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Why Oil Prices Keep Going Up
Submitted by Dan Sweeney on Fri, 2008-05-16 22:20.
Let us be brutally honest with ourselves. The alternative fuels industry is growing today primarily because of ongoing concerns regarding oil prices. Should oil prices collapse as they did in 1983 from a level that was close to $100 per barrel in constant dollars to a price of approximately $15 per barrel by the same measure then the investment in alternative fuels will dry up overnight just as it did then. Now of course we also have concerns about global warming which scarcely registered on the national consciousness twenty-five years prior, but, I submit, such concerns alone would not support a thriving alternative fuels industry. For most people who are buying motor fuel economics will always trump conscience.
So what are the factors behind the current protracted price elevation and is it likely to subside?
In attempting to answer those questions we must establish a context and indicate how the international market for petroleum is structured and what are the evolutionary forces impinging upon it and influencing prices.
Persistent Factors - a Checklist
. The market price for crude oil has been remarkably stable over a period of 150 years--around $20 per barrel in constant dollars.
. Major departures from this "natural price" of oil have only occurred in the face of sudden reductions in production, which themselves have always been associated with armed conflict in the past.
. Market speculation has never caused a sustained price rise in the past, and we can dismiss it as a major factor today.
. Political tensions alone do not cause significant sustained price rises. The Korean War, the Vietnam War, and the heightened Cold War animosity of the Reagan years did not cause oil prices to rise.
. The last three years have seen an absence of growth in oil production rather than an outright reduction. This may well explain the steady price increases over the same period, though we lack exact historical analogies.
The Evolution of Petroleum Industry Price Structures - Beginnings
The modern petroleum industry really begins in the United States just prior to the Civil War. Various fossil liquid fuels had been manufactured before that time going all the way back to the Bronze Age when crude petroleum was first used as a pyrotechnic, but only with the discovery of kerosene refining processes and the enormous, easily worked fields in western Pennsylvania did petroleum become a big business.
An oil rush of sorts began in Pennsylvania in 1859, and, less than two years later, oil producers began signing huge contracts to supply the Union Army at fixed prices. The quality and composition of the distillates produced was highly variable and the supply fluctuated wildly, neither of which made for stable pricing. With the decline of the whale fisheries the demand for the oil appeared to be strong, but petroleum had to compete with low cost ethanol which was widely used for illumination at the time, and the future of the new resource was only assured when President Lincoln managed to enact a heavy tax on ethanol as a wartime revenue producing measure. This made ethanol essentially uncompetitive as a liquid fuel for illumination.
In the wake of the Civil War the Rockefeller owned Standard Oil Corporation established a near monopoly on the production of refined petroleum products in the U.S. through a cartel of directly owned or affiliated refineries, and the Standard Oil trust set prices in a monopoly fashion, attempting to undermine market forces. Interestingly, those prices incorporated a fairly low profit margin, however. John D. Rockefeller was interested in expanding and rationalizing the market, and in establishing rigid quality standards in the interest of safety, hence the name Standard Oil. Contrary to legend, Standard Oil prices were anything but exorbitant, and in fact consistent low pricing made kerosene the characteristic form of residential illumination in the United States until well into the twentieth century. Kerosene, it must be remembered, had to compete with coal gas illumination in major cities, and managed to do so successfully on the basis of price (gaslights tended to be found only in the homes of the more affluent). Kerosene also competed with the products of the small but active shale oil industry which Rockefeller was able to put out of business.
Another interesting factor about early petroleum pricing is that Rockefeller moved it firmly away from the commodity model. Standard Oil kerosene was branded and distinguished from competing products on the basis of consistency and quality. It was sold in bright red oil cans emblazoned with the Standard Oil logo, and the product may be said to constitute a triumph of packaging and institutional advertising as well as quality control. It was also sold at set retail prices which could not be altered by distributors.
In this respect Rockefeller was following the lead of the first packaged food manufacturers in America who similarly sold expensively presented and packaged processed foods on the basis of quality, consistency, and purity, as well as purported health benefits. Most of the major food manufacturers also insisted upon set pricing and fairly low profit margins for the retailer and preferred to deal with the emerging chain stores who followed modern business practices and who were comfortable with the low margin high volume approach of the mass market manufacturers.
It is fashionable to assume that America in the late nineteenth century was a pure capitalist society with orderly, rational markets where pricing was entirely determined by supply and demand, but in fact the whole notion of branding and unique product positioning, which lay at the core of the American system of product development and promotion, carried with it the further notion that market forces could be controlled to a considerable extent. Supplies could be adjusted by the mere calibration of industrial facilities with effectively infinite manufacturing capacity, while raw materials could be obtained in almost any amount from supporting industries who grew ever more efficient in harvesting them. In this new economic regime labor inputs largely determined the price of products, and in America these were steadily shrinking in terms of units of production.
