Monday, May 23, 2005

Who Is Right?
Today's Financial Times (subscription may be required) reports that the President of OPEC has suggested that underinvestment in refineries, especially in the US, is a contributing factor in high crude oil prices. Producing countries trot this argument out periodically, but this time it contains a novel element: a proposal to link investment in oil exploration and production opportunities to investment in refining capacity. Is this a cynical smokescreen to mask OPEC's own underinvestment in new oil production capacity, or is there a some truth to their argument?

To answer this, you need to understand the relationship between the markets for petroleum products and for crude oil. There are three distinct markets that bear on this issue: for crude oil, wholesale products, and retail products (i.e. pump prices.) Each of these segments is related to, but distinct from the others. So while the wholesale price of petroleum products is strongly influenced by the price of crude oil, and vice versa, the difference--which determines the margin enjoyed by the refinery--varies constantly over a fairly wide range, from a dollar per barrel negative to $8/barrel positive, or more. Marketing margins, the difference between the wholesale and ex-tax retail prices, are much less volatile and don't influence crude oil demand very much.

So how do the markets for crude oil and wholesale gasoline, for example, interact? Higher crude prices put upward pressure on gasoline prices by squeezing refining margins and forcing refiners to charge customers more. Similarly, higher demand for gasoline pulls crude prices up, by expanding margins, depleting crude inventories and giving refiners an incentive to compete for more crude oil to run. Once refineries are running at full capacity, though, more demand just raises refining margins, without increasing the quantity of crude being run. In fact at that point the influence of product markets over crude markets diminishes, although the premium paid for high quality crude oils--which can make a larger proportion of gasoline and diesel with less processing--will typically continue to widen. (This explains why a higher price for West Texas Intermediate crude oil doesn't automatically mean a correspondingly higher price for Saudi crude. )

Things work similarly on the way down. As product demand slows, refinery margins compress, refiners reduce runs, and crude oil inventories grow, putting downward pressure on crude prices. The same thing happens when product demand is high but crude producers supply more than the market needs: crude inventories grow and crude prices drop. (This is the best of all worlds for a refiner.)

Now consider OPEC's assertion that inadequate refinery capacity is causing crude prices to go up. If anything, the opposite should be true, because crude oil inventories would grow, provided that supply was not limited. Fully-utilized refining capacity is a brake on the demand for crude oil, not an accelerator. In light of the mechanisms above, we see that the problem that limited refining capacity creates for OPEC is really competition between the producers of heavy, sour crude oil (e.g., the Middle East) and producers of the more desirable light, sweet oils (e.g. West Africa and North Africa.) There has always been friction between OPEC's members, and this is another source.

Is it possible that in trying to link oil exploration opportunities to refinery investment, OPEC is actually seeking to ensure equal market access for all its producers, regardless of the quality of their oil, rather than providing relief to the world's economies and consumers?

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