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Oil

Oil is generally classified based on it’s density and sulfur content. The density of oil is normally reported according to it’s API Gravity in conformance with standards set by the American Petroleum Institute (API). API Gravity is a type of dimensionless number and therefore, does not have any specific units, although gradations on the API density scale are commonly referred to as “degrees” in oilfield vernacular. Since the scientific difference between density and it’s more commonly understood “cousin,” weight, is not widely understood, oil density is often mistakenly referred to as weight, and instead of discussing “low density” and “high density” oil, the accepted practice is to talk about “light” or “heavy” oil.

Few inputs impact the world economy like the price of oil. Oil powers cars, trucks, boats, airplanes, and even power plants that make up the backbone of the global economy. As oil prices rise, costs go up for transportation companies, squeezing their profit margins and forcing them to raise prices, similarly affecting all the other companies that rely on them to transport products and people. By contrast, most energy companies benefit from higher oil prices, either from higher revenues for oil, or because of increased demand for substitute energy sources such as ethanol and natural gas. The extreme volatility of this important economic input has piqued interest in issues like peak oil, speculation, and the world’s rising energy appetite, and is leading to greater investment in renewable energy.

Who Benefits from Rising Oil Prices and Loses from Falling Oil Prices

  • Alternative energies like wind, solar, and geothermal, as well as alternative fuels like biofuels, ethanol, cellulosic ethanol, and fuel cells all see increases in demand when the price of oil, their main competitor, increases.
  • Coal companies like Peabody Energy, Arch Coal, CONSOL Energy, and Massey Energy Company see sales growth, as rising oil prices cause consumers to demand more local sources of energy; the U.S. is the world’s second largest coal producer, after China, and there are estimates stating that U.S. coal deposits have more energy than the world’s remaining oil reserves.
  • Hybrid car manufacturers like Toyota, Honda, GM, Ford, and Nissan benefit from higher oil prices because high oil prices lead to higher gas prices, causing consumers to seek out ways to reduce the amount of gasoline they use. Auto makers that have announced plans to produce electric cars also can benefit, and will if oil prices start to rise again over the next few years; these companies include Daimler, Renault, Toyota, General Motors, Ford and Mitsubishi.
  • Independent Oil & Gas companies benefit the most from high oil prices, as they can extract crude at a relatively constant cost from a reserve, but sell it at higher and higher prices. The higher the price of oil, the larger an E&P company’s margins.
  • Oilfield services see dayrates (and, thus, margins) skyrocket, as upstream oil companies scramble to increase production, causing demand for drilling rigs and other oilfield services go through the roof. Machine tools & accessories companies also benefit, as they sell individual parts to oilfield services companies that build, retrofit, and repair rigs.
  • Deepwater drilling contractors like Transocean and Diamond Offshore Drilling are even better off than their peers in the oilfield services industry; there are far fewer deepwater rigs in the world than normal rigs, and with conventional wells drying up, oil companies have been willing to pay more to get at the difficult-to-reach reserves. Before the oil price collapse in the middle of 2008, floating offshore rigs could go as high as $292,000, while deepwater oil exploration rigs were contracting at above $800,000 per day.
  • The oil majors are the very largest of the non-national oil companies, and are vertically integrated. These companies explore for and produce crude oil and natural gas; they transport it by pipeline and tanker; they refine crude oil into finished petroleum products; and they also market crude oil, natural gas, and refined petroleum products to industrial users and retail consumers. The majors get most of their money from selling refined petroleum goods; vertical integration allows them to sell high-priced crude to themselves at production costs, causing the margins on these goods to go through the roof. Often, however, they must buy crude to supplement their own production, as their refining capacities are greater than their upstream production capacities. This offsets some of their profitability.
  • With the price of oil having been above $100 per barrel, the world’s waste management companies (like Waste Management (WMI)) are considering “landfill mining”, as high-quality polyethylene prices have doubled since the summer of 2007, making the world’s trash landfill operators’ treasure.
  • Some chemical companies, like Sociedad Quimica y Minera S.A. (SQM), Terra Industries (TRA), Agrium (AGU), and Potash Corporation of Saskatchewan (POT); these companies produce chemicals like fertilizer, the demands for which increase when oil prices rise due to increased demand for biofuels that need such agricultural chemicals.

Who Loses from Rising Oil Prices and Wins from Falling Oil Prices?

Rising oil prices pose challenges for many companies as well as consumers, which is why rising oil prices are often seen as damaging to the economy.

