Editor’s note: This is the first in a two-part series about factors that influence oil prices.
I do not like going to the gas station. My car is one of my biggest expenses even when you discount the price of gasoline. I was nearly in pain when I saw a price of $3.61 per gallon the other day. Gas prices climbed nearly every day for the past month and a half. This nation is now nearing the infamous national average of $4.11 that was reached in 2008.
To go and just say oil prices are high may or may not be a true statement. We need a level or a benchmark of economic comparison to truly say oil prices are high. According to a chart from the U.S. Energy Administration, the national gas price average has been under $3.40 for at least the past 6 years. I would say that when the price of a commodity goes above a 5-year national average it becomes ‘too high.’
It’s easy for us to discount that rising oil prices are due to speculators. It’s not just speculators, however. Speculators play a small role in determining prices when compared to the much bigger roles that supply and demand play. “Speculation goes both ways,” said Dr. Richard Grant, professor and chair of the Department of Finance and Economics, “speculators cannot drive up prices independently of real activities without risking reversal.” In other words, speculators invest to make a profit. If they expect prices to rise, they buy. If they expect prices to fall, they sell. If speculators bid prices up, they also serve to conserve resources. Speculators are not in the game to just drive prices up. If speculators invest unwisely they lose money; they don’t have incentive or the resources to keep investing if they’re wrong.
If speculators aren’t the major cause of oil prices rising, what is?
Supply and demand
In a nutshell, we pay higher prices for gasoline because oil refiners have to pay more for crude oil (petroleum) – the naturally occurring, flammable liquid from which gas is derived. Oil refiners basically have to pay more for crude due to changes in supply and demand. The change of the levels of supply and demand for oil is due to a variety of factors.
In terms of demand for oil, there continues to be high demand because of economic growth. The U.S., China, Japan, Russia and Germany are the world’s biggest oil consumers. Sure, Europe is experiencing a recession now, and we are beginning to recover from a recession, but the world economy continues to grow. Oil is water for the economic tree. Many developing economies like China and India are consuming more oil all of the time. Prices of crude are rising to meet this demand.
Although demand in the U.S. has actually been falling for the past year, U.S. demand only accounts for about one tenth of world demand according to The Wall Street Journal’s business site MarketWatch. While demand in this country may be decreasing, the other 90 percent of world demand is not.
While demand for oil grows, there is uncertainty about the oil supply at the same time. There is a risk that the supply of oil might shrink in the near future. In addition to increasing prices because of higher levels of demand, supply risk factors that may occur (e.g. Mideast tensions) only add an extra premium to the price of crude that refiners have to pay. Since oil refiners have to pay a bigger price for crude due to supply factors, they must also raise prices of refined oil to keep profits. Oil refiners are further inclined to do this because of an increasing level of demand. Think back to basic economics- as demand rises and supply is lower, prices also rise. You, the consumer, then must pay more for gas at the gas station.
Contributing Factors
Below are several factors that are some of the main, current supply factors I believe contribute to higher gas prices and may cause gas prices to continue to rise. Note that the reasons for increasing gas prices extend much beyond what I have written. I believe these to be just some of the main supply factors.
- Two U.S. refineries closed in 2011. Three more U.S. refineries have already closed this year.
- Middle East Tensions:
- Continuing unrest in the Middle East (e.g. Syria, Egypt, etc.) and other major oil producing regions
- A recent Iranian news report that a pipeline exploded in Saudi Arabia
- Continuing conflict with Iran
- Keystone Pipeline XL Construction Decision Postponed
- Current EPA Guidelines
Two U.S. refineries in the South closed due to the river flooding disaster in Mississippi last year. At least three more refineries have already closed this year: two in Pennsylvania (Sunoco and ConocoPhillips) and one in the U.S. Virgin Islands (Hovensa SA). A fifth refinery is also for sale in Pennsylvania. As a result, the country’s gas supply is being squeezed. The effect of these closings will be felt first in the Northeast. The prices will rise there first and then continue to rise across the country. The two facilities in the Northeast account for nearly half of the refining capacity on the East Coast. According to Reuters, once the Sunoco facility closes in Philadelphia at least one fourth of the East Coast refining capacity could be adversely affected, causing oil prices to rise. The Sunoco refinery is closing because of financial losses due mainly to higher crude prices. Those higher crude prices are squeezing profits.
Why not build new refineries when one is destroyed, or why not have a new buyer purchase a refinery when one fails? Oil refineries are extremely costly to build and operate once acquired. A medium size refinery that could process up to 100,000 barrels per day can cost up to $1.5 billion to build and take up to 5 years to construct. They can also take a long time to plan. It can take up to 10 years to get an Air Quality permit to begin operating a refinery. In addition to putting up the initial capital required to build or buy an oil refinery, there is much risk in building or buying one. The oil industry has many barriers to entry and is very volatile.
The last new refinery in the U.S. was built in 1979. There are currently only 149 refineries in the U.S. The good news is that two new refineries are expected to open by the end of next year. The firms spearheading the constructions are Arizona Clean Fuels Yuma, LLC in Yuma, Ariz. and Hyperion Energy Center in Union County, S.D. The bad news is that it will be quite some time before the new supply of oil from the refineries affects the oil price for the consumers’ benefit.
International conflicts, ethical debates and environmental concerns also affect oil prices. Check back tomorrow for an analysis of those issues and how they factor into the money you pay at the pump.