Damage Control

Gasoline and other fuel prices are subsidized in the three representative oil-producing countries graphed on the top right - to the point that gasoline costs $0.12 per gallon in Caracas.

Compare the growth in oil consumption in those countries to growth for the world as a whole. Did you notice a pattern?

By Peter McKenzie-Brown

The world has two kinds of energy-consuming jurisdictions: Those which respond to high oil prices, and those which don’t. In this post, I want to help define which is which. I also want to offer a few explanations why dramatic increases in energy prices have not yet damaged the world economy. These are intimately related issues.

I recently had an interview with Marcel Coutu, the chair of Syncrude – the world’s largest oil sands plant. Syncrude has been in operation for 30 years, and it has gone through a great deal of debottlenecking and expansion. It now produces 350,000 barrels of light, synthetic oil per day.

I asked Marcel for his thoughts on peak oil, and he gave me a few comments that summarize things precisely.

All OPEC can now do is raise prices by cutting production. They cannot lower prices by increasing production because they don’t have the capacity. We are in a very pure free market situation, with prices being set by supply and demand. When I look at that dynamic, I have stopped worrying about the demand side. No matter how much the US goes into recession, for any period that is important to any of us, any decline in consumption there will be offset by increased demand elsewhere – in China and India, but also in developing countries that produce their own crude oil. Those countries generally subsidize oil products, and subsidies accelerate demand growth.

At these prices you are seeing some conservation somewhere, but it is being more than offset by increased demand somewhere else. Whether people are still going to be buying at $200 a barrel I don't know, but by the time we get to $200 it will be the supply side that will keep things tight and moving upward.

He didn’t seem to think this was a major global problem, and I wish I had asked why not.

Three Theories: Historically, rapid increases in oil prices have led to global recession. This certainly applies to the stagflation that influenced the decade after the energy crisis of 1973. The terrible recession of 1982 was without doubt related to the energy crisis of 1979-80. And the long, gradual boom that began in ’83 was closely tied to declining oil prices, and accelerated by their collapse in 1986.

What I think we need to ask ourselves is why high oil prices don’t seem to be doing a lot of damage to the global economy. According to The Economist, there are three possible explanations.

An important and interesting idea is that high oil prices are not hurting the economy simply because they themselves are the result of rapid economic growth around the world. “Rather than oil harming the global economy, it is global expansion that is driving up the price of oil” says the world's great champion of liberalism.

Another explanation is that developed economies are more efficient in their use of energy, thanks partly to the increased importance of service industries and the diminished role of manufacturing. For example, the EIA has calculated that the energy intensity of America's GDP fell by 42% between 1980 and 2007.

A third notion is that the oil price rise has been steady, not sudden. This has given the economy time to adjust. The Economist writes, “Giovanni Serio of Goldman Sachs points out that in 1973 there was a severe supply shock because of the oil embargo, when the world had to cope with 10-15% less crude almost overnight. Not this time.” It’s worth adding that during 1979-80, the percentage increases in oil prices were not as great as they were in the early 1970s, but in absolute terms those increases were greater by far.

The Role of Emerging Economies: As Marcel Coutu explained at the beginning of this article, the most important factor for higher prices has been the shift toward greater consumption by developing economies.

The US, for example, has responded to high prices by cutting consumption slightly. According to one source, the decline will be 1.1% this year, such that American consumption next year will be no higher than it was in 2004. Given such a niggardly response, growing demand from China and other emerging markets will be more than enough to offset this shortfall. With supply growth slight to neutral, the steady increase in demand is hauling prices remorselessly higher. It would take a recession in emerging markets to drive commodity prices substantially lower, and to date recession in those economies is not in the cards.

A couple of points deserve comment here. One is that the achievements of Western nations in reducing energy intensity are nothing compared to the achievements of China. According to an excellent paper on China’s energy consumption and demand , since 1980 China’s energy intensity has dropped by about 75% – nearly twice the drop in the US. The reason is that in every way the world's next superpower has become far more efficient.