The common assumption is that capitalist enterprises always charge what the market will bear and conspire to keep prices as highly as possible, and that assumption informs many of the political fulminations we're hearing today regarding oil prices. The oil companies are out to gouge us. But if that is the case, why did they wait until now? Why haven't they been charging motorists several dollars a gallon for the past thirty years? Or the past century? I'll explain why in succeeding sections of this article.
The Price of Gasoline
Gasoline was largely regarded as a waste product in the late nineteenth century or at best as a cleaning agent. Its use in illumination was extremely dangerous, and often it was simply poured into watercourses by refineries who had difficulty finding markets for it. It only began to be used in transportation in the early eighteen nineties when the first gasoline powered personal motorboats entered the market in the U.S. and the first internal combustion engine automobiles appeared in Europe.
During the first decade of the twentieth century, as both electric lighting and an improved form of gas lighting began to gain ground among American homeowners, Standard Oil management had to make a difficult decision regarding the future of their company and their industry. Some in the company favored pursuing markets for illumination abroad in order to grow the company's business, while others were willing to bet on the expansion of motorized oil-fired transportation. Both courses were ultimately pursued but the company elected to focus on transportation. U.S. refiners began producing gasoline in quantity shortly after 1900.
It is difficult to make valid cost comparisons that extend back one hundred years, but most authorities on petroleum pricing through history believe that the real cost of motor fuel was considerably higher during the Administration of the first Roosevelt, the dawn of the automotive age, than it is today. And that's not surprising. Until the Model T came in at under $1,000 in 1908, most cars were priced in the thousands of dollars or multiples of the median income of American wage earners and were aimed at the affluent. Moreover, maintenance costs were quite high due to the relative unreliability of the machines themselves and the generally poor roads over which they traveled. While many automobiles were largely recreational vehicles, the members of certain occupations, such as physicians and traveling sales agents adopted them early, and regarded them as indispensable if expensive business tools. The rather high price of gasoline was not a significant inhibitor.
The pricing of luxury items, and gasoline was at least an adjunct to a luxury item, is a rather neglected area, though I have studied it extensively myself, and indeed at one time I was involved in the manufacturing of a luxury product. Generalizing in this area is difficult, but it can be said that the pricing of luxury goods is rather arbitrary and that the profit margins assigned to them are relatively enormous even if they are manufactured or assembled with mass production technique. An interesting example from the first age of gasoline is provided by the phonograph record which was priced at several 1900 dollars apiece and was sold largely to the affluent. Cost in constant dollars was close to a hundred dollars, which, interestingly was the retail price of the first laserdisc which was similarly positioned as a luxury item and cost a couple of dollars to manufacturer. If gasoline were luxury, which I believe it was until near the end of the first decade of the twentieth century, then that would explain its high price.
At any rate, gasoline prices descended steadily in the years prior to World War I and then spiked alarmingly in 1914, the first year of the War, providing us with the first example of a terror tariff on pricing. The U.S. was almost entirely oil independent at the time, and provided almost no refined petroleum products to the European combatants, and yet the price appeared to reflect the fears and uncertainties connected with the global conflict. And it was during this same period when concerns about future supplies of oil began to arise, indeed a peak of global oil production was predicted in a 1915 German text on coal-to-liquids technologies and was discussed by officials in the U.S. government.
Nevertheless, the U.S. oil price spike did not survive even the second year of the World War, and prices declined to historically low levels and stayed there for over fifty years except during the interval in which the U.S. was engaged in the Second World War when prices were fixed by the government and gasoline was rationed. Cheap fuel remained the norm in this country through the Roaring Twenties, the Great Depression, the immediate aftermath of World War II, and the Age of Affluence that followed. Only with the commencement of the Yom Kippur War in 1973 and the consequent oil embargo by major Arab oil producers did prices rise significantly. And after the several cataclysms of the seventies and eighties, they returned to the same low level in inflation adjusted dollars.
Industry historians like to speak of a natural price for oil in constant dollars, and that price appears to have been in the $18 to $21 range from the late eighteen sixties when reliable price data first becomes available until the end of the twentieth century. During this entire period four major price distortions occurred, two during the World Wars and the other two in the successive Middle Eastern political crises of the seventies and eighties. In all four cases the operant factors in the price rise appear to have been actual declines in production combined with fear and uncertainty concerning the availability of future supplies.
