Tuesday, November 01, 2005

Gasoline – Economics 303


In the comedy film “Trading Places”, the Duke brothers sit down street con artist Billy Ray Valentine, played by Eddie Murphy, and begin to school him in the ways of Commodities Futures. After a brief example using breakfast food, the light comes on for Billy Ray, who comprehends that buying Commodities Futures is like running a Numbers game. That sort of thinking was funny for the movie, but it also represents how many people see investments in Commodities, especially when the MSM plays it up to suggest a sort of cartel in the United States. Make no mistake, this was once the case in America, and still is in a number of places (Japan’s MITI comes to mind), but the modern condition is rather more sophisticated and deep.

A lot of the discussion about Oil has focused on the forces of Supply and Demand, but it needs to be observed that these exist in different temporal conditions as well. That is, a rise in prices can be spurred not only by a present shortage in available supply, but also by an anticipated surge in the future of demand, as happens in bad weather and during holidays. Oil should also be understood as a commodity with many different levels, in that it can be a fuel, a material (as in plastics), or even a sort of currency between nations. In negotiations between Communist China and Vietnam a few years back, neither nation trusted the other’s currency, so several major trade agreements used barrels of oil as the standard valuation between them. Oil for consumption also exists in many different forms, from the heavy sort used by industry to the light “sweet” petroleum used for internal combustion engines. And then there is the genie of future oil supply; in the Yellow and China Seas, for example, there are supposedly vast oil fields waiting to be tapped, based on geological research done in 1996. Unfortunately, while the oil is known to be there, getting it out has proven tricky, so that a dip in prices when the oil was discovered was lost when the troubles in drilling became known.

Thus, while the ANWR range is potentially huge, there is understandable skepticism waiting to see how the production works out.

The claim that “we are running out of oil” is at once both true and false. In that we have pumped oil out of the most of the easy places, we have reduced our ability to quickly increase oil production. However, new technologies make oil discovery more successful than ever, and the production of the refined product is more efficient than ever before. Also, the development of hybrid and other energy-efficient cars is helping to reduce non-essential consumption of petroleum. Essentially, this is market driven.

But that brings me back to the market of oil futures. A lot of people forget that oil is not generally purchased the same way you or I would tank up our car. In many cases, companies forecast their consumption needs for two-to-five years, then buy contracts to meet that need at a confirmed price. If they guess too high on the price, they lose money, but they have a secure supply and can plan on a known cost. And of course, if the prices climb above their contracted level, the company buying by contract locks in an advantage. As a result, it must be understood that the so-called “record profits” are not coming in immediately, but are in fact projected on a combination of trends, and in the end result may not materialize after all.

You might look at it the same way you would your mortgage. You make a certain amount of money, and you spend a certain amount every month on your house note. If you make more than you spend, you are ahead of the game, but you are still committed to making the payments on your mortgage. That’s how a contract works, and the good or bad of it rests on how well you plan for known costs and anticipated events. It’s just the same for an oil company; they plan within a reasonable range for the cost of research to find new oil, drill it, pump it, refine it, and distribute it. Some years the costs are higher than they planned, or the price drops below what they expected. Other years they get a good price and manage their costs well. Considering that an oil company must hurdle the obstacles of multiple government bureaucracies, uncertain weather and local conditions, fluctuating prices and opinion-impacting events, that they have managed to do well shows neither conspiracy nor greed, but careful management of opportunities and resources. And as people have already observed, the industry is driven by the market; perception of unreasonably expensive oil can impact the future operation of a company, far more than Microsoft or Coca-Cola has to fear from Congress.

Finally, if you are convinced that a certain oil company is going to enjoy profits for a sustained period in time, my advice to you would be to buy stock in that company now. The bottom line, after all, is that these are publicly held corporations, and the people who own their stock are the people who gain from their success.

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