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Oil, and a bit of geopolitics

by Brad Setser
February 25, 2005

On Thursday, the Financial Times, the New York Times and Tom Friedman all weighed in on Asian reserve diversification.

Paul Blustein of the Washington Post has an A1 story today on another of my common themes: the US is taking on external debt not to invest in new export industries, but rather to fund the budget deficit and a housing boom.

It is clearly time to change the subject.

The Saudis indicated that they really don’t mind $50 a barrel oil. Shocking, I know.

The Saudis do want the world to eventually buy all their oil, and thus don’t want too rapid a move to alternative fuel sources. Consequently, they sometimes do start to worry if rising oil prices lead to a fall in demand for oil. This time around, though, high oil prices have not triggered much of a reduction in demand.

Asian economies (huge oil importers: most Asian economies have higher oil imports as a share of GDP than the US) have generally resisted letting gasoline prices rise in line with rising oil prices. Remember, China is still a communist country. The state oil companies seem to have been told to keep retail prices low. That is one way to contain inflation.

In India for example, our colleague Chetan Ahya reports that the government is not allowing the oil companies (mostly government-owned) to increase profit margins. This is akin to taxing oil companies’ profits to subsidize consumers. In China, where retail taxes are negligible, our colleague Denise Yam reports that the state development and reform commission publishes retail price “guidance” for industry participants. As a result Chinese retail energy price increases in 2004 (20%) lagged behind those in international markets (40%).

So long as Asian financing of the US continues, low US interest rates let US consumers borrow against their rising home values to keep on trucking. OK — I am exaggerating the “made in Asia” story for effect, other factors are at play as well, but there is not much evidence, at least that I am aware of, indicating that US demand for oil is faltering at current prices.

What is not for the Saudis to like? They get to produce at capacity and make tons of money without seeing higher prices lead to any fall-off in demand.Three other points:

1) Oil (West Texas Intermediate) averaged a bit over $41 a barrel last year. If light sweet crude stays above $50 for the rest of the year, it will have a noticeable impact on the 2005 US trade deficit. A basic rule of thumb is that a $1 a barrel increase in the average oil price increases US oil imports by about $5 billion over the course of the year. So if oil averages $51 a barrel, the US oil import will be go up by roughly $50 billion. That is one reason why the 2005 trade deficit is likely to be substantially bigger than the 2004 deficit, unless something changes. The impact of higher oil prices on US exports is ambiguous: oil exporters have more money to spend on US goods, but oil importers like Germany and Japan have less. The two effects probably cancel each other out, leaving just the higher import bill.

2) The Financial Times has a lengthy article highlighting China and India’s growing interest in investing in oil. General Glut and the Global Trader are right: China is not compelled to invest in Treasuries if it thinks oil companies will generate higher returns. I suspect China’s growing commercial ties with Iran also supports Tom Barnett’s argument that a coalition of the US, Europe and even Russia (“the willing”) won’t be able to isolate Iran all that effectively. China’s quest to secure access to oil and gas to meet its energy needs could well become a growing source of irritation to the US. The US would much rather than China buy Treasuries than buy Iranian oil and gas, but China may have different ideas.

3) The oil exporters are gonna have large current account surpluses this year, unless something changes. Where are they investing all their money? Probably some is going to Europe, helping to drive down the yields on a range of European assets (sound familiar?). Europe seems to be playing an increasing role in the intermediation of global savings — flows from outside Europe into the Eurozone drive down yields on European fixed income assets, leading European investors to look elsewhere for higher returns. The net effect: both inflows into Europe and outflows from Europe, with outflows well in excess of Europe’s current account surplus.

45 Comments

  • Posted by spencer

    As a monopoly supplier the best pricing strategy for Saudia Arabia is to set the price just below the level that will attract major new supplies.
    Ignoring the peak oil production argument for the time being, this is the error Saudi made 20 years ago when real oil prices rose to about $100 in todays dollars. The consequence was a 20 year glut in oil that lead to inadequate investment in oil in the 1990s and todays shortages. From the Saudia perspective are they making the same mistake, or is $50 oil still too low to attract major new investment in oil?

  • Posted by P O'Neill

    One thread that might link China’s investments in oil and Treasuries is that neither seems to be especially profitable. There have been various media reports of China scattering investments throughout oil producing countries, and possibly overpaying, in the belief that they are buying “access” to future oil. Consider for instance their role as a bit player in the Yukos shenanigans, providing some funds to the successor company that gets them … not clear what exactly. Good will from Pootie-Poot? The Communists may have done an impressive job of economic transition with political stability. But that doesn’t make them good investors.

