Normally, I like to speak about traditional financial planning topics here to inform people but every now and then there is a topical issue that is getting enough attention it is worth commenting on. This is one of those times.
We all have been feeling the pain of high inflation over the course of the past year. While prices on many products have been going up across the board the price of gas always seems to elicit a bigger response. The recent invasion of Ukraine by Russia has done nothing but accelerate those price increases. Many people are frustrated and there is a lot of blame to go around.
Complicating people’s views and understanding of what is going on is that too many news outlets today politicize these events and push out cute soundbites that direct blame in a direction that supports their own narrative. The truth is far more complex than that. I will try to explain below the main drivers of how we got here, what is driving the price and what can be done about it. Along the way, I will address many of the talking points you may be hearing and discuss the impact they may be having.
I am no expert on the oil industry so to help me out with this I turned to an old friend who has spent the past 25 plus years in the oil trading industry. His job is to understand every single factor that impacts the price of oil, the impact if one of the variables changes and to be on the right side of those price moves. There is no room for politics in this position. This is simple business and economics. The following comments are a summary of what he shared with me.
The price of oil and therefore gas is a simple study in the basic law of economics: supply and demand. To understand how we got where we are now, we need to go back a few years. In late 2019-early 2020, most of the world’s major oil producers were running full speed. At this time, the price of oil sat around $60 per barrel. In early 2020, we were hit with Covid, and we had a massive change in one of the two supply-demand components. Demand cratered almost overnight. We found ourselves quarantined at home, not going into work, not driving around town because everything was closed, and not traveling either. The problem was we had this massive supply because everyone was running full speed on oil production. The price of oil went to negative $30 per barrel in April 2020. Tanker ships were stuck floating around the ocean filled with oil and nowhere to put it as all our holding tanks on land were full. There was nowhere to put the oil because so little was being used.
Going back to our supply-demand model, the only way to get the price back to a reasonable level was to shrink supply to meet the demand level. With oil at such low prices, the oil companies shut down production, refineries where oil is turned to gas shut down, companies stopped exploring new areas to drill, and instead redirected their funds away from R&D, and instead paid down debt, bought back stock and increased dividends in an effort to keep their stock price afloat. The break even price for oil production is somewhere in the $40 per barrel range so there is little to no incentive to drill when prices are lower than that. We also need to remember this was not just a US phenomenon, this decrease in production was across the board amongst all oil producing nations. It took until January 2021 for a decent level of equilibrium to be reached. Oil was back to $50 a barrel, a level at which companies can profit and consumers get a reasonable price.
Covid was still hanging over the entire situation though. We had worked through our initial over supply issue, but demand was still low compared to previous levels and production levels stayed relatively low as well. The price of oil continued to rise through 2021 and hit a peak of $80 per barrel in late October. You can see the historical oil prices on this chart here. This was mainly due to production still lagging but demand continuing to rebound slowly but surely. Once we largely got past the Omicron variant, we were back to pre-Covid levels of demand but our global supply still had not caught up which was why prices had gone higher.
With oil prices already high we were dealt with the Russian invasion of Ukraine. While the US doesn’t rely that heavily on Russian oil (more details on that later), oil is a global commodity, and the world still needs its overall supply. The other thing commodity markets hate, just like the stock market, is uncertainty. The invasion brought up all sorts of new risks and the price of oil skyrocketed to almost $130 in early March.
So how much oil was Russia really providing? The global demand for oil sits at about 100 million barrels per day. Russia was providing about 7% of the export market meaning if the world decides to forgo Russian oil, we have a shortage of about 7 million barrels per day. To get oil prices back to where they were we need to replace those 7 million barrels or decrease demand. US daily demand alone for oil sits at about 20 million barrels per day. If gas prices go high enough people will drive and fly less, they will decide to skip summer road trips and the demand will come back down. But we don’t know exactly where that breaking point is. Ideally, we don’t have to find out either.
So that is a little history on the price movements given the supply-demand changes over the past two years. Now let’s get into some of those other factors that could be happening to change the supply-demand equation.
1. The obvious question is why can’t the US just produce more oil? According to my source, the US has the capacity to add somewhere between 800,000 to 1,200,000 barrels per day to their output using the current supply of wells. There really is nothing stopping our oil companies from increasing their production and they have begun taking steps to do just that. The reality is though that it could take 6-12 months for this extra supply to hit the market. It isn’t so simple as to flip a switch and a week later we have a finished gasoline product available to us. We also have that dreaded covid-related supply chain problem that is impacting our ability to do this. Oil companies, like everyone else, are short of workers and certain materials needed to drill. For instance, there is a shortage of sand which is a key component for drilling. Expect US production to increase but it won’t have an immediate effect on your gas prices.
