This is another area that throttles me up, so I’d like to see if I can shed some light on the subject for you.

The oil industry is complex not because the concepts are hard to understand but rather the number of financial instruments associated with oil production and world price of oil. In this article I will attempt to explain why increased domestic production will not translate to reduced prices.

To lay the ground work I need to present two micro economic concepts; supply and demand, and price elasticity. Let me start with supply and demand.

Assume  you decide to make marbles as a business. Your marbles hit the market, people take a liking to them so they start buying them. Soon, people like them so much that they order more, so demand increases. As a supplier you respond to that demand by making more marbles as long as you are making a profit. As demand continues to increase with supply remaining constant the price of marbles rises. Seeing a price increase, consumers decide not to buy so many marbles. Your neighbor seeing that you are making lots of bucks manufacturing marbles decides to get into the business also. With two of you making marbles, supply increases lowering prices so consumers respond by buying more marbles. Your uncle, seeing that you can make a bunch of bucks manufacturing marbles also gets into the business increasing supply further, which further increases demand. The cycle continues until suppliers see diminishing profits resulting from increased competition. So, people thinking about manufacturing marbles see profits are no longer as desirable and decide not to enter the market. Supplies stabilize prices stop falling so consumer demand no longer increases. Economists call this the equilibrium, which is the point at which quantity demanded equals the quantity supplied at a specific price. In a free competitive market, consumers are able to purchase marbles at the best possible price and suppliers are willing to supply the quantity demanded at that price. Lowering the price increases demand but suppliers are less willing to produce, so prices start to rise again reducing demand until equilibrium occurs. This adjusting back and forth is a continuum. This is the supply and demand function and how they interact.

Price elasticity describes how sensitive quantity demanded is to price. Let’s say that we are charged $0.01 for a breath of air. Suddenly, someone says to you  effective immediately a breadth of air will be $0.10. Will you decrease your demand for air? Absolutely not. So we say that a breadth of air is price inelastic – quantity demanded remains the same at any price. You will pay whatever is charged for a breath of air until such time as you can find a substitute. Clean water is yet another example of something that is price inelastic. Because oil is central to energy production and our economy, and there are relatively few alternatives like nuclear power, we say that oil is relatively inelastic. There are some substitutes but not many and for that reason quantity demanded remains unchanged (there is some decline but not by much) regardless of price.

Most of the oil consumed in the world comes from OPEC members. OPEC stands for Organization of the Petroleum Exporting Countries. It was  created at the Baghdad Conference on September 10–14, 1960, by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. The five Founding Members were later joined by nine other Members: Qatar (1961); Indonesia (1962) – suspended its membership from January 2009; Libya (1962); United Arab Emirates (1967); Algeria (1969); Nigeria (1971); Ecuador (1973) – suspended its membership from December 1992-October 2007; Angola (2007) and Gabon (1975–1994). OPEC had its headquarters in Geneva, Switzerland, in the first five years of its existence. This was moved to Vienna, Austria, on September 1, 1965.

OPEC’s Purpose:

OPEC’s objective is to co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry.

You can translated this objective to price fixing. OPECs purpose is to fix the price of oil globally.

When I had the privileged to serve my country in uniform some of the crustier CPOs and NCOs would frequently make reference to ” the great home coming f–k fantasy” it was their way of saying make sure “your ass is wired directly to your brain” on a mission. The dissolution of OPEC, so that oil production becomes a free competitive market was for many economics professors THE home coming f–k fantasy, in my years at Graduate School. Although OPEC has been “reasonably” fair in dealing with oil production, they impede free market competition among oil-producing countries, and oil supplies are held at predetermined levels.

Since the formation of OPEC in 1960, demand for oil has skyrocketed driven by China with an economy growing at double-digit rates and currently at 7% – 8 %. India also has an insatiable appetite for oil. So, going back to our opening paragraphs, demand increases but supplies remain controlled, by mutual agreement. Necessarily, oil prices will go up. Why? You know the answer – oil is relatively inelastic thus demand remains just about the same at any price point.

Why increased domestic oil production does not translate to lower fuel costs in the USA.

U.S. oil producers do not compete with OPEC. They sell oil at market price, the OPEC price, which provides them higher profits. Further more, we have a relatively limited number of refineries, so there is a limit to how much gasoline can be produced.  We see this from the increase in domestic fuels prices resulting from refineries being closed in Hurricane Issac’s path.

Now, if YOU are a refinery, would you be more willing to sell gasoline in the U.S. at $3.50 per gallon (3.785 liter = 1 gallon) or would you be more willing to sell to India, China and EU at € 1.20 (on average retail before VAT) per liter ($ 5.72 per gallon). You can probably answer that question yourselves.

The net effect of a pricing difference between the EU and USA is less domestic supply and increasing  fuel exports. When will that stop in the existing environment? When domestic prices equal international prices. This is why we need to create competition in the oil industry. Let me  illustrate my point by pointing you to this link:    http://articles.latimes.com/2011/dec/30/business/la-fi-fuel-exports-20111231

So, if you want to bring oil and fuel prices down what should be your strategy?

1. Break up OPEC so that oil production becomes a competitive market. In other words oil-producing countries compete with each other, U.S. included, for market share.
2. Accelerate the development of alternatives. There is no reason on the face of the earth that this country can not move more aggressively to nuclear power. Nuclear plants can deliver more Kw’s per square foot of plant size than coal or oil based facilities.
3. Or, through the application of well conceived fiscal policy that eliminates or reduces the profitability spread between domestic sales revenue and foreign sales. (This is the least desirable alternative)