  • Posted by steve kyle

    2 points

    1. If I were an oil exporter looking to put my money somewhere and also watching the US invade oil countries on a flimsy pretext while seeming to look for a pretext for the next oil country to invade I would not want to put my money anywhere it could be frozen by the US government. Remember, we have frozen OPEC countries’ assets in the past so there is a precedent. Even the Saudis have to be wondering if there isnt a point in the future when they will want to have their money somewhere we cant get our hands on it. I would bet a lot that the added CA surpluses of this year will be going a lot less to dollar assets than in the past.

    2. Having access to the world oil market isnt the same as owning the oil. The Chinese arent going to like it one bit if the US tries to move toward further control over the Persian Gulf. I take it as a given that they will want to promote diversification in oil supply just as much as diversification in reserves.

  • Posted by anne

    http://www.nytimes.com/2005/02/18/business/worldbusiness/18energy.html?ei=5070&en=05c346ea86f8e015&ex=1109998800&pagewanted=all&position=

    2 Big Appetites Take Seats at the Oil Table
    By KEITH BRADSHER

    MUMBAI – India, sharing a ravenous thirst for oil, has joined China in an increasingly naked grab at oil and natural gas fields that has the world’s two most populous nations bidding up energy prices and racing against each other and global energy companies.

    Energy economists in the West cannot help admiring the success of both China and India in kindling their industrialization furnaces. But they also cannot help worrying about what the effect will be on energy supplies as the 37 percent of the world’s population that lives in these two countries rushes to catch up with Europe, the United States and Japan. And environmentalists worry about the effects on global warming from the two nations’ plans to burn more fossil fuels.

    With engineering expertise and equipment more available around the world, one result is that oil executives and drillers in remote spots increasingly speak Mandarin or Hindi, not English. Their newfound commercial confidants live in pariah states like Sudan and Myanmar, one sign that the political dynamics of the world oil market pose a difficult challenge for the Bush administration.

    The prospect of China’s consuming ever growing lakes of oil has been noted over the years, although it is gaining new urgency as Chinese consumption continues to soar. China’s oil imports climbed by a third last year as its oil demand exceeded Japan’s for the first time.

    Now India is joining China in a stepped-up contest for energy, with both economies booming recently just as their oil production at home has sagged. China trails only the United States in energy consumption; India has moved into fourth place, behind Russia….

  • Posted by anne

    http://www.nytimes.com/2005/02/18/business/worldbusiness/18refinery.html?ex=1109480400&en=919dd7b4e61235d8&ei=5070

    A Former Gas Station Attendant’s Big Bet on a Refinery Has Paid Off
    By KEITH BRADSHER

    JAMNAGAR, India – The vast refinery and petrochemical complex here is the size of Manhattan south of Central Park. It could have been a costly white elephant.

    Instead, the quirky project, which includes the world’s largest mango plantation, has become one of the most profitable bets in the global refining industry. The success of the complex shows the changing economics of refining, a business once regarded as an unglamorous backwater by oil executives more interested in finding the next big oil field.

    Completed by Reliance Industries of Mumbai in 1999 at a cost of $6 billion, the operation’s $7 billion a year in sales equals 4 percent of the entire revenue of India’s corporations. It is one of the few refineries in the world that can take very thick high-sulfur highly acidic grades of crude oil and process them into extremely pure, low-polluting gasoline and diesel fuel.

    The New York region, with its demanding environmental standards, has become the biggest single destination for shipments from here, said Captain Sunil Pradham, who manages a four-mile-long jetty that stretches into deep water where tankers pick up cargos, four at a time….

  • Posted by DF

    Higher oil prices may not reduce consumption because right now the debt of the consumers increase. Agreed.
    Thus the savings have to fall in the USA. Thus the ceiling of debt will be reached sooner.

    So it increases the probability of deflation depression. (real wages fall why productivity increases go on)

  • Posted by anne

    http://flagship3.vanguard.com/VGApp/hnw/FundsVIPERByName

    Sector Indexes
    12/31/04 – 2/24/05

    Energy 18.8
    Financials -3.5
    Health Care 0.1
    Info Tech -5.8
    Materials 4.3
    REITs -6.8
    Telecoms -4.2
    Utilities 2.5

  • Posted by anne

    http://www.msci.com/equity/index2.html

    National Index Returns [Dollars]
    12/31/04 – 2/23/05

    Australia 2.9
    Canada 0.6
    Denmark 3.7
    France 1.4
    Germany -1.6
    Hong Kong -1.9
    Ireland 2.8
    Japan -3.0
    Norway 5.8
    Sweden -0.9
    Switzerland 0.7
    UK 3.1

  • Posted by Movie Guy

    I believe that a meaningful crude oil/refined product(s) discussion would involve a few different focus points. Global vs. U.S. demand and actual demand for specific grades of crude.

