A Short Crude History

It is hard to imagine any topic occupying the minds of investors and financial professionals to a greater extent these days than the price of oil… well, maybe the price of gold…oh, and the credit problems in the financial markets. OK – one of the items occupying the minds of investors and financial professionals these days, is the price of oil.

Fluctuations in the price of a barrel of oil have an obvious and immediate impact on the retail cost of refined goods such as gasoline and heating fuels, but oil prices impact other aspects of our lives as well. To get started, let’s review some oil basics before looking at the history of oil and the petroleum industry.

Crude Oil Types

All crude is not the same and market price is closely tied to the quality of the crude. Crude oil is usually referred to by its geographical location as the area where the crude was extracted impacts the composition of the crude. Oil is graded by its specific gravity and sulfur content, with “sweet” referring to crude with a sulfur content under 0.5% – anything higher is classed as “sour”.

“Weight” is used to describe the product and is usually classified as “light”, “intermediate”, or “heavy”. Crude oil weight refers to its viscosity (i.e. the thickness) and wax-content of the crude. The more wax the crude contains, the heavier the oil and the more difficult – and more expensive – it is to pump and transport. Lighter crudes with a lower wax content also render a higher percentage of gasoline than other crudes and for these reasons, refineries are willing to pay extra for lighter crudes.^[1]

Over the years, several benchmarks have been established to grade and price crude in the market. One of the most commonly-used benchmarks is “Brent Crude” – Brent is pumped from oil beds in the North Sea and is sold on the London International Petroleum Exchange (IPE) – Brent is used to price nearly two-thirds of the world’s crude even though other areas generate much greater volumes of oil.^[2]

While Brent Crude is the accepted benchmark for oil traded in London, in the U.S. West Texas Intermediate (WTI) is the most oft-quoted price benchmark. West Texas Intermediate is very high quality and produces a higher percentage of gasoline than most other crudes. It contains less than 0.24% sulfur making it the sweetest of the crude oil benchmarks. WTI usually trades at a premium of $1 to $5 dollars per barrel over other types of oil.^[3]

The last major classification of oil we will look at is referred to as the “Opec Basket”. This is a combination of the oil produced by the countries belonging to the Organization of Petroleum Exporting Countries (OPEC) and is the average price of the following crude oils:^[4]

• Saudi Arabia Light
• United Arab Emirate’s Dubai
• Nigeria’s Bonny Light
• Algeria’s Saharan Blend
• Indonesia’s Minas
• Venezuela’s Tia Juana Light
• Mexico’s Isthmus

The standard measure by which oil is sold in the market is a barrel. A barrel actually consists of forty-two gallons and while crude is no longer shipped in individual barrels, this measures still remains.

Products Derived From Oil

The crude oil refining process results in the production of a wide-range of retail goods. The type of crude oil being refined impacts the ratio of products created, but the following table provides a representative breakdown of the products typically derived from a barrel of crude:

Source: California Energy Commission website

History of OPEC and its Influence on the Price of Oil

OPEC – the Organization of the Petroleum Exporting Countries – was established in 1960 by the Five Founding Members consisting of Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Other oil-producing countries have subsequently joined including Qatar (1961), Indonesia and Libya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973), and Angola (2007).^[5]

OPEC was clearly designed to promote a unified front on the part of the producing nations as the balance of power at the time rested with the large multi-national refineries – the so-called “Seven Sisters”. These firms bought most of the crude produced by the OPEC nations and then distributed the refined products at a tremendous profit. The Seven Sisters consisted of the following firms:

• Exxon
• Mobil
• Chevron
• Texaco
• Gulf Oil
• Shell
• British Petroleum

Energy Crisis of the 1970s

During the early 1970s, OPEC’s growing ability to influence oil supplies and prices became apparent during the Arab-Israeli War (1973). As this conflict progressed, the Arab nations belonging to OPEC initiated an embargo and refused to export oil to countries they deemed to be supportive of Israel. The result was an unprecedented increase in the cost of oil products – most notably gasoline – throughout North America and much of Europe.

