PADDed History III

cont from PADDed History II…

The question of the Stagflationary Seventies is really to answer this conundrum:

Although the embargo led to a mere 5% decrease in world oil supply and effectively lasted only 2 months, although it officially ended in March 1974, crude oil prices increased fourfold during that period. A 5% decrease in the world oil supply does not justify a fourfold increase in oil prices. Theory predicts that oil prices will return to their original levels at the end of an embargo. After the 1973 embargo, oil prices remained at their postembargo level.

Coupled with the fact that the Arabs failed to get any traction when they embargoed the world twice before, in 1956 and 1967, a depiction of oil prices…

…and the story of the end of the system of fixed exchange paints the entire picture:

There was hope that the Smithsonian currency alignment in December 1971 would work for some time.  The U.S. dollar gained strength in the second half of 1972.  Unfortunately, after a heavy speculative attack on the dollar it was suddenly devalued on 12 February 1973 for the second time after World War Two.  This time, it was devalued by 10 percent, as the official price of gold was increased from US$38 per oz fine to US$42.22.  Soon after the second devaluation, there was another heavy speculative attack on the dollar so much so that foreign exchange markets all over the world had to be closed from 2 March for seventeen days.  When the exchange markets were reopened, the major currencies of the world including the US dollar,  Deutsch Mark, Japanese Yen, Pound Sterling, French Franc, Dutch Guilder etc. were all floating.  The world was now in a floating exchange rate system  as a revolt against the IMF fixed exchange rate system.

Oil clearly had been dictated through long-running price controls prior to the death of Bretton Woods on 19 March 1973.  Bretton had absorbed the vast majority of the shock in 1956 and 1967, rendering the Arab oil weapon inoperable.  The larger issue appears that Bretton had been absorbing ALL supply and/or demand shocks over its 29 year existence, leading to a nasty backlash when the system of fixed exchange collapsed. 

But the lasting effects of price controls would not be felt on the oil industry until the following decade.

The Last 35 Years

The system encountered its sea change in 1981:

In early 1981, the U.S. Government responded to the oil crisis of 1978-1980 by removing price and allocation controls on the oil industry. For the first time since the early 1970s, market forces replaced regulatory programs and domestic crude oil prices were allowed to rise to a market-clearing level. Decontrol also set the stage for the relaxation of export restrictions on petroleum products.

Soon after deregulation, many small refineries and older, inefficient plants could no longer compete and were forced to shut down. Between the beginning of 1981 and 1985, the number of refineries operating in the United States declined by 101 to 223, and operable crude oil distillation capacity fell 3.0 million barrels per day to 15.7 million barrels per day.

The loss of so many small, low-conversion refineries, which were a large source of unfinished oils, sent many sophisticated refiners overseas for intermediate oil supplies. From 1980, the last full year of price and allocation controls, to 1981, imports of unfinished oils more than doubled, jumping from 55,000 barrels per day to 112,000 barrels per day. Unfinished oils imports continued to rise and in 1993, peaked at 491,000 barrels per day. In 2000, the United States imported an average of 274,000 barrels per day of unfinished oils.

With fewer refineries in operation, refinery utilization increased between 1981 and 1985 despite the lower overall level of refinery inputs over this period. Since 1985, distillation capacity has remained fairly stable and changes in refinery inputs, not distillation capacity, have been the primary cause of changing utilization rates.

Decontrol of crude oil prices allowed producers to raise prices to the market-clearing level for the first time since the early 1970s, and domestic crude oil prices became more closely aligned with foreign crude oil prices. The production sector responded by increasing crude oil exploration and production in the Lower 48 States during the first half of the 1980s. However, sharply falling oil prices in 1986 reversed this upward trend in domestic exploration and production.

Increases in Alaskan North Slope (ANS) production during this period aided the domestic crude oil situation. This helped to stem the flow of imported crude oil, greatly reducing U.S. reliance on OPEC crude oil. Imports remained low until crude oil prices collapsed in 1986.

On balance, the effects of Reagan’s decontrolling oil seem to be positive at first glance, but the consequences of cutting 22 years of direct government subsidy to the refining sector have actually been horrifying:

The domestic oil refining industry has become much more efficient since the deregulation of oil and gas prices.  From 1959 to 1981, the federal government subsidized smaller refineries with quotas and preferred access to imported oil.  When the subsidies were abolished in 1981, these refineries shut down. As a result:

• The number of refineries fell from 324 in 1981 to 223 in 1985, and domestic refining capacity dropped by almost three million barrels per day (b/d).
• By 2006 the number of U.S. refineries had slipped to 149.

Total refining capacity fell as small refineries closed, but the capacity of the remaining refineries has grown due to expansions and improvements in efficiency. For example, due to efficiency improvements refineries that operated at 78 percent of their maximum capacity in the 1980s, on the average, have produced more than 90 percent of their potential output since 1993. However, higher utilization rates increase the seasonal volatility of gasoline prices.  Refineries cannot pick up the slack caused by shortages which arise when capacity is taken off-line because of maintenance or natural disaster. Thus, outages cause supply to fall and prices to rise.  In the summer of 2007, for example, the loss of output from two refineries led to a gasoline price increase of 24 cents in the Midwest.

