Cover Photo: Famous Bridges of the World -TowerBridge(London,England)
Yesterday’s visit to Costco for gasoline presented a pleasant surprise for me – the price per gallon for regular (87 octane) and premium (91 octane) had both declined an average of 4 to 8 cents. Needless to say, that put a smile on my face. I was tempted to belt out “hip-hip-hooray!” In yesterday’s ArizonaRepublic newspaper, Christopher S. Rugaber of the Associated Press writes in his article, Inflation Mild as Gas-price Rise Slows, “Gas prices remain high but have started to level off. In March, they gained 1.7 % compared with a 6% increase in February. In the past week, the national average price per gallon fell 4 cents to $3.90 on Friday.”
The recent run-up in crude oil and gasoline prices has been a conversation topic at the local, national and international levels for the past few months. While I was reading a few energy related articles over the last week, I was reminded of two companies within the semiconductor industry. I worked for one and did business with the other. What was interesting about the two companies, then and now, is how each handled market fluctuations, downturns in the economy, and other issues that posed a threat to their profitability. One had devised a strategy to re-tool during downturns to be prepared for the upturn and recovery. The other struggled to identify a strategy for market volatility and experienced serious highs and lows in profit margins. The latter firm appears to be doing better today, however, the lessons of their past were hard learned and resulted in the lost of their leadership position in more than one product market and unfortunately the loss of loyal customers.
This introduction is a great segway to the crude oil market. How does one read the volatility and price sensitivity of the crude oil market? Can anything be done to smooth or dampen the impacts to consumers within theU.S.and world-wide? The answer may be in your ability to read the tea leaves.
Sources of Crude Oil in the U.S.
The first question to answer is where does our oil come from? I suppose this question has been asked often, so the answer was easy to find under the Department of Energy’s Energy Information Administration (EIA) website. As shown in Figure 1, theU.S.produces 51 percent of all the oil and petroleum products that it consumes.
- Canada – 25%
- Saudi Arabia – 12%
- Nigeria -11% –
- Venezuela – 10%
- Mexico- 9%
A pleasant surprise was finding that our Canadians neighbors to the north supply 25% of our imported oil. I continued to dig for more information on where our oil comes from because if I recall correctly, one major trigger in the rise of crude oil prices that started in late December 2011 related to tensions between the U.S andIranover a possible closure of theStrait of Hormuz. On December 29, 2011, ABC World News reported that an Iranian navy chief warned that his country could easily close the strategic Strait of Hormuz at the mouth of thePersian Gulf. The Strait of Hormuz is a vital transit point for up to 20 percent of the world’s oil supply. Only a few dozen miles wide at its narrowest point, it lies betweenIran, theUnited Arab Emirates, and Oman. The navy officer warned that Iran could choke off world oil supplies if the United States and its allies imposed sanctions on Iran’s oil sector. 
Given the tension and speculation of the global oil market, I anticipated finding Iran in the top 10 suppliers of imported oil. Additional importers of crude to the U.S.(in 2010) include:
- Russia- 6%
- Algeria– 5%
- Angola– 4%
- Iraq– 4%
- Brazil– 2%
- Other – 12%
I suspect that Iran’s contribution to theU.S.oil market was less than 2% in 2010, and now it is zero based on recent political tensions. Two percent or less of U.S.imported oil certainly does not seem to justify the run-up in crude oil prices that we saw the first three months of 2012. Add to that, there was never a real shortage of oil with Saudia Arabia and some other countries operating at less than capacity. The amount of surplus crude oil capacity, which is the amount of oil available to meet surges in demand or disruptions in supply, increased in 2009 as demand for crude oil declined along with the global economic slowdown. According to EIA, OPEC’s surplus production capacity had fallen to 2.6 million barrels per day by the end of 2011, but is expected to increase to 3.6 million barrels per day in 2012.
So, why did this happen? And why do U.S.consumers tolerate it? Our current pricing strategy for oil as a commodity does not appear to reflect the reality of supply and demand in the market place.
