This week BP (NYSE: BP) released their Statistical Review of World Energy 2014. This is always a big event for energy wonks, and as always I will break it down in a series of articles. My goal is always to flesh out important tidbits that were perhaps overlooked by the media. Here are some of the major findings from this year’s release that have been reported. In 2013:
- US oil production had the largest increase in the country’s history
- US oil demand grew at a faster pace last year than China’s, although China’s overall energy demand grew faster
- Asia increased solar output last year more than Europe for the first time ever
- Emerging economies accounted for 80% of energy consumption growth
- Global oil production rose to a new all-time high
In one of those overlooked tidbits I like to point out, while global oil production did indeed set a new record — rising in 2013 by 557,000 barrels per day (bpd) over 2012 — without the US increase of 1.1 million bpd, global production would have declined by 554,000 bpd. But I will take a deeper dive into that starting next week. Today I want to talk about Iraq.
Or, more precisely the impact the unfolding events in Iraq have had on the global oil markets, and more specifically how those oil markets actually work. I had an interesting discussion with someone last week, after a remark was made about oil companies using any excuse — like potential supply disruptions in Iraq — to immediately jack up oil prices.
I explained that this is not how the oil markets work. In some cases you do have countries (e.g., Saudi Arabia) setting prices, but most of the oil on the markets is simply determined by how much people are willing to pay for it. ExxonMobil (NYSE: XOM) doesn’t say “I think I will raise the price of oil today by $5 a barrel.” What they earn in most cases is based on contracts tied to the price of oil set on exchanges like the New York Mercantile Exchange (NYMEX). There the price of oil is determined by buyers and sellers. It is influenced by fear, greed, supply, demand, hoarding, speculation — you name it.
Here is an illustrative example. The person I was discussing this with works at a supermarket. So I said to imagine the oil markets like this. Thanksgiving is approaching, and 30 families would all like to buy a turkey from the local supermarket. Unfortunately, this is the only supermarket in town, and they have only 10 turkeys. If the supermarket prices the turkeys at $1, they will be gone very quickly. In fact, unless the supermarket limits purchases to one per family, some enterprising person may buy them all up so they can resell them for a higher price.
If the supermarket prices them at $20 each, some of those families are going to decide they don’t have to have turkey for Thanksgiving. This is rationing by price. At certain price points, fewer and fewer people are going to buy the turkeys. At $100 each, nobody will buy them. At $1 each, they won’t last long.
Now imagine that the supermarket decides to allow the price to be determined by bidding. The 10 turkeys are priced by the amount the 30 families are willing to bid. Everyone is willing to bid a dollar or three or five, but people start to drop out as the price rises. Poorer families may not be able to afford a $20 turkey (although the poor may hang in longer than you might imagine, especially if they have no other options).
Further imagine that there is no limit on how many turkeys a family can buy. Someone who thinks these turkeys will be worth a lot more in the future could buy them all up. One family could buy up all 10 turkeys, outbidding the other 29 families. Or a local financial institution who has no need for them at all, but sees an opportunity to make money from a shortage, could get involved in the bidding (which happens on a large scale in the oil markets). This is speculating, and is one of the factors that sets oil prices.
To close the loop on the situation with Iraq, imagine that news comes along that 2 of the 10 turkeys are at risk of not being delivered to the supermarket. Suddenly instead of 30 families bidding for 10 turkeys, you now have them bidding for possibly only 8. Now instead of the top 10 bids being accepted, only the top 8 are accepted. This means that the overall price is higher.
That is the analogue to the situation in Iraq, and why oil prices react quickly to the possibility of some of Iraq’s oil supplies being taken offline. Iraq’s oil production has risen 8 years in a row, and makes up 3.7 percent of the world’s oil supply. This global supply has very little spare capacity in the system, so oil removed from the global supply has a disproportionate impact on the price.
So while the oil companies aren’t directly setting prices, they do of course benefit in this situation (unless they happen to have production in Iraq that is taken offline). As oil prices rise — due to whatever mechanism — the profit per barrel of oil increases. However, people often confuse cause and effect. Profits rose because oil prices rose in the market. Oil prices weren’t increased in order to boost profits. If that’s the way things worked, you would never see profits go down and the oil industry wouldn’t be cyclical as it has been for decades.