Market Forces Assert Themselves
When OPEC announced a five million barrel per day reduction in oil production in 1973, the price of oil quadrupled almost immediately and stayed historically high for a full decade afterward. The embargo itself was largely a failure since the U.S. was able to obtain alternative sourcing within weeks of the announcement, but the ensuing armistice between Israel and Egypt and the comprehensive and successful peace negotiations that followed did not initiate a return to prewar price levels. Through most of the decade of the nineteen seventies prices at the pump remained high.
Markets react to signals as much as to actual events impinging on supply and the signals emanating from OPEC members were disturbing during this period. OPEC was formed to provide price control and policing within world markets, and its pronouncements and production quotas certainly aroused fear in the oil dependent West including the U.S. which had become a net petroleum importer in the seventies. But OPEC was merely a manifestation of larger trends within the industry.
The first of those trends was the commoditization of oil which was largely complete by the nineteen sixties. During the early twentieth century petroleum markets were largely local, and trading in petroleum futures was almost unknown except in the United States where a vigorous futures market emerged as early as 1875. Supertankers and continent spanning pipelines did not exist, and consequently relatively inefficient producers could survive. That began to change in the years after World War II. Also keep in mind that the size of the industry was much, much smaller prior to World War II. In a thirties a few million barrels per day were produced. Today that figure is over 80 million.
The international trade in petroleum expanded enormously during the early post War period, and in the sixties an international oil futures market began to develop. This was extremely important with respect to price volatility because the expectation of future shortages could panic buyers and drive up prices rapidly as big institutional traders sought to secure as much of the resource as possible.
Another change was a heightened concern regarding oil security which was ultimately reflected in prices, though not immediately. This requires a bit of explanation.
Oil embargoes played some role in the victory of France, England, and the United States during World War I, but the role of petroleum in ensuring national survival was far more critical in the Second World War. Japan launched its war against the Western Powers in retaliation for a crippling oil embargo but was unable to secure adequate supplies even after occupying the huge Dutch oil fields in Indonesia. Acute fuel shortages hamstrung the mighty Japanese Imperial Navy and Air Force and left the nation all but defenseless against American air and naval assaults, eventually leading to defeat.
The situation in Nazi Germany was not quite so dire due to the emergence of a sizable coal based synthetic fuels industry and due to the fact that Germany occupied oil rich Rumania, but Germany was severely disadvantaged with respect to oil as compared to its enemies, and unquestionably oil shortages hindered its ability to conduct military operations.
Oil became the mainstay of mechanized total war, and the cost of losing such wars was prohibitively high, much higher than the costs of defeat in the limited wars of the nineteenth century.
Indeed, if it demonstrated anything, the Second World War showed that access to oil was a determinant of national survival; in truth, Germany ceased to exist as a unified nation in the aftermath of the War while Japan lost its newly acquired Great Power status. Thus on the level of national policy, demand for oil was inelastic and demand destruction could only come with the collapse of the State itself. Warring states would pay anything for oil, and states that were not at war would take up arms to prevent supply reductions. Japan went to war against the Western Powers largely to achieve oil security. It was literally willing to wager its integrity as a nation and the lives of millions of its citizens in order to obtain sizable oil resources. It lost both wagers.
Ever afterward concerns about energy security would color national policies with respect to oil and would influence prices profoundly.
In the wake of World War II the U.S. cemented its special relationship with Saudi Arabia in order to ensure its own energy security far into the future, pushing aside Britain which had been negotiating with the Saudis for the same purpose. Then, a mere eleven years after the conclusion of World War II, England made war against Egypt because the government of Anthony Eden believed that Egypt was about to cut off England's access to Arab oil. These two events were the most signal occurrences in the twenty years of cheap oil and expanding production following the end of the Second World War. And they clearly illustrated the impact of energy security concerns upon markets and international relationships.
The second event particularly, known as the Suez Crisis at the time, merits close study due to its powerful destabilizing effect on what had been a very tranquil market for international oil. In the fall of 1956 England, France, and Israel attacked Egypt in consort after Nasser seized and nationalized the Suez Canal in an expression of Arab nationalism, and at that point the Middle Eastern oil producers curtailed oil shipments to Western Europe in the first organized oil embargo in history. Egypt did not fare well in the ensuing conflict, and Russia threatened to intervene on behalf of Egypt, a newly acquired ally. This brought the crisis to a head, and at that point President Eisenhower threatened all out war against Russia although his Administration had been somewhat sympathetic to Nasser and he greatly disapproved of the French, English, and Israeli incursions. Oil prices tripled in Europe at the height of the crisis in November of 1956 and remained elevated for months thereafter, while in the U.S., which was energy independent at the time but which undertook to meet Europe's needs during the crisis, fuel prices rose by almost seven percent. Subsequently, the Department of Justice undertook an antitrust suit against major American oil producers which it lost.