    Example, our domestic producers turned down increases in Saudi crude oil exports last year. Why? It’s high sulfur. We weren’t chasing inventories of more high sulfur, but rather sweet (light crude – low sulfur).

    A more careful study of crude available from Iraq will reveal similar concerns with some of the fields.

    Saudi has offered to build refineries in the U.S. to counter the lack of interest in their crude. I’m unaware of any action on building such facilities.

    I believe that it’s clear that the U.S. is not the principal market for their crude oil. But the U.S. is certainly chasing sweet crude around the world.

  • Posted by Ian

    The interplay of oil and geopolitics is incredibly interesting.

    History has shown that governments will be drawn into costly wars to secure and protect energy supplies. For the last 50 years, the US government has treated the Middle East as its own personal back yard. Now clearly China and India want to move in and secure access to middle eastern oil and gas. The realist view is that this jockeying for power will inevitably lead to some sort of conflict.

    Of course this is all muddled by the fact that China and the US have this incredibly complicated economic relationship where they accumulate our debt in return for our buying thier goods. That 600 billion dollar hunk of US debt that China owns clearly gives it some signifigant leverage.

    Right now the US has been content to let Sinopec go around the world and “overpay” for second-class energy assets in overlooked corners of the world. But what happens when Sinopec and Exxon come into conflict?

    The coming (seemingly) showdown with Iran over thier nuclear program will certainly be complicated by China’s economic relationship there. For Iran, being a key energy supplier to a country with veto power in the UN Security Council allows them to ignore to some degree the pressure from the United States and Europe to halt thier nuclear program.

    I’m very curious to see how this will all play out in the next 5-10 years….

  • Posted by Lorenzo

    I almost hate to get involved in this discussion because economists usually look at me like I’m a three headed alien from Mars when I start talking about oil, but I can’t resist.

    OPEC has a marginal impact on oil prices in anything but the very short term. The evidence for this is pretty solid (as I mentioned in a previous comment) the timed nature of the data clearly show that OPEC’s production increases and cuts have tended to *trail* rather than *lead* oil prices. (I’d cite a link for this, but I can’t remember where I found OPEC production decisions charted against nominal and real oil price data).

    Furthermore, the data sinse 1965 clearly and unequivocably show that there is no correlation between oil prices and physical supply and demand, the best example being that supply outstripped demand for virtually the entire “oil crisis.”

    Oil futures prices are, in my view, primarily driven by perceptions of risk to future supply, mostly based on Middle East instability. In fact, the major influences on oil prices sinse 1965 have *clearly* been conflicts in the Middle East.

    Of course, the thing about Middle East instability is that it is mostly *politically* determined.

    Also, I’d argue that given that large oil companies profits and profit growth show a large positive correlation with oil prices, and that this also applies to armament companies (logical if you accept that Middle East instability is the primary driver of high oil prices, as then many of the petrodollars are spent on arms. I’ll note that this correlation is empirically demonstrable) and that the oil and arma sectors are very *very* good friends of the Republican party and the current administration in particular, that current Middle East strategy isn’t about securing access to oil so much as it conviently has phenominally profited the Oil and Amra sectors.

    Yes. Yes. I know. I’m crazy, and a conpiracy theorist and all that.

  • Posted by else

    “Europe seems to be playing an increasing role in the intermediation of global savings — flows from outside Europe into the Eurozone drive down yields on European fixed income assets, leading European investors to look elsewhere for higher returns.”

    And where are European investors looking?

  • Posted by Keith

    Movie Guy,

    You are correct that there are important differences between grades of crude. The two most common distinctions are heavy/light and sweet/sour.

    The first pairing indicates the specific gravity of the crude, which gives an idea of which petroleum products can be distilled from it. Light crude yields more of the lighter distillates (say, jet fuel) while heavy crude yields more of the heavy distillates (say, lubricating oils.)

    The second pairing, as you note, indicates the sulfur content. For pollution control reasons it is easier to refine sweet crude as it has less sulfer. Sour crude requires special refining equipment, so it is cheaper than sweet crude. The price difference between them is referred to as the “sour spread”.

    Most refinery capacity built in the last few years has been to refine sweet crudes, and this has been true in the US as well. When oil usage began to spike unexpectedly in the last year or two, there was no more capacity for refining sour crude, so most of the additional demand for crude oil must therefore hit the sweet crudes. The result is that the price spread between sweet and sour crudes is quite large. Sour crude is likely to remain cheap until some companies build additional capacity to refine it. This will probably take 2-3 years.

    As an aside there is one company, Valero Energy, that is profiting handsomely from the current situation. They had expanded their sour crude capacity in recent years, and they can now purchase sour crudes relatively cheaply while selling the final refined products at the prevailing high prices.

  • Posted by Movie Guy

    Keith

    Well stated.

    Let me add a few observations on the retail end.