Unfortunately, for reasons discussed below, the older, inefficient plants were not replaced with new, more efficient plants, and the increased capacity and efficiency gains at existing plants have not kept pace with growing demand. As a result, over the past few decades the United States has increased imports of gasoline refined in other countries. The Federal Trade Commission notes that from 1992 to 2004, the U.S. annual average of weekly gasoline imports more than doubled from 4.7 percent to 9.7 percent of gasoline used.

Gasoline demand has increasingly outstripped domestic supply:

• In 1981, the 18.6 million barrels per day (b/d) capacity of U.S. refineries exceeded the nation’s daily consumption of slightly more than 16 million barrels. 
• Between 1981 and 2005, U.S. oil consumption grew 29.7 percent to nearly 21 million b/d.
• But refinery capacity in 2005 was 17.1 million b/d — 8.1 percent less than in 1981.

The gap between refinery capacity and consumption is expected to grow [see Figure I]. The Energy Information Agency estimates consumption will increase 19.2 percent to 24.8 million b/d by 2020.  Refinery capacity will rise only 9.4 percent. This means refining capacity will only be 100,000 barrels a day more in 2020 than it was in 1981.

Some (such as D. Sean Shurtleff and H. Sterling Burnett who wrote the above entry in 2007) argue the issue of the contracting oil refinery sector is rooted in environmental regulation, but that ignores the fact that this problem is one of history repeating itself:

Table 3: the US Refinery Capacity VS the US Consumption, 1965-1974

Source: EIA, table 5.9 “Refinery Capacity and Utilization”, for consumption data: BP Statistical Review of World Energy 2010 “Oil Consumption”.

As the European countries pointed out in the report by GAO in 1973, they were the ones that had to export refined oil (like gasoline) to the US because the US did not have enough refineries to process it autonomously. Now, looking at Table 3 above, one can clearly note how the US oil refineries are processing less of the US oil consumption each year. Even prior to and during the 1967 embargo the US had to import gasoline. Thus, US vulnerability to an oil disruption is clearly connected to its refining capacity. Had the US built more refineries before 1973-74, it would not have had to import gasoline or other refined oil products that were needed in Europe during the crisis as well. This becomes apparent when looking at the gap between the US oil demand and oil refining capacity in 1973. A simple conclusion is that the US could clearly have diminished its vulnerability to an oil disruption, particularly in 1973-74, by building more refineries instead of importing more oil.

The Air Pollution Control Act of 1955, Clean Air Act of 1963, Motor Vehicle Pollution Control Act of 1965, Air Quality Act of 1967 and the creation of the EPA in 1970 never precluded increasing refinery capacity markedly during the 1970s; as opposed to an argument that government forces were actively destroying refining capacity for three decades after Reagan took office?  After refinery subsidies had been withdrawn by the god of the Republican Party?

Governmental interference is not stymieing oil refinery construction; prior to 1981 it was actively preventing a contraction in the sector.  Fortunately the U.S. has returned to the net exporter category for petroleum products (everything except crude oil) since 2011 but this has everything to do with Americans consuming less refined fuels than their pre-2008 counterparts (2015 was the first time refineries had greater capacity than the 1982 baseline when the EIA started taking note).  The contraction of the oil refinery sector continues, with only 137 refineries still operational as of 1 January 2015 (January 2016 will not be available until July).

The issue is simple–oil refineries are the industry’s bottleneck.  All crude oil must pass through a refinery prior to consumer consumption, but the financial markets act like the bottleneck is at the wellhead.  The planet is in the midst of an unprecedented oil glut, and Reuters is feeding bullshit to its readers:

World oil markets quietly breached an important barrier as they crashed nearly 30 percent to below $30 a barrel in the opening weeks of 2016, crossing the fuzzy line separating a rational response to fundamentals from an irrational fear where the only way forward is down, down, down.

Animal spirits have taken over the futures markets of New York and London, with momentum-driven algorithmic traders and big hedge funds driving oil prices far beyond the point that even once-bearish analysts say is justified – at least in the medium-term – by supply and demand.

That marks a change from most of the past 18 months, when oil’s long descent from $100 a barrel was broadly viewed as an often painful, sometimes lumpy adjustment to a fundamentally “new normal” in which OPEC would no longer restrain its supply, leaving U.S. shale drillers to balance the market.

The process has taken far longer than expected as shale firms proved remarkably agile, slashing costs and drilling in sweet spots to keep the oil flowing. As they did so, prices lurched lower, first in the summer and again this month.

But now things have gone too far, many say. Data due on Friday are likely to show that big funds and speculators in the U.S. oil market added to short positions that had doubled to a record 200 million barrels over the past three months.

“The price itself is irrational if you ask me,” Khalid al-Falih, the new chairman of the Saudi state oil company Aramco and one of the Kingdom’s most influential energy figures, said at the World Economic Forum annual meeting in Davos.

“Prices are supposed to be set by the marginal barrel. The marginal barrel is certainly way higher than $30 a barrel.”

No, it isn’t irrational and prices cannot be set by the marginal barrel of crude oil as understood by oil company executives under the circumstances.  Refineries are inundated with more crude oil than they can possibly process, and the demand for refined fuel products is dropping as it typically does in January after the Christmas holiday.  If oil stockpiled in Cushing and on oil tankers at sea continues to grow, crude oil prices should continue to drop.  That is how supply and demand actually functions in reality (as opposed to the floors of mercantile exchanges).

This leads the the largest conundrum of all: why isn’t the glut easing?