Who is to Blame for High Energy Prices?

As the price of crude reaches and surpasses $75 per barrel and gasoline exceeds $3 per gallon, one might be forgiven for looking for a scapegoat. And, indeed, in many political and media quarters, that is exactly what is taking place with blame being placed on oil companies and hedge funds for profiting from the current high prices and driving them higher. But, at the pain of repeating myself, let's examine the evidence and analyze what is really at work here.

Supply and Demand

One only needs to visit the OPEC, International Energy Agency or our own Energy Information Administration to come to the conclusion that demand and supply of crude oil and in regional markets, natural gas, are close to balance. Asian demand led primarily by China and India has continued to surprise on the upside and North American demand remains high. Talk of demand destruction to date seems to be just talk—there is little evidence of demand destruction simply because energy prices, even at such high levels, is still a much smaller component of overall family or national expenses than it was several years ago.

In examining the BP Statistical report of 2005¹ (for 2004) other trends become apparent. It reports that the world's reserves to production ratio fell to 40.5 years from 43.3 years in 2002. Although reserves continued to grow (17 percent higher than in 1994) production has grown even faster (20 percent). For natural gas, the numbers show the same trend (66.7 year reserve to production ratio, 28 percent increase in production since 1994 compared to a 26 percent reserve addition). With Chinese oil demand alone estimated to be growing at 600,000 to 1,000,000 b/d, one gets a good feel for the problem. In fact, the supply/demand balance is so sensitive that any global event that might be perceived as disrupting supply triggers another lift in prices. Geopolitical concerns today include Nigeria, Venezuela, Iran, Iraq and more besides and last year's hurricanes and concern over climate change factor in too. Finally, for us Americans, one must not forget the impact of the weaker dollar on prices, either.

On the supply side, there are also numerous issues to consider. While it is certainly true that oil companies have dramatically increased their E&P budgets this year, and that there are many good opportunities at these price levels for smaller E&P companies and entrepreneurs including working over stripper wells, enhanced oil recovery and more, there is still a problem. That is, people with skills and equipment. Everyone has been caught off guard by the sudden jump in oil prices and there simply aren't enough rigs, skills and equipment to satisfy the demand. Further, OPEC really can't do much more now to bring new production to market and has to be content with only having an ability to set a floor for prices. In other words, there is no quick fix to the situation available. At any rate, after two decades of returning money to shareholders and laying off skilled workers, the oil companies face a challenge in spending their newly re-invigorated capital budgets. Even under different circumstances, if they could spend the money there would still be a significant lag time to new production.

However, there are some signs of light on the horizon. There were new projects in the pipe including in West Africa, the Gulf of Mexico and elsewhere that are bringing new production to market or will be in the coming months. Syncrude production from Canada is also increasing. The problem remains that this new production does nothing more than cover new demand thus maintaining supply tightness.

The energy issues we are experiencing today don't stop with oil and gas. In Texas this last week, high temperatures and demand has resulted in rolling blackouts showing that in various regions there are electric power issues too. There have also been gasoline shortages in parts of the United States this last week and that doesn't bode well for gas prices at the onset of the summer driving season. The fact of the matter is that sustained lack of investment in our energy infrastructure is one root cause of our current energy woes.

So Are the Oil Companies and Hedge Funds to Blame?

The answer to that question is probably both yes and no. The oil companies get blamed for all sorts of things including not refining enough gasoline and stockpiling crude oil to drive prices higher and, of course, their "obscene profits." In reality, refining capacity is just about tapped out, especially when considering the seasonal formulation changes, hangover from last year's hurricanes and reformulated gasoline problems. Are they stockpiling oil? With a 20 million b/d gasoline habit at the peak of the summer driving season the answer to that question is no. Increases in crude oil stocks over the last several months when it has occurred has been only a fraction of a days supply! Are they deliberately not refining enough? Again, no. Refining capacity is tapped out and what oil company in their right mind wouldn't want to get more gas to market at these margins?

Where oil companies are to be blamed is that they have pandered to Wall Street and not invested enough on a continuous basis in their business activities preferring to profit from existing reserves and holding up their shares prices by giving cash to shareholders. Something that they are in some instances still doing. But, who can blame them? Hindsight is 20/20 and the captains of the oil industry where doing what they believed was in the best interest of their shareholders.

What about the hedge funds? Can blame be placed there? Well, it is true that there are a growing number of hedge funds trading energy commodities—perhaps 130 up from 10 several years ago, but how much money do they really wield in these markets. The Energy Hedge Fund Center² has estimated that figure as maybe $60 billion which, even with leverage, is frankly a drop in the ocean compared to the size of these markets. There have been a number of studies performed by the CFTC, NYMEX and even UtiliPoint on their impact and all have come to the conclusion that hedge funds bring liquidity to the market, may impact volatility but hardly impact prices. In truth, it is hard to measure their impact on price for two reasons: 1) Many funds trade through the banks, and 2) It is difficult to define a "hedge fund" and no one yet has had a hedge fund classify itself as such for the purposes of activity measurement. However, the fact remains that hedge funds are just one type of player in these markets and other non-commercial companies such as Commodity Trading Advisors and other entities play as big if not bigger role.

So Who is to blame?

My own view is that we all are to blame for our energy issues today. All of us have developed bad habits as a result of the relative cheap nature of energy. We have become energy hogs! However, is it really our fault? After all, we were conditioned to be the way we are. For my part, I blame the politicians who are so quick to blame everyone else and took years to deliver an energy bill that was full of pork and little real substance.

In reality, blame is easy to hand out as a cover for our own deficiencies. The fact is that there has been a demand-side surprise that has caught us all off guard. Our past and current habits have caught up with us finally and now we need to address the problem. So what can be done? Things we can all do are as follows:

1. Let's get the politicians to address the issue through raising the CAFÉ standards for vehicles upwards, encouraging them to break down barriers to distributed energy, work to put in place a carbon market with Federal mandate, engage in an efficiency campaign and encourage alternative sources of energy.
2. Consider our own energy habits and looking for efficiencies. Drive the smaller car to work, switch out lights and appliances not in use, bicycle on short journeys and look into efficiency improvements to our homes.

Ironically, I looked into some initiatives of my own just recently such as roof solar panels. But local red tape stops me from supplying my own power, not just in terms of local building appearance standards, but in being able to get a credit from the local utility for supplying them with excess power. Meanwhile, North Sea Brent last week was posting higher prices than WTI—something highly unusual and pointing to even higher prices.

I had lunch last week with a friend with perhaps too much time on his hands to think. He suggested that it is time for the government to start a new initiative such as the Los Alamos initiative of several decades ago. Put 200 of our best brains together with the resources they need and mandate them to come up with new technologies to leapfrog out of the fossil fuel age, he suggested. Not a bad idea….