    Pump prices versus crude oil pricing in the U.S.:

    In my opinion, the majority of pump prices for gasoline haven’t reflected the average jump in crude pricing. Yes, the prices for gasoline are up, but not on comparable percentage basis. Diesel prices, on the other hand, are higher than such should be in relation to gasoline prices.

    So, who is taking the majority of the crude oil pricing hit? Which nations and which grades of crude oil?

  • Posted by brad

    Else — there has been a lot of European interest in the US corporate debt market. I don’t know if this is hedged or unhedged.

    Keith — thanks for the informative comment. Sounds like Reliance (the indian company in Anne’s post) is in a similar position to Valero.

    I have also heard that the US is increasingly importing refined products from Europe — which could explain why US imports (of all goods) from europe have been resilient in face of the stronger dollar. Any insights?

  • Posted by IJ

    “The interplay of oil and geopolitics is incredibly interesting. . . The realist view is that this jockeying for power will inevitably lead to some sort of conflict”, from Ian.

    Signs of this already. Countries are being asked to choose between local politics and the global market. Canada is one example that Fox News reported, and is further mentioned in this link. http://www.iags.org/n0118041.htm

  • Posted by anne

    http://www.nytimes.com/2005/02/26/business/worldbusiness/26oil.html?pagewanted=all&position=

    OPEC Member Burdened by High Oil Prices
    By KEITH BRADSHER and JAD MOUAWAD

    JAKARTA, Indonesia – What’s good for OPEC is no longer good for one of its smallest members and its only representative from Asia.

    While most oil ministers, from Saudi Arabia to Venezuela to Libya, say high prices are here to stay, one oil minister may be trying to talk prices down.

    Purnomo Yusgiantoro, the minister of energy and mineral resources for Indonesia, said that a rough consensus had formed among oil ministers from the Organization of the Petroleum Exporting Countries that oil prices were too high. ‘It has got to be lower than what we see today, because even OPEC doesn’t like to see the high oil price,’ Mr. Purnomo said in an interview.

    That consensus may not be as widely shared as Mr. Purnomo says. There are growing indications that OPEC’s larger producers are actually getting more comfortable with higher oil prices.

    That puts Indonesia in a unique – and increasingly odd – position that reflects how its standing within OPEC has changed as Indonesian oil production declines and domestic consumption grows….

  • Posted by cymack

    Here’s an article from Energy Bulletin
    http://www.energybulletin.net/print.php?id=2913
    that’s linkable from LewRockwell.com Blog, beginning thus:

    Published on Wednesday, October 27, 2004 by Global Research
    The Real Reasons Why Iran is the Next Target: The Emerging Euro-denominated International Oil Marker

    By William Clark
    `The Iranians are about to commit an “offense” far greater than Saddam Hussein’s conversion to the euro of Iraq’s oil exports in the fall of 2000. Numerous articles have revealed Pentagon planning for operations against Iran as early as 2005. While the publicly stated reasons will be over Iran’s nuclear ambitions, there are unspoken macroeconomic drivers explaining the Real Reasons regarding the 2nd stage of petrodollar warfare – Iran’s upcoming euro-based oil Bourse.

    `In 2005-2006, The Tehran government has a developed a plan to begin competing with New York’s NYMEX and London’s IPE with respect to international oil trades – using a euro-denominated international oil-trading mechanism. This means that without some form of US intervention, the euro is going to establish a firm foothold in the international oil trade. Given U.S. debt levels and the stated neoconservative project for U.S. global domination, Tehran’s objective constitutes an obvious encroachment on U.S. dollar supremacy in the international oil market … ‘

    Very interesting article, which probably should be chewed thoroughly before swallowing.

  • Posted by brad

    I am not one who thinks the “real reason” for US concerns with Iran is that it simply plans to price its oil in euros. So what? The US only needs to worry if countries that sell oil to the US want to price oil in euros rather than dollars. China might worry to if it had to buy oil in euros so long it keeps a dollar peg … the renimbi has depreciated a lot v. the euro since ’02. That helps China’s exports to Europe, but would make euro denominated oil imports more expensive.

    And look at how much Iraq is costing the US — $200 b and rising. Iran is a much bigger country. No way does any cost/ benefit equation show that similar costs are a worthwhile investment just to prevent Iran from setting up an exchange to sell oil in euros!

    US concerns about Iran are not entirely independent of Iran’s oil and gas either — the US wants to make sure that Iran does not trade oil/ gas for nukes, among other things. And the fact that China/ India and others want to do business with Iran b/c it was something (energy) that they want makes it a lot harder to “contain” Iran generally, and contain its nuclear ambitions specifically …

  • Posted by Movie Guy

    I was pleased to see a discussion on crude oil and refined petroleum products on an economic blog. Once a reasonable information foundation is built from which discussions can evolve, the subject can be fun.