Of course, I am raising this point because it suggests a very deep irony: Exporting the world’s manufacturing sector to developing countries has not only enabled the West to become a more efficient energy consumer. It has also helped those countries to become more efficient. Don’t blame the Chinese, in other words: They are doing a far better job at using the world’s resources efficiently than the West can even imagine.

Final Thoughts: These ideas, too, hark back to Marcel Coutu’s earlier comments. By subsidizing energy consumption within oil exporting countries, the world is contributing to inefficient energy consumption. Some of the cheapest gasoline prices in the world are in Saudi Arabia, Kuwait and Venezuela – the last being the all-out winner, with gasoline selling for $0.12 per gallon. The economies of these countries are not known for their gathering efficiency, yet the charts illustrate how much more dramatically oil consumption accelerates when prices are subsidized than when they are not.

The plain truth is that energy importers are subsidizing the inefficient consumption of oil in these countries because of the geographical reality that they have oil to export. Yet the countries we are most anxious about - China and India, for example - are the ones that are increasing their energy consumption not because of large subsidies, but because they are able to provide goods and services with greater energy efficiency than the rest of us.

Oil and Gasoline Prices: The Crack Spread

When a major US refinery shuts down, why do oil prices go up? This is counterintuitive. After all, a shut-in refinery means reduced demand for oil, and less demand should mean less price pressure, right? Wrong. Here's an account of the strange ties between oil and gasoline prices. By the way, I could not find the original source of the excellent graphic above, although I know it comes from this blog.

By Peter McKenzie-Brown

The Question of Collusion: Motorists often express concern – call it anger, sometimes – about rising gasoline prices. Citing the reality that neighbouring service stations charge almost identical prices for gasoline, many consumers claim that oil companies illegally collaborate with each other to manipulate gasoline prices. It has frequently been shown, though, that market forces keep local prices the same. If a service station on one street corner charges a penny more per litre than its competitor across the street, motorists will buy from the competitor. It is in each dealer’s self-interest to match the competition’s price.

Economists have no trouble with this explanation of how companies set gasoline prices. It is nonetheless understandable how identical local pump prices cause motorists to suspect collusion by the oil companies – especially when those companies often raise gasoline prices, almost simultaneously, at the beginning of a holiday! Raising prices in anticipation of strong holiday demand is a marketing tactic, however, and not collusion.

Links between Oil and Gasoline Prices: The oil industry’s critics also argue that companies move gasoline prices up quickly when crude oil prices rise, but fail to bring them down when oil prices falter. This argument is also flawed, as a review of the ties between crude oil and gasoline prices in 2006 helps illustrate.

In the week of August 6, the average OPEC crude oil price hit what was then an all-time high: US$71.33 per barrel. That week Canada’s average price of gasoline also reached a peak, at $1.15 per litre. Compared to their averages during the previous two weeks, prices for both commodities rose by about 5 per cent. The following week, OPEC oil and gasoline prices dropped – in both cases, by about 5 per cent. By the week of October 1, which preceded Canada’s Thanksgiving holiday, OPEC oil had dropped by 22 per cent. However, the average price of gasoline for that week had declined to 86 cents – a drop of 27 per cent from its peak price two months earlier. Oil and gasoline prices do track each other, but they are also influenced by other factors. The most important are crude oil prices and taxes.

Refining Problems and Gasoline Prices: In North America there has been a price disconnect between oil and gasoline in recent years. This is partly because the market for gasoline has been strong. This has worsened the limitations in America’s capacity to refine enough gasoline for its consumers.

Canada’s refining centres are at or near Vancouver; Edmonton; Sarnia and Nanticoke, Ontario; Montreal; and St. John, New Brunswick. There are also some smaller refining centres – notably Regina, Saskatchewan and Come-by-Chance, Newfoundland.

Canadians ordinarily produce more than enough gasoline for domestic use. We sometimes import gasoline because refineries need regular maintenance shutdowns or have unexpected operating problems. As the following chart illustrates, our imports are offset by exports to the United States.

