Guest Juice: What Have We Discovered from Katrina?

By Published On: September 2, 2005

<i>By Dr. Rich Ferguson</i> Hurricane Katrina threw short-term energy markets into a tizzy this week. Oil and gas production facilities around the Gulf of Mexico were shut in. Oil refineries and gas processing plants were knocked out. Pipeline operations were shut down for lack of power. Spot prices for petroleum products and natural gas soared. And NYMEX declared force majeure at Henry Hub to allow traders more time and flexibility to settle accounts. But in addition to the short-term havoc created, Katrina highlighted the longer-term energy supply problems facing the U.S. and the world. The major oil- and gas-producing regions in the Gulf of Mexico are located west of the storm’s track. Damage assessments are still being conducted, but initial reports indicate relatively little serious damage to production facilities. Production capacity is expected to return to normal within a few weeks. A spike in spot prices is to be expected, but why has the average futures price for the coming 12 months increased 10 percent since last Friday? Oil refineries have been operating near capacity in recent months, but many have been knocked out of service and may be out of commission for an extended period. Not surprisingly, wholesale gasoline prices have jumped to over $2.40 per gallon. With fewer refineries in operation, U.S. demand for crude oil is down. So why has the price of crude oil risen and not fallen? Part of the answer may lie in the inability of market participants to distinguish between different forms of energy. There are two issues at work. One is the difference between crude oil and refined products (or raw natural gas and gas ready for pipelines), and the other is the difference between short-term (spot) prices and longer-term (futures) prices. But the real lesson Katrina has taught us is that energy in any form is an increasingly scarce commodity. “Wait just a minute!” I hear readers saying. “There is plenty of oil, gas, and especially coal still in the ground-how can you talk about energy scarcity?” We know energy is scarce because we are paying dearly for that scarcity. When supplies of any commodity are plentiful, the price stays at around the cost of producing the most expensive supplies. But oil and gas prices today are much, much higher than production costs. For example, the world’s most expensive oil is the synthetic crude coming out of the tar sands in Alberta at a production cost of about $30 per barrel. The market price is hovering in the $70/bbl range. An economist would say that producers are collecting ?scarcity rents? of $40/bbl. From the consumers’ point of view, we are paying an extra $40/bbl scarcity cost. Collectively, we are willing to pay extra to obtain scarce supplies rather than curtailing our consumption. The situation in U.S. natural gas markets is even more extreme. The most expensive gas, from deposits of shale and coal beds, costs something like $3.50/MMBtu to produce. The average price for deliveries in the coming 12 months is over $10.50/MMBtu. The scarcity cost is $7.00/MMBtu, double the marginal cost of production. In other words, the scarcity cost of natural gas is now twice the production cost. Added together, the total cost of natural gas is triple the marginal production cost. Even the price of coal is climbing. When asked why coal producers were raising prices, a colleague replied simply, “Because they can.” In fact, it is their fiduciary duty to shareholders to sell their product at the highest possible price. Litigation would ensue if they did otherwise. Energy scarcity is real, as evidenced by the fact that we are willing to pay for it. There are many theories about why energy is scarce. Some blame the Saudis, who keep promising to supply more oil but haven’t (Oil Minister Ali Naimi renewed their promise again this week). Others see a dark conspiracy among the oil giants. My own opinion, for reasons detailed in my recent Risky Diet report, is that conventional oil resources have been seriously depleted. The natural gas situation is different, since scarcity is a North American regional phenomenon rather than a global one. There are those who believe that massive imports of liquefied natural gas will be sufficient to reduce U.S. gas scarcity costs within a few years. Whether you agree or not, LNG would provide only temporary relief. By about 2020, gas is likely to become scarce globally, with a price to match, if consumption stays on its current path. The fact that scarcity costs constitute so much of today’s energy prices makes price forecasting extremely difficult, if not impossible. Analysts have been quoted this week citing the possibility of $100/ bbl oil and $20/MMBtu gas this year. I don?t expect prices to go that high so quickly, but I don’t doubt that they could. Today energy is allocated by “market forces”-that is, energy is rationed by price to those who can afford it. So long as energy is rationed by price, it’s hard to see any upper limit on prices whatsoever. $50/ MMBtu? $100? Few analysts would say such prices are impossible. But at some point, consumers would rise up in rebellion and demand energy at “affordable” prices. The alternative to rationing energy through high prices that include huge scarcity costs is to limit consumption by both the rich and the poor through a quota system with price controls. Such measures would be anathema to Western governments, of course. Prices would have to go very high indeed before they would be taken. Moreover, lack of coordinated action by all governments would make quotas and price controls especially difficult, as the Chinese are discovering. Katrina has increased the scarcity of U.S. energy in the near term, but spot prices will fall when the situation returns to “normal.” She has also highlighted the fact that energy scarcity is a structural, long-term, and global problem with no easy solution in sight.

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