    I don’t think the foundation has been built thus far. A lot of jumping around (which is fine), but how is one supposed to tie it together?

    I’m on the road, so I can’t access my archive of oil materials. Hopefully, someone will fill in some of the background.

    If this subject takes hold, you could have three to six active threads discussing various aspects of crude oil => refined products => economic implications => facts vs. fiction vs. misunderstandings.

  • Posted by gillies

    facts, fiction, and misunderstandings.

    in spite of the respect for facts among economists, and the reliance upon fiction among politicians, – at great turning points in history, it is probably the third category which holds the balance.

    and it seems likely to me that the last straw (that breaks the camel’s back) is in itself statistically insignificant. no number crunching can identify it.

  • Posted by Anup

    MovieGuy says:

    In my opinion, the majority of pump prices for gasoline haven’t reflected the average jump in crude pricing. Yes, the prices for gasoline are up, but not on comparable percentage basis. Diesel prices, on the other hand, are higher than such should be in relation to gasoline prices.

    If you look at EIA’s This Week in Petroleum, you can clearly see that virtually all of the increase in gasoline price over the last year can be attributed to the higher crude oil prices.

    Brad says:

    I have also heard that the US is increasingly importing refined products from Europe — which could explain why US imports (of all goods) from europe have been resilient in face of the stronger dollar.

    It is true that US is increasingly importing refined products from Europe. The reason for this is simply that European refinaries currently have a lot of excess gasoline due to large scale penetration of diesel vehicles.

    Barry Ritholtz has had a few good posts on his blog trying to connect many of the issues relating to oil.

  • Posted by Anup
  • Posted by anne

    Anup

    It is true that US is increasingly importing refined products from Europe. The reason for this is simply that European refinaries currently have a lot of excess gasoline due to large scale penetration of diesel vehicles.

    Please explain this passage further. How does increased use of diesel in Europe free refining capacity? Is it that diesel is more easily refined or that refining capacity is highly specialized at all levels and so more diesel means less refining of other fuels?

    We have been slow on diesel, the reason given is pollution control.

  • Posted by Movie Guy

    Brad -

    “I have also heard that the US is increasingly importing refined products from Europe — which could explain why US imports (of all goods) from europe have been resilient in face of the stronger dollar. Any insights?”

    I wonder where the blending is being done. The principle problem that the U.S. has had recently with regard to pump gasoline has more to do with blending requirements than actual refining capacity limits. One study suggested that if we did not have blending requirements, a portion of our refining capacity problems would not exist.

    Anup -

    “If you look at EIA’s This Week in Petroleum, you can clearly see that virtually all of the increase in gasoline price over the last year can be attributed to the higher crude oil prices.”

    I don’t disagree with this statement in general as I’ve studied their data. What I said was that on comparable percentage basis, average gasoline pump prices did not increase at the levels of jumps (runup) in crude oil pricing.

    I tracked the crude oil vs. gasoline pricing on a weekly basis throughout last year.

    There were weeks during which gasoline pump prices actually decreased while crude oil market prices were increasing. This was an interesting development as compared to similar movements in crude oil/pump price runups in the past.

    I asked a number of people to study this issue and all agreed that gasoline price increases were not tracking crude oil pricing on a comparable basis of increase.

    For purposes of clarification, I normally exclude California pricing from some discussions whereby prices are averaged; California’s petro market situation is not necessarily representative of the pricing in other states.

    ——

    “It is true that US is increasingly importing refined products from Europe. The reason for this is simply that European refinaries currently have a lot of excess gasoline due to large scale penetration of diesel vehicles.”

    I’m not questioning you, but what’s your source for this information? What’s the financial advantage of importing refined oil products from Europe, even if some capacity is sitting idle? I don’t understand how the European refineries make any significant profit on this arrangement.

  • Posted by Keith

    Movie Guy,

    Regarding your retail gas pricing versus crude pricing comment–I don’t know what data you see, so I can only generalize:

    Retail prices should not increase as much as crude oil on a percentage basis because the cost of crude is the largest but not the only component of the price of gasoline. The cost of the crude in gasoline will be somewhere in the 60%-75% range, which will vary by state. Other cost components will increase less than an increase in crude, and these include the costs of refining, transportation, state sales tax and retail markup. In addition, there are some costs that won’t vary with crude costs at all, and the most important would probably be per-gallon taxes.

    Given that you call yourself Movie Guy, can I assume that you live in California? California has a special blend of gasoline that is really only produced for that state, and this means that the market is a subset of the overall gasoline market. The retail cost in California is usually some of the highest in the US, but this has nothing to do with the cost of crude. As a result of this special sub-market, California gasoline prices will be more sensitive than average to changes in demand, but a little less sensetive than average to changes in the cost of crude.

