Low Gas Prices

If you are anything like me, you are probably appreciating the current low gas prices.  It feels good to pull up to the pump at Costco and see that gas prices for 87 octane is only $2.16/gallon! Especially when you drive a gas guzzler that drinks 26 gallons of fuel at each fill up.

Low gas prices are derived mostly from low oil prices. It is said that crude oil makes up about 65-70 percent of the cost for gasoline. Interestingly enough, crude oil is nothing more than a commodity that fluctuates in price based on traders bidding on futures contracts. The majority of these traders are representatives from businesses that need the oil. They bid on the oil and actually have it delivered. It is purchased now at a fixed price for a future date.  Others are just commodities traders trying to make a buck on the spread. So depending on what these traders believe the oil is worth in the future, crude prices could go up or down.

I definitely enjoy the low gas prices at the pump, but are there adverse consequences to these low oil prices?  Can oil drillers survive? Will OPEC have to limit oil production to keep the price per barrel from falling to low?


Dr. Tufte said...

Hank Hill: 100/100

Actually, there's a lot more to it than "traders bidding on futures contracts".

The cost of crude oil is the main component of the price of everything made out of it: gasoline, other fuels, lubricants, solvents, plastics, and so on. Refining is the other big component of the final price. Shipping costs are a very small part of the whole. And, for gasoline at the retail pump, profit margin is not a very big component either.

An additional consideration for gasoline is the costs of modifying the gasoline to meet pollution requirements. The main cost here is not necessarily that those modifications have high variable (and marginal) costs, but that there are big fixed costs to retooling refineries. Refineries do runs of one type of input, leading to the same proportion and set of outputs. They try to do these runs for as long as possible: every time the input or output mix changes substantially, the refinery needs to be retooled for days or weeks. That's a big fixed cost that gets spread out over each subsequent unit sold.

The main determinant of the price of crude oil is whether the stuff is coming out of the ground faster than it can be refined and sold. The oil industry has a huge number of wells that individually don't produce very much. In conventional wells, there is not too much control over how fast or slow the oil comes out. But, once it's out, it has to be stored or refined. There are many storage tanks and refineries. But if they have all the oil they need, the price of the stuff coming out of the ground is driven down. What we experienced a year or two ago, and still benefit from is that the demand for oil is actually fairly inelastic: shift supply to the right, and the price goes down drastically. Basically, storage tanks are full everywhere, refineries are processing as fast as they can, and therefore the price of anything new coming out of the ground is not high.

Of course, the reason that oil and gas prices have been high for most of the last 15 years is that supply has shifted to the left. The same inelasticity that led to price drops the last few years, led to price increases before. Both of those tie back to our limited storage and refinery capacity.

What we are really unsure about is how supply will work with so much horizontal drilling and fracking going on. Horizontal drilling allows for individual wells that, when successful, have much larger potential production. Fracking allows the flow of oil to be "turned on" or "turned off" by whether you actively frack or not. This alleviates the dependence of prices on available above ground storage capacity. Part of the reason that supply shifted right a couple of years ago was that free entry into horizontal drilling and fracking in the U.S. increased the number of producers (and pushed down economic profits).

What we all wonder is, that if demand keeps rising steadily, and eventually we begin to have oil stockpiles in tanks declining, will horizontal drillers and frackers be able to quickly shift supply to maintain low prices.

CChilds said...

This topic reminds me of a gripe I hear from my husband ALL the time. According to him, diesel fuel is a by-product of producing gasoline and, historically, has been cheaper to buy than gasoline. That is no longer the case. Diesel fuel fluctuates on its own cycle and, until recently, has typically been more expensive than gasoline, sometimes by a large amount. Using his reasoning, diesel fuel is less expensive to produce, so should be less expensive to buy. He has a couple holes in this reasoning that I can see. The first relates to demand. I would expect the demand for diesel fuel to be quite different than gasoline considering I suspect most diesel fuel is a marginal cost for business consumers rather than a product for retail consumers. More importantly, I think he is mistaken in his view that diesel fuel is still a by-product. You mentioned costs due to modification of fuels because of pollution requirements and I think this is certainly the case here. There have been several modifications to diesel fuel starting in 2005 that would require more processing to produce then a simple by-product would have.

Dr. Tufte said...

CChilds: 50/50

There's lots of issues here, but I'll admit that I've been perplexed from time to time about the pricing of diesel fuel. Anyway, here's some random thoughts.

I don't know that it's correct to say, from a technical standpoint, that diesel fuel is a byproduct of producing gasoline. They're both outputs of oil refining. For the most part, I think you get what you get.

Even if diesel is a byproduct, most people get the economics of that wrong. A byproduct is an opportunity cost of producing the gasoline. This means its presence increases the cost of gasoline: you know ... what the heck are we going to do with all this other stuff now? Finding a way to sell it as diesel actually reduces the marginal cost of gasoline by distributing some of its opportunity costs to other products.

Diesel does seem to fluctuate on its own cycle, and it seems to me that this is a phenomenon of the last 10-20 years.

I find the whole argument that diesel is cheaper to produce specious. How cheap or expensive anything is to produce depends a lot on where you sit on your cost curves. I can't imagine that they'd be much different for gasoline and diesel, so scale would be an important determinant of where you sit on them.

An additional difficulty is that the fraction of crude oil that refines into each product is fairly constant across the class of crude used as the feedstock. So if a refinery is geared to process West Texas Intermediate, producing gas and diesel in roughly constant proportions (making their supplies inelastic), then a shift in demand away from gas towards diesel will make the price of the one fall and the other rise. This would be fairly persistent because it's expensive to retool refineries to process different types of crude. My guess is that a big explanation of the higher price of diesel over the last decade has been these more efficient and clean diesel engines in European cars (yes, the same ones that VW was cheating with).

I don't know the extent of new-ish requirements for cleaner refining of diesel. I do think it's useful to point students to the map of different gasoline blends required in the United States. Each of these can be viewed as increasing the average fixed costs of gasoline at the pump. I do not know of a similar map for diesel.