Given the magnitude of the disruption, one might have thought that U.S. prices would have ascended far higher, but Eisenhower's nuclear threats were made through diplomatic channels, and the press downplayed the crisis in the United States. Fear and uncertainty were restrained, as was price volatility.
The Suez Crisis was skillfully defused by John Foster Dulles, the Secretary of State, and an incident which had brought the world to the brink of nuclear war and resulted in the utter humiliation of Great Britain which was forced by Dulles to withdraw immediately from Egypt, was quickly forgotten. Most people today assume that the Suez Crisis was a simple border clash between Israel and Egypt. It was on the contrary the most significant historical occurrence between the end of the Second World War and the American anticommunist wars of the nineteen sixties, and it clearly demonstrated that oil prices were held hostage by political events in a way that was unique among major commodities.
In the years subsequent to Suez, the price of oil on the world market collapsed, so much so that American producers in anticipation of OPEC years later, tried to form a voluntary organization that would set production quotas to keep prices high. That effort failed.
I mentioned the special relationship between the U.S. and Saudi Arabia, a relationship which appears to be fraying today. This too merits some discussion in terms the global oil price structure.
When the third Roosevelt Administration began negotiating with the Saudis, the Saudi royal regime had been in power for only two decades and had no real historical legitimacy. The survival rate of Arab monarchies in the period after the departure of the colonial powers had not been very high, and the Saudis were aware of their own vulnerability. The basic bargain proposed by the Americans was attractive to them, a guarantee of national security and massive military aid in return for a favored nations relationship in terms of the pricing and availability of Saudi oil. The bargain was sealed in the late forties long before Saudi imports into the U.S. were significant.
The special relationship was severely tested over the years. The Saudis were appalled by the pre-emptive attack by Israel on Egypt in the Six Day War and attempted to organize an Arab oil embargo then. Against the still enormous output of the west Texas fields it was useless, however. Further friction occurred in the middle seventies when President Nixon asserted that any attempt on the part of the Saudis to utilize petrodollars to purchase major U.S. business holdings would be regarded as an act of war, and insisted instead that U.S. Government securities would be the only legitimate investment they could make in the U.S.
Nevertheless, the Saudi government subscribed to the notion that the American economy comprised the linchpin for the entire world economy and that low domestic oil prices in the U.S. were essential to preserving the economic health of the nation and ultimately in promoting their own national security. Interestingly, they did not extend this notion to the nations of Western Europe whose suppliers paid approximately double the prices paid by American independent oil firms.
Today the Saudis evince little interest in shoring up a consumer friendly price structure that would obtain only in America, and this has allowed American consumers to be much more exposed to the fluctuations of the world market. While conceding that American economic interests were everybody's interests as recently as the beginning of this decade, they are manifestly unwilling to dump oil into the international marketplace to help the U.S. consumer economy, and, in any case, they may lack the ability to do so any longer. But that is a topic for a later section.
The Nationalization of Oil Production Facilities and the Coming of OPEC
OPEC (Organization of Petroleum Exporting Countries) was formed in 1960 but only flexed its muscles in the seventies. The rise of OPEC occurred in parallel with a movement among major oil producers, especially in the Middle East, to void their prior relationships with Western oil firms, and to nationalize completely their respective industries.
In general the assertion of national prerogatives served to raise oil prices during the seventies and explains to a large degree the sustained high costs of that decade. The other explanation lies in the behavior of the futures market which remained agitated due to the continuing and growing unrest in the oil producing regions of the Middle East where the Yom Kippur war was followed in fairly short order by the Lebanon conflict, the revolution in Iran, and then the protracted war between Iran and Iraq which itself caused world oil production to decline by more than two million barrels per day.
Many believe today that the unrest America has spread by invading Iraq and threatening Iran and Syria have created similar fears among oil traders which account for the shocking four fold increase from 2001 until the present, but that is matter I will take up in a later section.
The Last Twenty-five Years
After oil prices collapsed in 1983 following the end of the protracted war between Iraq and Iran, they remained low in constant dollar terms for more than twenty years. During the past four years, however, they have ascended more or less steadily, a situation unprecedented save for the ten year period from 1973 until 1983, and even then the analogy is inexact because that decade was marked by two massive spikes separated by an elevated trough while the present price rise has been marked by a whole series of significant increases separated by very minor corrections.
Why the difference today? That is the subject for the second installment of this piece.