Streetwise Professor

November 16, 2007

Crude Propaganda

Filed under: Commodities,Economics,Energy — The Professor @ 12:02 pm

OPEC is trying to lay blame for high oil prices anywhere but on its own doorstep:

Mr El-Badri said, however, that the the “US should help to resolve the problem” and enumerated several factors, among them bottleneck in refining, geopolitical concerns and the weakness of the US dollar, that were affecting the oil price.

“The US has not invested in refining capacity in 30 years. The refineries are operating at 80 per cent. That is not adequate,” Mr El-Badri said. “We have also the problem of the dollar,” the secretary general added.

Mr. El-Badri is either laying on the bullshit with a big trowel, or he needs a lesson in basic economics. (My money is on the former alternative.) “Bottlenecks in refining” cannot explain current high oil prices. Indeed, refining bottlenecks cause the price of crude to decline relative to the price of refined products. An outright decline in refining capacity should cause the price of crude to fall. Consider the extreme case where there is no refining capacity at all. In this case, the price of crude would be zero because there would be no use for it as it could not be refined into anything useful. Crude would be as it was before Drake–a nuisance, a pollutant.

In fact, refining margins have declined substantially as crude prices have risen. An increase in demand for refined products would cause an increase in the price of crude–but the price of refined products would rise even more. Indeed, if refiners were operating at absolute capacity (infinite marginal cost of refining an additional barrel–the extreme bottleneck), an increase in demand for refined products would cause the price of gasoline and heating oil to rise, but the price of crude would not budge as due to the putative bottleneck in refining the increase in demand for refined products would NOT translate into a rise for the derived demand of crude. Moreover, US refineries have been operating at 80 or better for years. Sure, no refineries have been built from scratch, but refining capacity has continued to grow as refiners expand existing facilities. And memo to Mr. Al-Badri, with the exception of the 2005-2006 time period, refining has hardly been a wildly lucrative business. If it were the major bottleneck, refining would be a lot more profitable.

Thus, the simultaneous rise in the price of crude and a decline in refining margins is flatly inconsistent with El-Badri’s “explanation.” It is instead consistent with an adverse crude supply shock. Such a shock causes the price of crude to rise and refining margins to decline. Therefore, contrary to El-Badri’s babbling, price relations in the petroleum markets point directly to crude supplies–and crude suppliers–as the culprit.

The dollar story is also so much eyewash. Econbrowser does a very good job at debunking this chestnut. The price of crude is rising in terms of other currencies, and variations in the value of the dollar are not significantly correlated with changes in the price of oil.

So, let’s give El-Badri’s explanations the respect they deserve–none–and move on to the interesting issue. OPEC says it won’t raise output. There could be two reasons for this: they don’t want to, or they can’t. There are clearly some countries (notably Iran and Venezuela) that don’t want OPEC to increase output. But there are a lot of folks out there–notably Matt Simmons–that have been trumpeting the view that Saudi Arabia in particular is facing an inexorable decline in production, and is incapable of enhancing output even if it wanted to. Simmons and the peak oil crowd are the most outspoken on this issue, but there is reason to doubt whether the Saudis actually have the capacity to increase output. There is an intense debate over whether the recent decline in Saudi output was volitional, or instead resulted from the peaking of its megafields. That debate won’t be resolved any time soon, but OPEC’s (and KSA’s) refusal even to consider increasing output, and their lame rationalizations of the causes of the recent runup in oil prices, lend some credence to the view that Saudi Arabia has less available productive capacity than it claims.

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