What's the Real Price?
How much is a barrel of oil these days? Depends on which price you consider the real price?
Since the start of the Iran war I have been one of the voices in the choir of higher oil prices. It never made any sense to me, nor to many other pundits and analysts that oil prices are as relatively low as they are; at the time of writing a barrel of brent crude is $88, while expectations for oil prices under a prolonged shut down of the Strait of Hormuz usually fell somewhere between $150 and $200. I have been consistently wrong along with those pundits and analysts, and many barrels of ink have been consumed in the search for why we were wrong. As detailed on the blog previously, in my infinite humility, I’ve argued that the explanation for this discrepancy between how bad the supply shortage is versus how little that has affected prices is that the market is wrong and I’m right. The objective of this essay is to build on my previous, most pertinently by showing that the brent price and the price of refined products have diverged markedly, and to try to make sense of how and why this is so.
The best place to start is to introduce some evidence to support my claim that the price of brent crude is lower than what I’ll call the true oil price. Below are three charts, the first two are from BCA Research’s Iran War Tracker, and the third is from economist Paul Krugman’s Substack:
What these charts show is what is known as the crack spread, e.g. the difference between prices of crude oil and refined product. It is most often used as a gauge of oil refining capacity, as the supply of refining capacity drives the difference between crude and say diesel. As you can see, the crack spreads are at more or less all time highs, presumably driven by the increased price of refined products and the relatively low price of crude given the circumstances. It appears from the charts, and is supported by a couple of other sources (though I cannot vouch for the accuracy of macromicro.com, Freightwaves, or oilprice.com) that normal crack spreads run around $25.
Now, obviously refining is a complicated and technical process, and while I may be an amateur economist and amateur political commentator, I know little of hydrocarbon engineering, so I may be missing something here. That being said, the current price of crude plus the current diesel crack spreads minus $25 equals $163 (88 + 100 -25 = 163). And for petrol the same calculation comes to $148. To me, those figures sound much more realistic and reasonable almost six months into the largest disruption to the oil markets in history than $88.
There are legitimate reasons for why the crack spreads are so high. Ukraine has been bombing Russian refineries, and with much of the Persian Gulf’s refining capacity being trapped inside the double blockaded Strait of Hormuz there is much less refining capacity than normal available. Still, if you are a savvy capitalist this sounds like a profit making opportunity, right? Why let refineries pocket $100 per barrel of margin when they usually get $25 (a 4x increase in margins!)? Why not jack up the prices to refineries, which are pretty much the only companies who need crude rather than refined product, and thereby capture more of the profits for yourself? After all, the reason why end point, customer facing prices of petrol and diesel are so high is precisely because Hormuz is shut, creating a shortage of car and heavy machinery juice.
Tracing the demand for petrol and diesel up the production chain it is obvious that high prices for refined products should mean high prices for crude, as crude’s only use as an input is to be refined into fuels, plastics, or other hydrocarbon-based chemicals, and crude in itself has no uses. If there is a shortage of refined products creating a crack spread fully four times above the long-run average you would expect refineries to bid up oil prices. But this is not happening, why?
As I’ve written about in previous posts, it appears that oil traders face an asymmetric pay off curve. If a Trump tweet can send oil prices down $5-10 in 5 to 10 minutes, it is not worth the risk to be long oil. In a normal market for input goods this would not matter as prices are set by suppliers and refiners who actually use the good traded, but oil features a lot of trading of so-called paper oil, i.e. contracts which do not actually stipulate a requirement to deliver physical barrels of oil. Given how important oil is to the global economy this means that there are more people trading paper oil than real oil, so the price is not set by industrial market participants but by financial market participants.
This is the core of my argument that the oil market is broken: the financial price of the commodity is low while the price of the physical, industrial output is high resulting in unprecedented profit margins. This should not happen in a well functioning market.
