ZEV mandate.

In 1994 oil companies attacked Ballard Power Systems for developing a hydrogen fuel cell to power cars. With a game plan similar to the one they'd used to undermine the ZEV mandate, they took out ads decrying the fuel cell, challenged the company's veracity at trade conferences, and questioned its ability to actually bring a viable product to market. Oil companies pointed out that useable hydrogen was in short supply and an entirely new hydrogen refining, delivery, and fueling infrastructure would need to be built at the cost of many billions of dollars. As a result of these attacks Ballard backed off, and further development of its fuel cell was hidden in an internal R&D program for over a decade.

So the demand for oil is driven by economic and social trends far beyond the control of individual consumers, who are stuck, at least in the short term, paying whatever price the oil companies set if they want to fill their tanks and heat their homes.

Finally, it's impossible to get the whole picture of demand for oil without recognizing one very special oil consumer: the U.S. military. Every tank, armored vehicles, truck, humvee, jet, and missile runs on refined oil, as do most ships. In 2007, the U.S. military consumed about 250 million barrels of oil and 2.6 billion gallons of jet fuel, making it the world's single largest fuel-burning entity. Without oil the Army and Marines could not maneuver, the Air Force could not fly, and most of the Navy could not sail. The United States would be a paralyzed superpower, unable to project power throughout the world. Since all the other military forces in the world also run on oil, the ability to cut their oil lifelines is a tremendous strategic advantage in any conflict. These factors make oil more than just another commodity. Oil is a weapon, a strategic commodity, a national security resource; it is not just like wheat or widgets. By the same token, any shift in U.S. foreign policy that reduces the country's military engagements can also represent a sizeable drop in U.S. oil demand.

Multiple Market Failures

Today's global oil market is working well for the major oil companies, their managers, and their shareholders. It is also working well for the oil-producing countries, at least to the extent that they are garnering vast revenues. (Of course, the extent to which these revenues are benefiting ordinary people in the oil-rich countries varies dramatically.)

But the oil market is characterized by many kinds of market failure: the workings of the market are producing less-than-optimal results on multiple levels. For instance, oil price spikes can lead to "demand shocks" that suck money rapidly out of the economies of the oil-importing nations. If the global financial system cannot get this money re-invested and generating demand quickly, the result can be a drop in global demand followed by an economic downturn. According to energy economist Philip Verleger, over the last 50 years there have been six major oil price spikes, each causing economic losses that have totaled more than $1 trillion. Verleger posits that a 20% increase in the price of a barrel of oil results in a 0.5% decline in global economic growth. Based on that formula, the current $100 spike in the price of oil, if sustained, could wind up causing a reversal in the global economy from a baseline of 2% growth to a 1% contraction.

By and large, Americans have benefited from the fact that the price of oil worldwide is denominated in dollars rather than another currency. Right now, though, the falling value of the dollar against other major currencies is one factor pushing up the price of oil in the United States. Moreover, not only can fluctuations in the value of the dollar affect oil prices; oil market shifts can affect the value of the dollar. Hence, a second type of market failure in the global oil market is the increased "risk premium" that attaches to a whole range of financial transactions when a build-up of petrodollars makes the financial markets worry about an increased risk of either a devaluation of the dollar or a run on the dollar. In both cases the U.S. Federal Reserve may not be able to successfully intervene because trillions of petrodollars are outside of the Fed's control. In general, increased risk is bad for the economy and leads to higher interest rates and slower economic growth.

A third group of oil market failures are environmental. Oil is a dirty business that pollutes the air, water, and earth, often in health-threatening ways. Take oil spills for example. In Ecuador a pipeline runs over the Andes, connecting Ecuador's eastern jungle oil fields to its Pacific coast refinery. When earthquakes or landslides break the pipeline, all the oil between the break and the shut-off valve simply pours out, contaminating a broad swath of the mountain below.

Six thousand miles to the north, Exxon's supertanker, the Valdez, struck Bligh Reef on March 24, 1989, spilling 11 million gallons of oil into Prince William Sound. The oil contaminated 1,500 miles of Alaskan shoreline; nearly 20 years later, local economies dependent on fishing and tourism have still not entirely recovered. There are thousands of similar cases all over the planet.