  1. Rising oil prices increase costs for many companies. These costs may be difficult to pass on to customers, who are loathe to pay more for the same goods, thereby eroding profit margins.
  2. Rising oil prices reduce consumer demand for products that consume oil.
  3. Rising oil prices make travel and shipping more expensive.
  4. Rising oil prices have increased interest in electric vehicle conversion.
  • Oil & Gas Refining & Marketing companies buy crude oil, process it, and sell the processed product to the end market. Companies like Sunoco, Valero, and Western Refining are all prolific U.S. refiners. When these companies must purchase crude oil at a higher price, they then have to sell the refined product (gasoline, jet fuel, diesel, etc.) at a higher price, which then causes demand to drop as people travel less. Furthermore, refined goods prices rise by a smaller amount than crude price. At the end of the 1990s, oil traded below $20/barrel, while gasoline cost under $1.50/gallon. In June 2008, crude traded at around $121 (after rising to over $135, while gasoline averaged $4.10. Oil prices rose by a factor of six, while gasoline prices rose by less than a factor of three. The clear losers, in this case, are the companies that make and sell gasoline, though when oil prices fall, they fall further than gasoline prices, making refiners the winners.
  • Shipping companies are harmed by higher oil prices because oil is necessary to operate the planes, trucks, and ships that transport goods around the globe. These companies include brand-name shipping companies like FedEx and UPS, industrial shipping companies like TNT and Con-Way Trucking, and international shipping companies like Teekay Shipping and Frontline. LTL trucking companies, however, are relatively shielded from fluctuations in diesel fuel prices, as the industry generally passes on fuel price surcharges to its customers like Wal-Mart Stores (WMT). Also, aircraft leasing companies such as Aircastle (AYR) are hurt by rising oil prices.
  • Airlines like Delta, Northwest, United, and American Airlines are harmed by rising oil prices; in the past, jet fuel has accounted for 10-15% of an airline’s cost, but by mid-2008 they made up 30-50% of costs, albeit before the price collapsed below $50/barrel.
  • The lodging industry sees declines in occupancy rates and revenues when oil prices rise, as higher travel prices cause fewer consumers to take vacations.
  • Other vacation and travel alternatives (e.g. cruise lines like Royal Caribbean Cruises and Carnival) see higher fuel costs, forcing them to raise prices and drive potential customers away.
  • The Chemical industry is harmed by higher oil prices because petroleum is a key ingredient in plastics. As the price of oil rises, plastics become more expensive to produce, causing margins to shrink.
  • The retail industry is harmed by rising oil prices because shipping companies charge higher prices, making it more difficult for retailers to get their products to market and forcing them to raise prices. Discount retailers, including Family Dollar Stores, Dollar Tree Stores, Big Lots, Wal-Mart, Target and Dollar General are especially exposed as their consumers generally have lower incomes, making them more sensitive to rising energy prices.
  • Online retailers that subsidize the cost of shipping, like Amazon.com and Overstock.com, are forced to pay part of the shipping price increases, causing margins to shrink.
  • Car companies that are heavily dependent on sales of SUVs for profits, such as General Motors and Ford, see fewer sales as consumers tend to reduce their purchases “gas-guzzlers” when oil prices are high.
  • Automotive parts retailers like AutoZone, Advance Auto Parts, and O’Reilly Automotive, who depend on heavy driving and automotive wear-and-tear, struggle when drivers conserve due to high oil prices and demand fewer repairs.
  • Automotive retailers like AutoNation and CARMAX depend on replacement demand for new cars due to wear-and-tear, which decreases as fewer people drive.
  • Agricultural production companies must absorb the increased cost of oil derived products, such as fuel, fertilizer, and plastic products. This decreases a company’s net profit and increases the price of food for consumers..
  • More and more people are looking into the electric vehicle conversions as a way to get off gas all together, without buying a new vehicle. Conversions are getting more range than factory built electric cars at a lower cost. It is growing by leaps and bounds in the U.S.
  • Chinese manufacturers lose their low-cost production advantage, as rising oil prices cause the prices of whatever is being shipped from China to be artificially inflated. Lower oil prices, at around $20/barrel, were equivalent to low tariff rates (about 3%). With the oil that was being used in shipping during the 2nd quarter of 2008, the equivalent tariff rate was around 9% and rising (until the bubble burst).

Why Oil Prices Rise Or Fall

IEA Outlook Stresses Increased Output

According to the IEA, global output of crude needs to increase significantly in 2011 in order to meet faster-than-expected oil demand growth. In its January report, the IEA increased estimated demand for 2010 and 2011 by 320,00 barrels/day. As of January 2011, the IEA predicts a rise in demand of 1.4 million barrels a day in 2011 compared to estimated 2010 levels.

The direct consequence of tighter oil supplies is higher crude prices; a consequence the IEA believes will stymie the global economy. According to the IEA, if oil prices reach and remain at $100/barrel in 2011, global expenditures have the potential of rising to 5% of GDP, a level associated with economic problems in the past. The IEA plans to pressure OPEC to lift its production ceiling as a result of these findings, but OPEC has disagreed with the IEA’s predictions. While the IEA believes that global inventories are not sufficient to meet demand without an increase in production levels, OPEC believes the IEA’s estimates of inventories are incorrect and does not expect as drastic an increase in demand relative to supply as the IEA does. Nevertheless, global production levels have the potential of being crucial to the price stability of crude oil in 2011.