Given that oil is exclusively priced in dollars (at least for now), and that the US has some of the biggest, most well capitalised, and most advanced financial institutions my guess is that a lot of the paper oil trading emanates from New York. To be clear, I am not alleging some dastardly conspiracy from the top where Trump has instructed oil traders to nefariously intervene to benefit him. Rather, these people have the same interests – to make money in their trades – and as psychologists have shown, the pain of a loss is always greater than the satisfaction of a commensurate gain, making oil traders naturally cautious. This caution manifests in their trades, and as paper oil is a bigger share of the market than physical oil, cautious financiers move the price down more than refineries move it up, resulting in massive margins for refiners. Essentially the price signal has been moved from the oil price to the crack spread.
This creates some problems given that crack spreads is a relatively niche industry measure whereas oil benchmarks are global statistics. Major sectors of the economy like airlines, chemicals, shippers, agriculture, and electricity generators all make plans for future investments based on oil prices. How much one should charge for a transatlantic flight depends a lot on who dear jet fuel is, which is of course a function of oil prices, and the same is true for a bushel of wheat, a standard shipping container, and a kilowatt hour. The reason why oil benchmarks like brent crude, West Texas intermediate, and Urals oil are useful is that they are supposed to inform about the price of petrol, kerosene, plastics, diesel, and bunker fuel all in one. But if oil is cheap while oil-derived usable products are expensive crude benchmarks cease to be useful.
If oil is ~$85 when the Strait of Hormuz is closed, then it might not make sense to invest in a new more fuel-efficient car engine, as milage will not be a key consideration for drivers in two years or whenever the new engine is finished; oil is relatively cheap now, imagine how much cheaper it will be when the Strait reopens! This is an example plucked from thin air, but you can imagine similar scenes playing out across the global economy. Executives, managers, and board members are not trained to be familiar with the difference between crack spreads and oil benchmark prices, as those differences have never been business relevant until now. As such the risks of malinvestments are very high when previously reliable price indicators have broken down.
Leaving climate issues aside, a clear negative externality from the breakdown of oil benchmarks is that fewer new wells are drilled than would otherwise be the case. The economics of pumping oil are worse than they should be for every company which does not have its own refining capabilities. If crack spreads were $25 then a lot of finnicky and relatively high-cost sources of oil would be viable businesses. The world could make up for the shortfall from the Persian Gulf through a combination of rationalisation of oil use and new oil pumps if the price at which you could sell a barrel of oil was closer to the price at which you can sell a barrel of diesel minus refinery costs.
Now, there are some upsides to the relatively low oil price too, at least from Washington’s perspective. It makes sure that US adversaries like Iran and Russia get less money than they would if crude prices were closer to the true price, which is a key concern for an administration which loves using economic sanctions and threats to try to achieve its political goals. But this too is a double-edged sword. Oil rich despots across the world may well take away the lesson that you cannot leave refining to actors abroad as they capture stratospheric margins in exactly the kind of crisis which would normally represent harvest season for a petro-regime.
In a previous post on oil I made the point that if important markets like the oil market are genuinely bad at their core function of price discovery, then we need to rethink the central idea in Western political economy since the 90’s: that price signals are key to structuring a well functioning economy, and society. But we also need to consider the inverse: what happens in an economy predicated on the efficacy and almost infallibility of price signals when prices diverge significantly from the logic of supply and demand?
To me, significant malinvestment seems a likely outcome, and the specific type of malinvestment is likely to be in an increase in refinery capacity, and a higher level of reliance on hydrocarbons than would otherwise be the case. That is bad from a climate point of view, but crucially also from a fossil fuels point of view. If oil prices had really spiked the way I and others predicted back in March, then the world would have made strides towards relying less on Gulf energy, lessening the power of the Strait of Hormuz in the long run. Those changes have not seemed as necessary as they truly are given the way in which oil prices have diverged from diesel prices.
If you liked this post you can read a previous post about Hormuz here or the rest of my writings here. I also have a section for longer reads I call essays here, I particularly recommend my series called The Bird & The Technoking exploring Elon Musk's takeover of Twitter, and its political and cultural implications. It'd mean a lot to me if you recommended the blog to a friend or coworker. Come back next Monday for a new post!
I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson
Sources:
Cover photo by Jack & Sue Drafahl from Pexels, edited by Karl Johansson
Kommentarer