The mother of all oil market failures is climate change. When oil is converted to energy, it gives off CO2 which traps heat in the atmosphere and, in large quantity, can alter the climate. The result is a global, cumulative, and intergenerational problem that an increasing number of climate scientists fear may become a crisis of biblical proportions: higher sea levels flooding coastal cities around the globe; droughts, heat waves, pests, and more frequent extreme weather events affecting food supplies and human health.

No matter where CO2 originates, it spreads quickly through-out the entire atmosphere, and so makes the problem a global one. The longevity of atmospheric CO2 creates a cumulative problem. Since 1850, our species has dumped so much carbon into the sky that atmospheric CO2 levels are at their highest point in a million years. That is 500,000,000,000,000 pounds of carbon stuck in the sky, as if the atmosphere were an open sewer! And that longevity makes the problem intergenerational: it will take the earth 16 generations (400 years) to reabsorb 80% of the CO2 we emit today, and the remaining 20% will stay in the sky for thousands of years.

Solving climate change begins by realizing that the oil market doesn't have to be managed for the benefit of a small number of extremely rich people. We must also put to rest the canard that oil resources are best allocated by the free market's "invisible hand." Columbia University economist Joseph Stiglitz points out, "the reason that the hand may be invisible is that it is simply not there—or at least that if is there, it is palsied." The public needs to fight to remove the control of oil pricing from the oil corporations and establish an oil market that is more fair and sustainable.

In a sustainable energy market, the price of gasoline and other fossil fuel products should reflect the real costs these energy sources impose—above all, on the environment. That means prices that are higher than what Americans are accustomed to. But a progressive oil agenda would include recapturing that additional revenue and using it to compensate low-income consumers and, especially, to move the economy toward one based on renewable energy. Paying that extra dollar or more a gallon at the pump would feel very different if U.S. consumers knew the money was being spent not to line the pockets of dictators and oil executives, but instead to offset the extra cost for low-income families and, especially, to generously fund myriad projects to put the economy on a green-energy path.

Paul Cummings is a software engineer with a longstanding interest in environmental and social issues. His article (with Adria Scharf) "After Kyoto" appeared in the July/August 2005 issue of Dollars & Sense.

Sources: Sohbet Karbuz, "US military energy consumption: facts and figures," Energy Bulletin, May 20, 2007; Chalmers Johnson, "The Arithmetic of America's Military Bases Abroad: What Does It All Add Up To?" www.tomdispatch.com, 2004; OPEC, "World Oil Outlook 2007"; Paul Roberts, The End of Oil (Houghton Mifflin, 2005); U.S. Federal Trade Comm., "Investigation of Gasoline Price Manipulation and Post-Katrina Gasoline Price Increases: Report to Congress" (Spring 2006); Eric Noe, "For Oil Giants, Pricey Gas Means Big Profits," ABC News, Jan. 25, 2006; Steven Mufson, "ExxonMobil's Profit in 2007 Tops $40 Billion," Washington Post, Feb. 2, 2008; U.S. Energy Information Admin., "OPEC Oil Export Revenues 2007"; Michael Renner, "Five Hundred Million Cars, One Planet—Who's Going to Give?" (Worldwatch Institute, August 2003); Daniel Engber, "How Gasoline Becomes CO2: A gallon turns into 19 pounds?" Slate, Nov. 1, 2006; Matthew Kahn, "The Environmental Impact of Suburbanization," Jrnl of Policy Analysis and Mgmt 19:4 (Fall 2000); Philip Verleger, "A Collaborative Policy to Neutralize the Economic Impact of Energy Price Fluctuations," Policy paper, June 10, 2003; "The Real Price of Gasoline: An Analysis of the Hidden External Costs Consumers Pay to Fuel Their Automobiles," Int'l Ctr for Technology Assessment, 1998; Joseph Stiglitz, Making Globalization Work (W.W. Norton, 2006); Laura Peterson, "Big Oil Wields Ultra Deep Influence," Ctr for Public Integrity, Dec. 2004.
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