Supply Shocks

Production Cuts

The global oil supply is dependent on the ability of oil companies to produce and the willingness of oil-exporting countries to export. Historically, periods of oil price spikes have been caused by oil-exporting countries placing embargoes on certain countries. In 1973, for example, the world’s largest oil cartel, OPEC, placed an embargo on oil exports to the Netherlands and the United States, in response to the countries’ support of Israel in the Yom Kippur War; the price of oil acquired by refiners increased by approximately 100%, and the U.S. experienced widespread shortages. In 2007, however, despite a 57% increase in prices, the amount of oil exported by the world’s top exporters fell 2.5%. Demand for oil in the world’s six largest exporters (Saudi Arabia, United Arab Emirates, Iran, Kuwait, Iraq and Qatar) increased by more than 300,000 barrels, while their exports fell by over half a million barrels. In this case, growing demand in each company acted as a natural embargo, forcing them to meet their own needs before exporting to the rest of the world.

Violence Against Producers

Violence in unstable regions can cause oil prices to be volatile because of geopolitical events affecting the ability of upstream oil companies to produce. Terrorist and political attacks can damage drilling rigs or the transportation and refining networks — including pipelines, shipping facilities, and refineries — that bring oil from where it is extracted to the consumer. During the spring of 2008, for example, Nigerian rebels initiated attacks on the oil majors’ pipelines and deepwater drilling rigs in the country. Despite the fact that OPEC’s lead producer, Saudi Arabia, announced it would increase production by 2%, a rebel attack on one of Shell’s deepwater rigs sent prices to $136.

Transportation Bottlenecks

When there are problems with the pipelines that transport oil, it can’t get to market; this effectively reduces the supply of crude oil to the world’s refiners, causing the supply of refined products to fall. When supplies fall, prices rise. On March 28th, 2008, the day after the bombing of one of Iraq’s primary export charges, Brent crude rose on the London exchange by $1.01.

Peak Oil And Declining Production?

Peak oil refers to a “peak” on the graph of global oil production. But, is Peak Oil a fact? Has oil already peaked in the USA and more than 50 other oil producing countries? Is oil a finite supply? There is evidence for both ‘yes’ and ‘no’. It is important to do out of the box thinking on this subject matter.

U.S. Dollar Value Fluctuations Cause Positive Feedback on the Price of Oil

The United States imports much of its oil, and that oil is purchased abroad in U.S. dollars. The price of oil, in fact, is pegged to the dollar. The changing value of the dollar in comparison to other currencies impacts the price paid by end users. A strong dollar means a lower price, in dollars, for oil, and a weak dollar means more dollars must be spent to purchase the same amount of oil. Currency fluctuations are complex (for a more complete discussion see currency fluctuations) but the value of a currency is impacted by the relative value of goods imported and exported by an economy (known as the trade balance), its interest rates, the size of its national debt, and its economic growth.

Speculation

Some analysts believe that oil prices are at record highs because of speculation about the future value of oil. Specifically, these analysts claim that the belief that oil supply is lower than it is and the belief that future oil supply will be just as low has led traders to inflate the prices of oil futures. When oil futures are traded, oil purchasers, like refiners, try to buy oil at prices that will benefit their margins in both the short and long term. If it is believed that oil prices will rise in the future (indicated by futures prices being higher than present prices), purchasers will want to stock up on oil at lower prices today and put it in inventory; this drives up demand for crude in the present, forcing oil prices up in the present. Thus, high prices for oil futures leads to high prices for oil in the present.

OPEC believes that record fuel prices are not a function of supply and demand, but a function of Western government policy and rampant speculation, and has used this belief as an excuse not to raise production by the amounts demanded by the West. While much of the data shows that production has been slowing, it’s likely that speculation could account for some of the present price spikes.

When oil prices closed at record highs for five days in a row during the week of May 5th, 2008, a House of Representatives committee announced an investigation regarding the role of hedge funds and investment banks in pushing up prices. In June 2008, the U.S. commodities futures regulator announced new rules requiring daily large trader reports, and position and accountability limits for foreign crude contracts traded in the U.S.

Contango Causes Some Oil Price Volatility

In early March, 2009, an April 2009 oil delivery contract traded for $38.10, while an April 2010 contract traded for $50.26, making it $12.16 more profitable for oil companies to hold onto their oil until April 2010. When the future price of a commodity (e.g. oil) is higher than its present price, a situation known as “contango”, it is more profitable for a commodities producer (e.g. XOM) to store the commodity and sell it at a later date. This causes oil price volatility through various channels: for example, storage of a commodity causes supply to be reduced in the present, raising spot prices, while expectations regarding future supply increase – thereby reversing the cycle, which then causes contango all over again. The wider the spread between the present price and a future price, the heavier the contango and the heavier the volatility.

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