  • Posted by anne

    Keith

    Has there been any study done done on the California gasoline cost difference and the cost of refining the specific blend of gasoline? Interestig to know the result…

  • Posted by anne

    Answering Brad’s question:

    Brad

    “I do not deny the benefits of a weak real exchange rate — stronger exports, stronger employment in export sectors, stronger profits in those sectors as well. But I do think the costs associated with sustaining that policy are increasing.”

    Anne

    Robert Rubin said just this, with more emphasis on the costs involved.

    Brad

    Anne — do you have the link to Rubin’s quote? I suspect he was talking about the US, and I was talking about Asia, but it is still sort of strange …

    Anne

    Robert Rubin was talking to us at dinner somewhat more than a year ago, and was asked about the refrain “a strong dollar is in America’s interest.” Brad DeLong later also remarked that Rubin’s refrain was a bit puzzling. Rubin however explained that a strong dollar is reflective of proper health for the American economy. The strong dollar was the measure of confidence Rubin could have.

  • Posted by Keith

    Anne,

    If memory serves me correctly there was some newspaper that did investigate whether the higher retail price was justified by the higher cost. I seem to remember that the answer was “no”. I have heard it said on more than one occassion that California gas retailers charge more because they can. Oh, well, micro econ theory doesn’t always work out!

  • Posted by anne

    Keith

    I thought so, and will search my records. Paul Krugman thought early on, as did so foolish a person as I, that energy prices were being manipulated in California during the so-called crisis. Work from Berkeley and Stanford researchers indicated this was so, and so it was. But, I remember researchers arguing that too a lesser degree gasoline prices moved in suspicious ways season to season. Hmmm… I will find the essays by Paul Krugman.

  • Posted by anne

    http://www.wws.princeton.edu/~pkrugman/wolak.html

    FRANK (WOLAK) THOUGHTS ON THE CALIFORNIA CRISIS

    We’re approaching the first anniversary of the sudden, unexpected end of California’s energy crisis. I went way out on a limb, at least by journalistic standards, by saying that market manipulation was a key feature of that crisis. I have since been vindicated: arguments that people called leftist nonsense a year ago are now conventional wisdom.

    But of course I wasn’t a brilliant investigative reporter; I just knew enough to talk to the right people, and to understand what they were saying. Paul Joskow and Severin Borenstein were very helpful. But my most helpful source of all was Frank Wolak, the Stanford professor who also heads the CAISO market surveillance committee. (CAISO is the “system operator”).

    In a recent paper (which doesn’t seem to be on his web site yet) Wolak offers a very nifty model to explain what was going on. However, as they say in the journalistic trade, he buries his lede: the model is in passing, amid a dense discussion of institutions and their reform. So I thought I would lay it out here, to give you an idea of how I think about the whole thing.

    Wolak’s model starts with a simplified demand curve. We assume that the demand for electricity is totally inelastic at some given quantity – say 900 megawatt-hours – until the price reaches a ceiling, say $1000 per mwh. It doesn’t matter for current purposes whether that’s a legal ceiling or the price at which utilities simply refuse to buy.

    On the supply side, we assume that there are a smallish number of generators, each with limited capacity – let’s say 5 generators with a capacity of 200 mwh each. Each generator has a marginal cost of, say, $20 per mwh actually produced….

  • Posted by anne

    http://www.wws.princeton.edu/~pkrugman/oil.html

    April 9, 2002

    A QUICK NOTE ON OIL

    If you want to get slightly scared about the economic implications of Middle East conflict, here’s a useful chart from an Energy Information Agency report from a few years back. It shows how the strategic importance of OPEC, and of the Persian Gulf in particular, declined dramatically after the oil crises of the 1970s; that’s why there weren’t any more crises for 20 years. But now, through inattention, laziness, and greed, we’ve revived that strategic centrality.

    And no, drilling in ANWR is no answer. At peak, more than 10 years from start, it would produce a bit more than 1 percent of the world total. Take a look at the chart and see if that would make much difference.

    Conservation is the only way to make big inroads on this vulnerability in the medium term. And alternative sources of energy are the only long-term answer.

    ….

    http://www.wws.princeton.edu/~pkrugman/wolak.html

    May 27, 2002

    FRANK (WOLAK) THOUGHTS ON THE CALIFORNIA CRISIS

  • Posted by anne

    November 12, 2000

    THE REAL WOLF
    By Paul Krugman – New York Times

    Evidence mounts that California is spiraling downward, powerwise Recently I received a letter from an economist I respect, chiding me for my “Naderite” columns on the California energy crisis. He just didn’t believe that market manipulation by power companies could possibly be an important issue; it sounded too much to him like the sort of thing one hears from knee-jerk leftists, who blame greedy capitalists for every problem, be it third-world poverty or high apartment rents. The left has cried “Wolf!” so many times that sensible people have learned to discount such claims.