The graph also illustrates the seasonal nature of gasoline consumption – we buy far more in the summer than in the winter – and the fact that Canada produces far more gasoline than we consume. Canada exports significant volumes of gasoline, primarily from refineries in Atlantic Canada to the U.S. eastern seaboard. Each year, Canadians consume more than 40 billion litres of gasoline and 25 billion litres of diesel fuel. The bar on the far right of the chart shows Canada becoming a large net-importer of gasoline – for the first time in recent history – in May and June 2006. This occurred because the industry needed to modify many refineries to meet new refining standards. These shutdowns reduced gasoline production just as summer driving was ready to begin, and Canada had to import large volumes to meet demand.

During that summer, motorists witnessed higher, more volatile prices than they had in a long time. Canada was extremely vulnerable to unplanned refinery outages. That brief experience was a small reflection of a large, chronic problem in the United States, and America’s problems affect gasoline prices across the continent.

American Vulnerability: The US has become highly vulnerable to refinery shutdowns, and gasoline prices have developed a volatility that reflects both oil price movements and problems in the refining industry. To some extent, this vulnerability and volatility have splashed across the border into Canada. Gasoline is increasingly a global commodity.

Americans consume about 1.51 billion litres of gasoline every day. The United States is thus the largest gasoline consumer in the world, but it is also the largest refiner. The United States does not produce enough gasoline to meet its own needs, however. It always needs imports, and imported gasoline can be expensive.

“Turnarounds” (scheduled maintenance programs) at US refineries put pressure on international gasoline supply, including supply from Canada. But in recent years unexpected breakdowns at refineries have added urgency to the challenge of meeting consumer needs. These events and stronger demand during the summer driving season contribute to higher prices.

As a rough average, in recent years the US refining sector has operated at 90 per cent of capacity. Put another way, 10 per cent of US refineries have been out of operation at any given time. In that environment, imagine what happens when one or two refineries shut down, reducing capacity use to 89 per cent, say. In a tightly balanced gasoline market, this can cause steep and rapid price increases – something the world witnessed dramatically in 2005, as Hurricane Katrina shut down refineries and closed ports that could have imported gasoline from overseas. The panic that followed briefly took Canadian prices to an all-time high of $1.26 per litre.

A Spiral in Gasoline and Crude Oil Prices: One of the oddest phenomena in the present world of gasoline pricing is its impact on the price of crude oil. As this article has explained, it is logical for gasoline prices to go up along with oil prices. After all, refiners manufacture gasoline from crude oil, and rising input costs contribute to rising total costs.

However, higher gasoline prices also result in higher oil prices. This is less intuitive, for a number of reasons. If a large refinery shuts down, it is reasonable to expect gasoline prices to rise. Less gasoline will be produced, lowering supply; prices will therefore increase. Since there would be less demand for oil to refine, one would normally expect crude oil prices to drop. What actually occurs, however, is the opposite: When a big North American refinery shuts down, both gasoline and oil prices rise. Welcome to the world known to traders as “crack spreads”. “Crack spreads” refers to the spread, or margin, that a refinery can earn by “cracking” (refining) a barrel of oil into such marketable products as gasoline, jet fuel and heating oil. Roughly speaking, three barrels of West Texas oil can be refined into two barrels of gasoline and one barrel of heating oil. If these products rise in value, the value of the barrel of oil they come from will also increase, even if refinery demand for oil has dropped. Thus an off-the-wall oil price spiral: rising crude oil prices increase the price of gasoline, and rising gasoline prices increase the price of oil.

Changing Dynamics: This article has reviewed many factors that are changing the dynamics of gasoline pricing. These factors include rising oil prices. Also, some taxes climb in response to escalating fuel costs, and this further complicates the issue of rising gasoline prices.

We are becoming increasingly reliant on gasoline as our society changes, and there are inefficiencies in the North American petroleum infrastructure that – because petroleum refining and marketing is such a huge industry – will take a long time to strengthen. Of course, this begs the question of whether the oil would be there to supply a larger, more efficient refining sector. That's a question for another day.