Around the same time as the embargo, negotiations to amend existing contracts with the refineries to form arrangements more favorable for the producing nations collapsed. Flexing its new-found muscle, OPEC responded by imposing strict production quotas on its members in a deliberate attempt to reduce global supplies and increase costs.^[6]

In the second half of the seventies, OPEC continued to assert its ability to influence prices and take even more control over the oil industry by further reducing quotas. World oil prices increased by 400% from 1973 to 1974 to nearly $30 a barrel and more than doubled again in 1979 during the Iranian Revolution.^[7]

Price Swings – 1980s and 90s

While OPEC was initially able to maintain unity and force members to abide by the production quotas established, as the market price of oil increased, this became more difficult. In response the higher costs, consumers found ways to reduce their consumption, and in North America particularly, smaller cars with improved efficiency gained a greater acceptance. Prior to the embargo, a four-cylinder car was unheard of by most North Americans but by the early 1980s, smaller cars were being produced domestically and imports from Japan and Europe were reducing gasoline requirements at the consumer level.

Concerns over permanently losing a large portion of its market caused some OPEC countries to ignore quotas and increase supplies to bring prices down. With Saudi Arabia as the largest of the OPEC producers leading the break, other producers soon followed and oil supplies increased substantially well into the late 1980s.^[8] Oil prices hit lows not seen for a decade and there is no question that the trend towards reducing consumption was halted and possibly even reversed. A return to big cars and big homes was fuelled by a new generation too young to recall the energy crisis of the 1970s, and if the ultimate goal was to instill a belief that cheap oil would be available permanently, then the mission was successfully accomplished.

But how quickly this attitude has changed given today’s reality. With oil priced at over $100 a barrel, the planet is facing the highest oil costs ever witnessed and forced conservation is the reality once again. Consumers are increasingly making choices based on consumption and are asking “How many miles to the gallon?” – or “How many kilowatts used per hour?” when making purchases. At the same time, governments are attempting to change behaviors by providing rebates for energy-conscious choices and introducing new taxes that can only be described as punitive to discourage the purchase of products deemed to use excessive resources.

While it remains to be seen how effective these measures will be, ultimately it is likely that North America and Europe – just as happened during the energy crisis of the seventies – will see a reduction in consumption. In fact, if the U.S. economy deteriorates into a full recession triggered by the subprime mortgage debacle as some experts predict, the economies of Canada and Europe could also take a hit resulting in an even greater pullback in the demand for oil.

Will this be enough for OPEC to increase supplies in order to maintain their their traditional markets? On the surface at least, the situation seems very similar to the crisis in the 1970s, but this time around, there is a new wildcard to be considered; namely, the growing demand for energy in India and China. The economies of both countries have grown at a record pace for several years now and this is giving rise to a growing middle class driving a new consumerism in this part of the world. Speaking of driving, consider the launch of the Nano by Tata Motors as an example of how the world is changing.

Billed as the world’s cheapest car with a price tag of just $2,500 U.S., the Nano falls within the grasp of many workers in India and it is expected to add millions of cars to India’s already crowded road system.^[9] The fact that Tata recently purchased the venerable Jaguar and Land Rover marquees underscores how powerful the Indian economy has become. In China, Cherry Motors is poised to bring a record number of automobiles to the masses there as well.

For OPEC – and all the world’s major oil producing regions for that matter – the short-term future must seem very bright indeed. Oil has remained north of the century mark for a few months now and despite breaking the psychological $100 barrier, demand continues to grow. There are a couple of dark clouds on the horizon however, and the fact that oil is a non-renewable resource that some experts estimate will be exhausted in the region within a few decades might be cause for concern, but for now, the lights are still on and the party is in full swing.

The Effect of Energy Costs on Food Production

As anyone who has bought a loaf of bread lately can attest, the price of staples including wheat and rice have risen significantly. In fact, in the past twelve months alone, corn has increased over 70%, soybean by 65%, and wheat has more than doubled.^[10] When you consider that these staples make up much of the diet of large segments of the world’s population, you can understand how these massive increases are a cause for concern.

In a recent article in the Financial Post newspaper, writer Alia McMullen quotes Donald Coxe of BMO Financial Group who warned of a growing food crisis while speaking at a recent meeting in Toronto.

