The Crude Paradox

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I will gladly pay you Tuesday for a Supertanker today

One of the key drivers of business success is to effectively implement an optimal pricing strategy.  The idea here is that, as you raise the price, your profits increase, but your volume starts to decrease.  At some point the lines on the graph cross, and that's your optimal price - a structure that doesn't maximize unit volume or even, necessarily revenues, but profits.  Arriving at this number is challenging, and is often an iterative process as current data becomes available.  But it's a particularly fascinating exercise when applied to crude oil, where you have a unique convergence of political, technological, social and societal concerns, many times being weighed or calculated differently for the various crude exporters.

The simple math suggests that at a given volume, a higher price results in more revenue flows, and after consideration of extraction costs, more profits.  There is, of course, the always-present concern that, at some price point, sales volumes flatten and begin to decline, but since so much oil is used for day-to-day transportation requirements, volumes can tend to be a little stickier than with other commodities.  It's not, after all, as if people can simply NOT go to work or airlines can NOT fly, and in much of the west we have built our communities around the central organizing principle of cheap oil for transportation.  Thus we find ourselves with a level of dependency that reacts to price fluctuations with limited flexibility.

But the oil business in 2012 is very different from other commodities, and as a result is struggling to find an optimal pricing level.  First there is the challenge of increasing demand, particularly in the developing nations with very large populations.  The oil exporting countries find themselves in a situation where any event that reduces supply has a disproportionate effect on crude prices, as supply dips dangerously close to demand.  Government instability and outright conflict in the Gulf region, supply disruptions in Africa and Latin America and failures of production and refining infrastructure all serve to limit the pricing flexibility of the producing countries.

That condition leads to a second problem of supply constraints.  In a weak global economy, the oil exporters have no real problem meeting demand, provided some major external event doesn't significantly reduce daily production levels.  But whenever the economy of the US, the EU and the Asian nations begins to heat up, GDP growth increases demand and, with very little excess production capacity available, prices immediately begin to rise.  In fairly short order, the rising energy costs consume the available capital that would otherwise be used for investment and growth and the economic growth slumps once again.  This energy/economy 'yo-yo' effect will unfortunately be an increasing challenge to boosting global economic growth as long as oil represents a key energy source.

A key political feature of many oil exporting nations is that they are not democracies.  When despotic leaders don't have to fear their ouster at the ballot box, their remaining fear is popular revolution.  What these monarchies and dictatorships have available, however, is wealth, and they typically appease their otherwise restless population by spreading some of the oil wealth around, in the form of infrastructure, subsidized prices and even direct income supports.  As the so-called "Arab Spring" has roiled the political stability of oil-producing regions like the Middle East and North Africa, surviving rulers have felt it necessary to increase these payments in the face of popular anger and dissatisfaction. These increased government outlays have put significant upward pressure on crude prices, to the point where the major producers such as Saudi Arabia consider $85.00/bbl to be a hard price floor, and will act to reduce supply to prevent the price from falling below that.

But here's where it gets interesting.  All these conditions serve to keep the price of crude oil exports high, which is a short-term benefit to oil producers in general.  Certainly, at times of extremely high prices, consumers will work to reduce consumption, but that reduction is more than offset by the higher prices themselves.  But in the longer term, the greatest threat to the economic health of oil exporting nations is alternative fuels.  Due to the way global economies have traditionally chosen to price fossil fuels, however, alternatives, including using electricity instead of internal combustion for transportation, have been markedly more expensive to implement and use.  But of course, as the price of crude rises, these alternatives become not just more economically viable, but attractive for their stability and predictability over time.  So the oil exporters, particularly the OPEC cartel, needs to keep the price below a threshold that would cause competition from non-traditional oil sources (tar sands, fracking etc.), wind, solar and other solutions (electric cars, distributed generation etc.) to begin to eat into their oil shipments.  Unlike other cyclical changes, these changes in energy sources are permanent, and with rising global concerns around carbon pollution and climate change, there will not be any real opportunity for the oil exporters to recapture that lost market share.

The result of all these conflicting conditions is an oil market that is ripe for turmoil.  There more stable nations, such as Saudi Arabia, are trying to think the process through and strategically manage the pricing decisions in order to optimize national income over the long term, while unstable and damaged nations like Iraq, Iran and Nigeria seek to maximize their near - term revenue streams.  And the fact that, in the face of increasing climate distress, rising temperatures, dying forests, wildfires and mega-storms, we as a species cannot find a way to address the cause of these very serious problems indicates that we will not allow mere concerns about our survival to impact our oil consumption, it's going to be a long-term balancing act for the producers to try to keep prices withing this narrow "sweet spot".  And ultimately, they can only manage the margins.  There will be occasional massive shocks, wars or revolutions or geo-political realignments that are entirely beyond the control of the oil companies, and those are the events that will cause the largest, fastest price changes.

Obviously, the intelligent thing for oil consuming nations is to set a price floor for fossil fuel products so that prices at the crude level would have no effect "at the pump", and use that difference in revenue to develop and deploy alternative solutions that are not subject to the vagaries of global events and the impulsive decisions of aging despots.  With the twin imperatives of economic growth and stability and carbon-based climate change, there would seem to be no other path to follow, and it would not require any real debate or political courage to move swiftly in that direction.  But if we've learned anything from post-industrial revolution history, it's that western governments are corporate entities, and they make decisions based upon the desires of the corporate community, and the corporate community is not interested in matters of human survival, or even well being, unless they can profit from it...
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