The Spot Market
A spot transaction is the exchange of one currency for another currency, fixed immediately in respect of an underlying foreign exchange commitment, at a specified rate, where settlement takes place two business days later. The two day settlement process is due to the fact that the bank requires two business days notice to process payments due to time zones and currency cut-off times. In instances where urgent payments/receipts are to be processed, one-day value or even same-day value rates of exchange may be provided depending on currency cutoff times. It is also commonly known as Spot Cover. 
As mentioned in Blogs 2 and 3, History or Rising Gas Prices Parts 1 & 2, crude oil prices are set globally through the daily interactions of thousands of buyers and sellers in both physical and futures markets. Most of these transactions occur in the spot market. Prices reflect participants’ knowledge and expectations of demand and supply. In addition to economic growth and geopolitical risks, other factors, including weather events, inventories, exchange rates, investments, spare capacity, OPEC production decisions and non-OPEC supply growth all figure into the price of crude oil.
EIA reports that weak economic conditions in theU.S.and around the world in 2008 and into 2009 led to less demand, which helped push prices down. With the worldwide economic recovery under way, demand is on the rise again but unrest in the Mideast and North Africa has put supplies at risk. This combination of rising demand and reduced supply helped to push prices higher.
As prices rise in the global market, they are immediately reflected in the price that we pay at the pump. While many argument against this pricing strategy, others argue that it is reflective of real costs since most refineries do not keep more than a 30-day inventory of crude oil. Whether we agree with the pricing strategy, the recent tension in between theU.S.andIrandid not reflect a decrease in the volume of oil that was available to consumers and a run-up in the price paid for a barrel of crude. That now leads us to speculators.
So, who are crude oil speculators? There are commodities traders, stock traders, and then there are crude oil speculators who purchase futures contracts for crude oil, betting that they will be able to make a profit off of these contracts at a later date. Future contracts for crude oil are a bit dicey compared to stock and commodities – the effects on the economy are significant. Both businesses and consumers end up having to pay more for transportation, taking money away from other areas of the economy and a major reason why rising gas prices gets so much media coverage.
According to Rick Unger, a contributing writer for Forbes Magazine, there are two, very different types of speculators in oil futures. First we have the companies who are actually in the oil business and have every reason to try and ‘lock in’ the future price they will pay for oil. If these buyers believe that the market price, at the end of the futures contract they are purchasing, is going to be higher than what their contract requires them to pay, they are wise to set the price now. While they are taking a risk —as the price could turn lower— at least these outfits have a perfectly valid reason for getting into the business of speculating.
Then there are the speculators who have no interest whatsoever in actually taking delivery of the oil they are buying via a futures contract. These are the money managers who are simply engaging in yet more casino activities to make money despite the havoc they wreak on the economy and our pocketbooks as they artificially drive up the price of gasoline. Motivating these non-oil industry speculators to gamble on oil prices is the anticipation of trouble inIran—where one of every five barrels of oil in the world must pass through the Straits of Hormuz to reach the world market. 
The roller coaster ride of oil and gasoline prices have been up and down for some time – kinda like the dog chasing its tail. While I am not opposed to anyone making money in the oil futures market, I really do believe this country is overdue in revisiting the pricing strategy for crude oil in theU.S.
1. Energy Information Agency, www.eia.gov
2. ABC News, “US-Iran Tensions Flare After Carrier Transited Strait of Hormuz”, December 29, 2011, http://abcnews.go.com/blogs/politics/2011/12/us-iran-tensions-flare-after-carrier-transited-strait-of-hormuz/ (last reviewed on 04.13.2012)
3. Standard Bank Global Markets, Brochure: The Spot Market, March 2009
4. Forbes Magazine, Rick Unger, Contributor: The Truth About Obama, Oil, and the Gasoline Blame Game, Part 2, March 17, 2012, http://www.forbes.com/sites/rickungar/2012/03/17/the-truth-about-obama-oil-and-the-gasoline-blame-game-part-two/3/ (last reviewed on 04.13.2012)