• Harry N. Stout

300- Understanding Oil and Gas Prices


Written by Guest Contributor: Paul A. Werlin, President, Human Capital Resources, Inc.


Depending upon who you listen to, the TV network you watch, or the social media outlet you follow, the skyrocketing price of oil and gas is the fault of the President, Putin, the Saudis, the greedy oil companies, or a vast conspiracy of all of the above. But the truth is, like so many of today’s complex issues, it’s almost always more complicated. When it comes to oil and gas prices, it really is a very complex problem with many factors and no easy short-term solutions.


As I write this, the price of a barrel of oil (42 gallons) is hovering around $100 (oil is priced on the world market by either “West Texas Intermediate Crude” or “North Sea Brent Oil.” This is so buyers and sellers have a standard of quality and composition). Back in 2008, oil broke $140, and in 2020, for a blink-of-the-eye, oil was actually negative - that is oil producers had to pay buyers to take it off their hands!


Professionals and analysts spend years following the price of oil and trying to understand the interplay of all the relevant factors. In this post, I will try to just explain some of the basics and help you really understand how complex it really is.


Oil is truly a world market. US produced oil is indistinguishable from Saudi or Canadian oil. “The World” doesn’t care where oil comes from - it only cares about cost, supply and demand. There is no doubt that cutting off Russian oil, about 8% of the world’s production, is pushing prices higher. But of even more impact has been the lingering effects of the COVID pandemic. It wasn’t so long ago that oil and gas prices plummeted as people were locked down and the roads and airports were virtually deserted. With demand down dramatically, companies and oil producing countries stopped or slowed production.


Despite what others may claim, it isn’t as simple as just turning on a faucet when demand increases. It takes time (and money) to get the flow going again. While oil is the same all over the world, the costs to get at that oil vary widely. For example, Saudi oil is estimated to actually cost the Saudis about $2.80 a barrel, while shale oil wells in the U.S., because of higher drilling and fracking costs, the average break-even point for new wells ranges from $46 to $58, depending on the site, with the higher-cost wells coming in at $90 a barrel! So, it’s easy to understand why some oil companies may be hesitant to gear up production—particularly if you have high production costs—if oil prices fall you can (and many did last year) go bankrupt.


The United States is the largest producer of crude oil, producing about 12.108 million barrels per day. The U.S. surpassed both Russia and Saudi Arabia in 2018 to become the world’s largest crude oil producer. While the United States is the largest producer of oil, it is also the largest consumer of oil. The U.S. consumes about 19.69 million barrels of crude oil per day. Because this is more oil than the U.S. produces each day, the oil must be imported from other countries. Canada is our largest source, followed by Mexico and Saudi Arabia (Russia was in 4th place, but only accounted for about 8% of our imports). It is estimated that OPEC is responsible for about 40% of world production and about 80% of the world’s proven reserves (Venezuela is the largest member of OPEC).


Given this information, why are prices so high now? Most (non-political) experts agree that it’s a combination of the lingering supply cutbacks due to COVID, a big spike in demand as countries reopen, overall increases in inflation (due to Fed policy, unprecedented spending, and higher costs across so many sectors of the economy) and the impact of the war in Ukraine (i.e., impact on Russian oil exports into world markets). Like gold, or diamonds or corn, in a free market something is worth whatever a buyer is willing to pay. Plus, some of the increases we’re feeling are due to a runup by speculators.


As to gasoline, everything that applies to oil is at play here and couple of others. About 45% of a typical barrel of crude oil is refined into gasoline. An additional 29% is refined to diesel fuel. The remaining oil is used to make plastics and other products. So, to get gasoline you have to get the oil to a refinery, convert it to gas, then get the gas to the retail station. This takes time, money, equipment, and people to do the work - all adding costs along the line. And retailers can change the prices they charge as often as they like and pass along those higher costs (and don’t forget the taxes on the gas!)


Clearly, we’re all feeling the pain at the pump. Higher fuel prices mean all transportation costs are climbing. It’s impossible to escape. But as a consumer you can drive less, get rid of that gas guzzler, or even consider going electric or hybrid. As investors, you can consider adding quality energy companies like Exxon or Chevron Corporation to your portfolio, which also pay a nice dividend. Or there are literally dozens of energy mutual funds and ETF that specifically track the price of oil. It does look like we’re in for a period of higher oil and gas prices. How high or how long it lasts is anyone’s guess.

 

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