    But now a bona fide wolf has arrived, whose predatory behavior is doing terrible damage to our most populous state — and nobody will believe it.

    True, California would be heading for a summer of power shortages even if it had never deregulated. And even if there was workable competition in the wholesale electricity market, prices in that market would spike during periods of peak demand, transferring billions of dollars from either taxpayers or consumers to the generators.

    But the evidence is now overwhelming that there isn’t workable competition in California’s power market, and that the actions of generators “gaming the system” have greatly magnified the crisis. The key fact is that California has somehow remained in a state of more or less continuous power shortage and very high wholesale prices regardless of the level of demand. A rash of outages has kept the electricity market conveniently — and very profitably — short of supply even during periods of low demand, when there ought to be lots of excess capacity….

  • Posted by anne

    http://infoproc.blogspot.com/2005/02/housing-and-inflation.html#comments

    Cleverness from the Economist and Steve Hsu:

    Housing costs comprise 30% of the core inflation indicator (CPI) used by the Fed. Because the recent run-up in home prices is not reflected in increased rental costs, you get very different results for the core CPI if you use home prices (cost to purchase a home) instead of rental cost in the calculation. You could argue this means that US inflation is much higher than previously thought. I prefer to see it as yet another indication of a housing asset bubble.

  • Posted by Movie Guy

    Keith -

    “Retail prices should not increase as much as crude oil on a percentage basis because the cost of crude is the largest but not the only component of the price of gasoline. The cost of the crude in gasoline will be somewhere in the 60%-75% range, which will vary by state. Other cost components will increase less than an increase in crude, and these include the costs of refining, transportation, state sales tax and retail markup. In addition, there are some costs that won’t vary with crude costs at all, and the most important would probably be per-gallon taxes.”

    Before I launch into this discussion, let me say that I prefer low gasoline prices. No question.

    Yes, I agree that crude oil as the primary component of gasoline represents approximately 60-75% of the pricing per gallon. I have no data in front of me, but that is what I recall as well.

    If gasoline prices were tracking crude oil prices on a comparable basis, we could be experiencing processed per gallon increases in the range of 60-75% of crude oil price increases or increases near those levels. We’re not seeing that.

    The current prices for gasoline represent a range of 11% to 13.8% in per gallon price increases from January 2004. (just a quick analysis)

    Compare the average increases in per gallon of gasoline costs to crude oil pricing since January 2004. Depending on the grade of crude oil, the market has experienced increases of 25%, 31.25%, 40%, 50%, 56%, and 62.5%, with many of the increases weighting to the higher percentage increases. Of course, this excludes consideration for long-term futures contracts versus short-term spot market “needs”.

    I made a few telephone calls to friends across the country this evening. All indicated that their gasoline pump prices were up an average of $0.19 – 0.25 per gallon from last January, representing a range of 11% to 13.8% in per gallon price increases from January 2004. Same situation on my front. Yes, prices spiked above those levels temporarily, but fell back in a short period following the spike bumps.

    I agree that higher percentage increases exist in certain markets, but I doubt that such have very much to do with crude oil price increases other than deliveries from Alaska (California market, as an example). Some are also further driven by diesel fuel increases imposed on the tanker truck fleet delivering the fuel loads, even in the cases where deliveries are close to pipelines. Sure, some of those costs are internal to the suppliers, but may be passed on.

    Meanwhile, U.S. oil companies are posting record levels of profits. Very high profits, indeed.

    If you recall, previous experience with crude oil price increases were typically accompanied by near immediate retail gasoline increases of a few cents. Such increases were not based on a LIFO or FIFO inventory systems. They just happened. None of the higher priced crude had made the journey to any U.S. refineries before the retail pump prices jumped. I and friends were always humored by the marketing tactics of the big suppliers. But this practice may be tampering off.

    One change that has occurred which is worthy of note is the spread in pricing between octane levels at the pump. We’re seeing typical $0.10 jumps from 87 to 89 to 91/93 octane pricing. Previously, such pricing spreads weren’t that wide. Of course, the spreads are not justified in terms of production cost differences, but such exist now.

    Brad stated that a “basic rule of thumb is that a $1 a barrel increase in the average oil price increases US oil imports by about $5 billion over the course of the year. So if oil averages $51 a barrel, the US oil import will be go up by roughly $50 billion. That is one reason why the 2005 trade deficit is likely to be substantially bigger than the 2004 deficit, unless something changes.”

    While I don’t disagree with this general statement, I suggest that the role of existing long-term supply contracts at lower than current spot market valuation of crude oil by grade (specific gravity/other factors) may downplay this potential impact. MOreover, Greenspan downplayed the role of contract futures in crude oil a few months ago, much to my surprise.