2. What about those 9000 unused leases? The government has historically granted leases to oil companies to drill for oil on federal lands. All this amounts to is the right to drill on that land. Going back to what we discussed earlier about what happened to oil during Covid, the oil companies haven’t spent the money on R&D to see if these leases would even produce much oil. This is where politics enters into the equation. The Biden administration has been in favor of a clean energy agenda which has left the oil companies unsure of how smart it is to make the investments into exploring these leases. Publicly the administration has said they have the green light to drill but there is lingering doubt from the oil companies on the true level of support. Again, it would take up to a year for this oil to hit the market if these leases were to be developed.
3. Would the Keystone XL pipeline help? The Keystone pipeline itself has been up and running since 2013. This pipeline brings in oil from Canada and routes it to various areas of the United States. All told, the existing portions of the pipeline deliver about 1.3 million barrels per day to the United States. The Keystone XL pipeline was to be an addition to the existing pipeline that would have added roughly an additional 800,000 barrels per day from Canada to the US. The XL segment was to bring in a heavier type of crude oil which raised environmental concerns. The project was put on hold in 2015 by the Obama administration and revived by the Trump administration in 2017. Soon though the project was subject to litigation and got hung up in the courts. Eventually, the Biden administration struck it down and the company that was going to build it said they were canceling the project for good.
I have zero knowledge of what the real environmental risks of this project were so won’t try to quantify that here. That said, my industry contact does think this was a mistake by the Biden administration and would have helped our oil supply situation. It is not clear if the pipeline had been allowed to move forward if it would even be operational yet though. Had it been up and running it would have only replaced about 11% of the shortage from Russia. So, while this would have potentially helped our current situation, it is not the magic bullet that some people are touting it to be.
4. Where can we get extra oil supply to make up for Russia? What happened with our oil situation in 2020 happened everywhere. All oil producing nations slowed way down and are still not back at their previous levels. OPEC has decreased its exports as well. My industry contact said OPEC countries could very quickly add about 400,000 barrels per day, Iran could add 1-3 million barrels per day over the next three to six months and between Saudi Arabia/UAE and Venezuela we could see another 1.5 million barrels. All of this combined with what the US can add gets us pretty close to replacing the 7 million barrels from Russia. Again, this won’t happen overnight though. It will take three months to start to see the initial benefits and could take up to 12 months for everyone to be running at full speed. So far though these other countries have been slow to respond.
My source shared with me a point that doesn’t get mentioned often. An oil well is a machine and like any machine needs maintenance and upkeep just like a car. One of the risks is that over the past two years while some of these wells have been mothballed is that they haven’t been maintained. Remember that some of these countries have nationalized oil, meaning it is not done by private companies as we have in the US. Some of these countries may not have the financial resources to maintain their wells so it could take longer for them to get up and running and/or they may not be as efficient once they are running.
5. Why were we buying Russian oil to begin with? I have heard we were energy independent. There is a lot to this point. First, let’s understand how we define energy independence. If you mean we do not rely on or import energy products from other countries, then no, we were never energy independent. Even people touting the Keystone Pipeline are advocating for the US importing oil as all of that comes from Canada. This chart here shows the history of US oil consumption, production, importing and export levels. There was a time in 2020 when we produced more oil than we consumed and we became a net exporter of oil, meaning we exported more US produced oil than we imported from foreign countries, by about 700,000 barrels per day.
That said, we continued to import oil the entire time from a number of countries. We were still importing almost 8 million barrels per day, so we never relied solely on US oil production to meet our needs. This chart shows our level of imports by country over the years. This also shows a measurable amount of oil imports from Russia beginning way back in 2002 and never really subsiding, and in fact, saw an increase starting in 2019. By far, our biggest trading partner is Canada with almost 40% of our oil imports coming from our neighbors up north.
With regards to Russia, they are a very small player for US imports overall. Especially, we don’t use much of their crude oil as it is the typical thick black sludgy oil you think of, and we tend to prefer the lighter oil found in Texas and parts of Canada. That said, we do rely fairly heavily on Russia for a number of other petroleum related products as you can see here. These products tend to be used in mixing and added to other fuels to make our gasoline.
While the US and our NATO partners may eliminate or cut way back on Russian oil imports, that oil will still find a way to be sold. Russia may have to sell it at a discount, but China will likely buy all they can and India has been reported to be buying some as well. Those two countries account for over 2.5 billion people so there is plenty of demand.
The truth is oil, and its related products are truly global commodities. We rely on peace in the world to let free markets and trading partners work in harmony. Even when our production was at its highest, we still imported oil from all over. This is because it costs less to import oil from a foreign country in some cases than transport that oil from a refinery to its end destination within the United States. So, we may sell our product and ship it to South America but we buy oil from somewhere else because it can be delivered to the east coast at a lower total cost. We could do away with this global system, but it would result in higher gas cost and that is the very issue we are concerned with.
