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Seven Secrets About U.S. Oil Prices

Aug 27, 2015

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SMITH BRAIN TRUST -- U.S. oil prices have dropped to six-year lows, and the main reason is no secret. “The world is currently oversupplied,” says Charles E. Olson, a professor of the practice at the University of Maryland’s Robert H. Smith School of Business. “After years of declining production, we entered a new boom around 2008 when companies started using fracking technology to extract oil.” Other realities are less obvious, such as why companies keep pumping oil when stockpiles are full — or why gasoline prices vary so much across the United States. Olson shares seven keys for making sense of recent headlines.

1. What happens in the U.S. stays in the U.S.

Light crude from the United States is largely the same as Brent, the global benchmark produced in the North Sea. But prices tend to vary. The difference on Wednesday was more than $4 per barrel ($38.60 on the New York Mercantile Exchange compared to $43.14 for Brent).

Olson says the main reason is a U.S. law that dates to an era when policymakers worried about shortages. “We can’t export crude,” Olson says. “That’s an artifact of the 1970s. If we could ship it, these things would equalize because we would send more out. There would be less supply in the United States, so prices would rise here and fall there.”

2. Natural gas provides an edge

That does not mean all domestic crude stays within U.S. borders. Companies have permission to export refined products such as gasoline, which makes economic sense despite the added transportation costs. This is partly due to cheap natural gas available in the United States. “We can refine oil more cheaply here because natural gas is a major input into refining,” Olson says.

More recently, companies also have been able to exchange light U.S. crude for heavy Mexican crude, which requires a costlier refinement process. “They’re not swapping barrel for barrel,” Olson says. “They’re swapping at different prices.” The arrangement suggests that U.S. policymakers might soften their stance in other ways. “They’re working in that direction,” Olson says.

3. Crude is only as good as your refinery 

Crude oil is valuable, but only if you own a refinery. Nobody else wants the messy black goop until it comes out the other side as gasoline, diesel, jet fuel or petrochemicals. This explains why refineries do well when oilfields suffer. “Relative winners within the energy sector are refining companies such as Philipps 66 or Valero,” Olson says. “They’re getting their input cheaper, and people will buy more gasoline because it’s cheaper.”

Consumers quickly realize how important refineries are when things go wrong. Exxon Mobil had a recent disaster at its refinery in Torrance, Calif., which raised prices in that region. And BP suffered an outage at its overworked refinery in Whiting, Ind., which impacted Chicago. Importing refined products from other markets is expensive without pipelines already in place, so supplies typically take a hit. “There’s a transportation cost,” Olson says, “and that pushes up the price.”

4. Some voters choose to pay more

Other factors affect regional prices beyond crude oil supplies and access to pipelines and refineries. Tax rates and environmental policies also contribute to wide disparity across the United States. On Aug. 27, 2015, for example, GasBuddy.com reported a low of $1.82 per gallon in Rock Hill, S.C., and a high of $5.03 per gallon in South San Francisco. “California has strict air quality requirements,” Olson says. “They won’t allow gasoline to be sold if it doesn’t meet certain specifications, which contributes to shortages.”

5. There’s a price war going on

Even as profit margins shrink, Olson says some multinational companies will continue pumping to meet their bank obligations. “Some have borrowed a lot, and they have to pump every barrel they can to pay the interest on the debt,” he says.

National oil companies have their own strategies. Olson says Saudi Arabia is running a budget deficit as oil prices fall, but the country will keep pumping as part of a strategy to undercut U.S. frackers. “Saudi Arabia is fighting a defensive war, and they’ve got the money to do it,” Olson says. “They carefully had saved and invested in U.S. treasuries, and they have quite a war chest.”

Other global players have struggled to keep up. “It’s killing Russia,” Olson says. “They are very dependent on oil and natural gas exports.”

6. Costs keep shrinking

Logic would dictate that at some point, exploration and extraction companies will hit a wall when it's no longer cost effective to pump. This already has happened to some degree. “There are marginal producers,” Olson says. “There is presumably oil not being produced today because incrementally it costs more than $45 per barrel.”

But something else has happened at the same time. Improvements with technology and business processes have allowed some companies to extend their production. “As prices have dropped, producers have become more efficient,” Olson says. “They’ve found ways to do things using less in the way of resources.”

7. Industry takes two paths

Another factor is the way multinational companies choose to divide their operations. Some companies, such as Conoco Phillips, have split their upstream and downstream businesses — so one side focuses on exploration and extraction while the other side focuses on refining and marketing. “This feeds back to what we teach in business school,” Olson says. “For the most part, the view is that you should focus on what you’re best at.”

Other companies, such as Chevron and Exxon Mobil, have taken a more integrated approach. “They follow the theory that says you should diversify your risk,” Olson says. As a result of the alternative strategies, predicting the industry’s overall performance remains tricky.

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