    What is the pricing relationship between delivered crude oil prices per barrel and the refined gasoline per gallon pricing today? I don’t know, but it’s not following the 60%-75% component analysis that I thought one could apply.

    Perhaps 2005 will be the year that we begin to experience the full effect of crude oil price increases. I actually expect the U.S. to fair better than Europe and Asia with regards to crude oil price increases, but we’ll see.

    Lastly, it would be helpful if someone could explain the existing pricing for diesel fuel. I offer no justifiable explanation as to the current high prices for diesel.

    Ok, I’ve offered enough general information for others to attack, correct, or confirm. Happy hunting, petroleum experts.

  • Posted by anne

    Profits of oil companies are so high they will be wary of increasing prices too much for fear of public reaction. There is much leeway on prices.

  • Posted by IJ

    Interesting to read that Paul Martin (Canada’s PM) is reminding the US that Canada is a sovereign nation too. This assertion of course has implications for energy exports to the US – Canada is its biggest foreign supplier. http://www.nytimes.com/2005/02/27/international/americas/27canada.html?th

    The distribution of vital energy resources is turning into an unseemly scramble. International management seems the fairest arrangement.

  • Posted by c

    Anne -

    Why wants Indonesia lower oil prices:
    Maybe because they are not an oil exporter

    How does increased use of diesel in Europe free refining capacity?: It doesn’t free up refining capacity. When you distile crude oil you end up with diesel, gasoline and a lot of other oilproducts. You could change the gasoline into diesel if you really wanted too but it is just more economical to sell it to America.

    Movie Guy -

    Why don’t you use the option price of gasoline? Should be much clearer in following the crude oil price than the retail price

  • Posted by cymack

    ::I am not one who thinks the “real reason” for US concerns with Iran is that it simply plans to price its oil in euros. ::

    I don’t know that that was my point, exactly. But the materials do seem to suggest that a lot of folks have been edging toward the door for a lot longer than we busy Americans may have realized — techtonics, as the author put it, rather than increments reflected in routine occurences.

    ::Cleverness from the Economist and Steve Hsu::

    Bearing in mind that single-unit rents and prices are linked through the household tenure decision, here’s an analyst who thinks the imbalance may be short-run but not necessarily catastrophic in resolution as a bubble probably would be, depending I guess on how suddenly those stymied capital funds reverse their flow into non-real estate assets.

    http://www.realfacts.com/4162004.html

  • Posted by Movie Guy

    I reviewed some of the latest EIA DOE information.

    Link provided by Anup:

    http://tonto.eia.doe.gov/oog/info/twip/twiparch/050224/twipprint.html

    Crude oil, as a component of retail gasoline pricing is slightly above 60% at this point. Moreover, it would appear that gasoline prices are tracking crude oil increases a bit closer on a comparable basis that I thought. There is room for more detailed questions based on the EIA data, but I’ll pass for now as it would appear that this subject is quickly playing out on this blog.

    Here is some information that may interest others:

    U.S. Petroleum Import Sources, 2003 (Percentage)

    Africa – 15%
    Other Regions – 15%
    Persian Gulf – 20%
    Western Hemisphere – 50%

  • Posted by Dry-Hole Harry

    I read a few comments above about how the trends in the “awl bidness” may lead to geopolitical instability and maybe even war. I note that China already has roughly 100,000 troops protecting its oil interests in the Sudan. Oddly enough, there seem to be no demands for the “foreign occupiers” to get out. As for Ann’s comments above anout Canada exercising its “Sovereignty” by refusing to participate in the BMD plan and warning of possible nationalistic pressures to cut off the sale of oil to the US, puhlease. Any move by Ottawa to use Alberta oil as a trade weapon will result in a surge of support for separatism – in the West! BTW, Canada”s tar sands contain more recoverable oil than all of Saudi Arabia.

  • Posted by anne

    Harry

    Was surely not me. The idea of Canada refusing energy sales to America is not an idea I ever entertained. The tar sands are most promising resources for Canada of course, and for America.

  • Posted by IJ

    Should Canada stick with the global market in energy? The country would sell oil in the market, which means there is one less barrel available for its neighbour.

    >“Given the rapid rise in demand for energy from China and India in particular, there’s little chance of a coherent world energy policy without these nations sitting at the same table as the G-7 members,” says Jim O’Neill, London-based head of global economic research at Goldman Sachs Group Inc. . . G-7 members also know Asia’s thirst for oil could get ugly.< http://quote.bloomberg.com/apps/news?pid=10000039&cid=pesek&sid=aNbflepgrClw

    At least there’s talk now of the need for a coherent world energy policy.

  • Posted by Tunde Damilola
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