6. How about if we made the switch to clean energy? I think it is clear we are heading in this direction. While this topic gets highly politicized as well, there are many strong reasons to keep moving in this direction. There is an environmental need to do it, it allows us to use renewable sources instead of oil which will run out at some point (although likely not for 100 years) and moves us further in the direction of true energy independence. We don’t have to rely on another country to supply sun, wind, water or electricity to us. And, the truth is, many of the major oil producing companies tend to be viewed as bad actors on the world stage and it allows us to get untangled from that mess.
But it will take time. In the US alone we consume 20 million barrels of oil per day. Each barrel contains roughly 40 gallons. That is a total of 800 million gallons per day. That is a huge process to turn around that level of consumption. If you want to make the argument that the Biden administration has been no friend of the oil industry and we are not where we should be with our oil production, then you can make the same argument that the Trump administration largely turned its back on the clean energy industry as well and we aren’t as far along as we should be with our clean energy production and infrastructure.
Regardless of how you feel about that, we would still not be in a position from a clean energy perspective to replace those 800 million gallons of gas per day. That will likely take decades and massive amounts of investments in a clean energy network. The other issue we have with clean energy is that it still requires natural resources to produce the equipment needed to harness the source of the energy and make it usable. For instance, EV vehicles rely on batteries and these batteries use resources like nickel, cobalt, and lithium while semiconductor chips used to run the cars need neon. And wouldn’t you know, Russia is among the leading producers of Nickel while Ukraine is the dominant player in neon. If you’re worried about the cost of oil, you would be shocked to see what has happened to the price of Nickel since the start of the invasion. While clean energy is the direction we are headed, it will take time and further developments, so we don’t just trade a dependence on oil for nickel and neon.
7. So why did gas prices go up so quickly when oil prices increased but didn’t really change when oil got cheaper? For those of you paying attention, the price of oil came down from its high of $130 per barrel all the way down to under $100 on March 16th. Blame your local gas station for this. Gas at a gas station is a very low margin business. When the price of oil increased quickly we saw the price of gas go up in lockstep. That price of oil is tied to the spot price for a barrel purchased at that time. The gas that was in the tanks at your local gas station had already been purchased at a lower price but they increased the price immediately so they made a nice profit off that. On the flip side, when oil fell by 25% to $100 per barrel we saw the average price of gas decrease by just 1-2%.
What happens within the local gas station market is that each station bought their gas potentially at a different time and a different price but they all have to sell at pretty close to the same price or people will just go to the lower priced station across the street. When one station is able to purchase their gas at a lower price and lowers their price to the consumer then all the other stations lower their price as well even if they bought that gas at a higher price. As a result, the local gas stations take their profits when there is a window to do it.
8. So what can the government do now to help? My source indicated that there isn’t much they can do to move the needle very far in the short term. One thing he mentioned and is something I had not heard of was that they could relax the rules on the various grades of gas. Each state can set its own specs for various grades of gas which ends up creating a large number of boutique gas products. This means the refineries have to create a number of unique products which increases cost and slows down the delivery of the various gas specs to their final destination. A waiver could be done for certain types of gasoline which would result in a more uniform gas product that could be distributed more quickly and help with supply.
That is a not so quick run down of some of the various factors impacting where we are with the current price of oil and gas. You can go back quite a way with our US government decisions on energy policy and find that all administrations have probably made some decisions that have helped and some that have hurt our overall energy situation. There might be a tactical decision that works for now but hurts down the road or on the flip side, hurts now but is positive for the long term.
For all of the various reasons laid out above, we are limited in what we can do to change the supply side of the equation in the short term. In order to change the price to be something more palatable, the change most likely has to come from the demand side. This was one of the drivers for the drop in oil price last week as Covid (still impacting things) related shutdowns in China were going to put a damper on demand. The other option for changing demand is that the price gets high enough that families start making choices that impact their usage. Do they not make the summer road trip? Do fuel prices drive airfares high enough that people don’t make a trip at all? Do workers decide to continue to work from home to avoid their commute? This is your most likely solution in the short term before oil production can catch up.
Look, I’ve talked to a lot of people who are upset by gas prices and understandably so. We don’t have enough fingers to point at all the parties who share in the blame (Covid, Putin, every administration going back to Carter, all other oil producing nations, our own insatiable demand). The bigger takeaway though is the reality that the price of oil goes way beyond just what our government can control. There are hundreds of various factors and players that impact the supply and demand balance which determines the price of oil and gas. In a global marketplace, so many things get intertwined that when there is a disruption to the smooth flow of goods it can get very complicated very quickly. For now, it sounds like we likely will have higher prices for at least the next three months.
By the way, the next similar situation we could face like this is semi-conductor chips that are used for the processing all of our computerized devices. 80% of this production takes place in Taiwan which could be in China’s sights.
I hope that helps explain and brings some clarity to this complex issue. As always, if you have any questions, comments or concerns feel free to reach out or respond in the comment section. I am always interested to see what people have to say.
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