“The greatest challenge to the world is not US$100 oil; it’s getting enough food so that the new middle class can eat the way our middle class does, and that means we’ve got to expand food output dramatically.”^[11]

The point that Mr. Coxe is making in this statement is that as a new middle class emerges in the east, comes a change in expectations. Just as we are witness to an increase in automobile ownership – long seen as a given right for the middle class – we are now seeing a rejection of the typical “peasant” diet consisting primarily of rice, wheat, and corn. The new middle class is now in a position to include a greater proportion of meat products and this has placed an even greater strain on the world’s supply of wheat and corn in order to feed a vast increase in livestock.

The other factor contributing to high demand is the increasing percentage of crops formerly bound for the table that are now being diverted to the production of biofuels. In the U.S. alone over 16% of agricultural land previously reserved for the production of soybeans and wheat is now being used to grow corn specifically for the biofuel market.^[12] The fear of course is that as more jurisdictions legislate a greater use of ethanol as a fuel substitute, even greater amounts of produce will be shifted away from the food supply.

Indeed, the recent riots witnessed in several countries in response to sharply increasing food prices may only be a precursor of much more serious consequences. Several countries – including Vietnam and Thailand, two of the world’s largest exporters of rice – have cut back or even suspended shipments over fears that they will not be able to meet domestic demands. The inevitable result of course is higher prices and sadly, even greater incidences of hunger throughout the world.

What Does the Future Hold for Oil?

While there is nothing currently on the horizon that will entirely replace fossil fuels and the many products derived from oil, small steps are being made on some fronts to reduce dependence on oil and this will surely be accelerated in the coming years. Granted, this trend is still very much at the individual level with consumers making choices based on costs or a personal commitment to conservation, but change is taking root.

North Americans – often derided for their dependence on automobiles – are more frequently choosing smaller cars or embracing new “hybrid” technologies. A recent Census Canada report also noted that a greater percentage of the population now lives in urban areas where people are increasingly taking advantage of public transit for commuting and basic transportation.^[13]

In countries with colder climates, alternatives to typical oil and gas furnaces are being adopted such as solar panels and thermal heating. Currently, these options are still more costly than traditional heating systems, but a greater number of environmentally-focused individuals are choosing to absorb the added expense. As these options gain greater acceptance and technology improvements become available however, costs will certainly come down, making alternative systems available to a greater number of households.

While individuals may be making changes to reduce personal consumption, real and meaningful change will only take place once corporations and manufacturing facilities also move to reduce their consumption demands. Whether the impetus for this change comes in the form of a desire to reduce costs or possible mandate by government or programs similar to the Kyoto Protocol is irrelevant – over time dependence on oil will be reduced.

Just as we moved from burning wood and whale oil for heating and light and adopted fossil fuels, we are now moving from fossil fuels to other forms of energy. This change will not happen overnight of course, but given the fact that world oil reserves are not infinite and will be exhausted at some point, we will be forced to find alternatives. As oil prices continue to rise – and as pollution and carbon emissions increase – the incentives to find alternatives becomes more urgent. While the timetable for this shift may not yet be known, it is nonetheless inevitable.

References

1. ↑ New York Mercantile Exchange website
2. ↑ Intercontinental Exchange website
3. ↑ Energy Information Administration website
4. ↑ Oil Markets Explained – BBC News online
5. ↑ OPEC website
6. ↑ OPEC – Benjamin Zycher – The Concise Encyclopedia of Economics
7. ↑ Government of Canada website
8. ↑ OPEC – Benjamin Zycher – The Concise Encyclopedia of Economics
9. ↑ Tata Rolls Out Nano – World’s Cheapest Car – CBC News, January 10, 2008
10. ↑ Rice Jumps to Record on Concern World Demand to Outpace Supply – Glenys Sim, Bloomberg, April 3, 2008
11. ↑ Forget Oil – The New Global Crisis is Food – Alia McMullen, Financial Post, January 7, 2008
12. ↑ Food Crisis Being Felt Around the World – Peter Goodspeed, National Post, April 2, 2008
13. ↑ National Post, April 2, 2008