The Politics of Oil

July 14, 2004

By Charles Kohlhaas

The oil industry once again finds itself in the familiar, but unpleasant, position of being the focus of controversy, investigations, political attacks, vilification and public indignation.  The outcry seems to have derived from high gasoline prices and the fact that Iraq has oil reservoirs.  As has been typical with previous periods of outrage, however, many of the accusations are based on misperceptions about the industry and the world oil supply system.  With these misperceptions guiding the criticism, proposed solutions are ineffective at best for remedying what are real and significant problems.

John Kerry is blaming Bush for high gasoline prices, calling for a halt to Bush’s policy of using US government oil to fill the Strategic Petroleum Reserve and invoking the old chimera of “energy independence” as a policy objective.  He says that he wants to free the White House from the influence of various dark forces; always including “big oil” polluters, special interests, lobbyists and various other implied charlatans.  The link between the administration and “oil companies,” particularly Halliburton, is cited repeatedly and ominously as the cause for a myriad of problems ranging from the Iraq War to high gasoline prices. 

The facts are that prices are high because worldwide demand for oil exceeds world productive capacity for the first time in history; prices are determined by open trading on the New York Mercantile Exchange for an open and freely-traded worldwide market system; prices are higher than they need be because the trading system is inconsistent with the supply and investment requirements of the industry; “big oil companies” produce only a small fraction of the world’s oil and have little influence on supply or prices; and oil supplies are very vulnerable to major disruptions, so we had better have the Strategic Petroleum Reserve full for a real emergency rather than use it to trim 3 to 5 cents off the price of a gallon of gas for a political campaign.

Oil companies are generally perceived as massive organizations with vast worldwide political and economic power who manipulate world markets and prices at will as they accumulate vast wealth to the detriment of the consuming public.  In fact, the oil industry has contracted between 70% and 80% since the early 1980's, yields low returns on investment, and finds itself a struggling victim – not a dictator – of political and price policies.  Growth has been achieved by merger to the point that few non-government integrated major companies remain in business as independent entities.

Because of their inability to achieve meaningful growth or to find opportunities for significant long-term investment, most oil companies, what few remain now resort to stock buyback programs to maintain share price.  These programs are a form of slow liquidation and demonstrate the political and financial impotency of the companies at a time of unprecedented demand for their products.  For the first time, world demand for oil equals world productive capacity and yet these companies are slowly going out of business.   This is not a picture of power and control.  The antagonism of the American public to American oil companies for the last several decades has taken its toll; most of the world’s oil is now produced by foreign governments who do not like us very much instead of by our neighbors and fellow citizens.  

Oil prices are determined by the trading of 1,000-barrel contracts of West Texas Intermediate oil in an open market bid system on the New York Mercantile Exchange.  Worldwide prices are adjusted from this price for oil quality and distance from markets.  Oil producers, mostly governments, sell their oil into this world market system and refiners buy from it for oil to refine into products for their customers.  The ownership of a particular barrel of oil may change several times between production and refining.  This is a worldwide, largely open market; oil companies have little or no influence on these prices and participate in the trading market on the same basis as any other trader or investor. 

Open-market, small-contract marginal pricing of this type has the advantage of driving prices down during periods of surplus production.  This system has several disadvantages, however.  It drives prices unnecessarily high during periods of supply shortages, such as now.  Prices become very sensitive to small changes of supply and demand and thus to rumors, conjecture and bad data regarding supply and demand.  Trading of small contracts is necessarily dominated by short-term (literally minute-by-minute) considerations and is inconsistent with the investment requirements of an industry which needs to invest billions of dollars for projects which may not start to generate revenue for five years or more.  Price volatility and market inconsistency have driven investment from the industry and give us the paradox of an industry that is not investing during a period of high prices and strong demand; another indication of the inability of the oil companies to influence markets or political policy. 

Nevertheless, we have Congressional members and state Attorney Generals asking for an investigation of oil industry collusion in fixing markets; one Senator claims that “the anticompetitive practices of the oil industry gouge American consumers at the gas pump,” despite the fact that past investigations have not found evidence of oil-company collusion in price fixing.  Political rhetoric continues to portray these companies participating in some dark conspiracy plotting against us all.  The political system is still beating on an already nearly-dead horse just when we need him to carry a big load - namely, develop some large new oil supplies to meet growing demand.    

The fact that Vice President Cheney was once the CEO of Halliburton is commonly cited as the reason Halliburton got the contract for work in Iraq and has had various logistical and administrative difficulties performing that work in a war zone.  Claiming that the contract should have been put out for competitive bid is like claiming that when one’s house is on fire he should send out requests for bids to various fire departments.  A competitive bidding process for the services contracted with Halliburton would have required at least a year and the scope of work would have been out of date when the contract was finally awarded.  Besides, with the destruction of the domestic U.S. oil industry over the last 20 years, the oil-service industry has contracted to the point that only one company has the scope of services, the logistical depth, and the quick-response capability required: Halliburton.  That’s it; worldwide, there is only one number to call.  Looking at the Halliburton situation, I do not see a political issue.  Halliburton provided a wide range of services on a large scale on short notice in a war zone.  They have had over 40 employees killed and are still there; this is not a company known for weakness.  Were there some inefficiencies in their accounting and some employee-kickback problems?  Yes.  But Halliburton discovered most of those with their own internal reviews and audits and took steps to correct the situation – and turned over the information to authorities.  That is rather typical and should be expected in such a situation and is all a corporation can do; they have neither prosecutorial nor penal authority.  

I personally have dealt with Halliburton, bought their products, used their services and, yes, disputed their bills, for nearly 50 years.  Although other companies compete on some of their services, when the job is big and time is short and you are in a remote place, you can count on Halliburton to show up.  That is why they get called and why they stay in business.

John Kerry, along with Charles Schumer and Barbara Boxer, is calling on President Bush to stop using government oil to fill the Strategic Petroleum Reserve and keep gasoline prices from rising and thereby provide relief to the American consumer.  It is difficult to imagine a more ill-conceived proposal than this one.  This is a recommendation contrary to the purpose of the SPR, which is to provide a reserve for emergencies, not short term price manipulation for political gesturing.  Several studies have shown that the rate of oil injection currently used to fill the SPR affects gasoline prices by less than 5 cents per gallon. 

On the other hand, the Middle East supplies about 20% of the world market and is in a state of violent political turmoil and  social instability.  Middle East supplies are vulnerable and subject to disruption in several countries.  In particular, terrorist action could close the Strait of Hormuz, causing a worldwide shortage of crude and prices escalating suddenly to double current prices or more.  Such an event would create a true emergency for which the supplies of the SPR would be most welcome.  At such a time, it can fulfill its intended purpose and the fuller it is, the better. 

High oil prices and uncertain supplies are a significant problem not only for the United States, but for the world economy.  Belligerent competition for supplies has in the past led to major conflicts and has the potential to do so again.  Establishing a secure and adequate world supply of oil at reasonable prices is a major requirement for economic prosperity and conflict avoidance for both advanced and developing nations.  Unfortunately, current political rhetoric and proposals do not bode well for establishing such a supply system.  "Energy bills" become bogged down in Congress by partisan bickering, environmental hysteria and various tangential issues.  A reasonable, cooperative industry-government effort must be initiated to address this problem quickly with realistic recommendations and policies or we shall all come to wish for current gasoline prices in retrospect.  

Charles A. Kohlhaas is a former Professor of Petroleum Engineering at the Colorado School of Mines and has worked for, founded, managed, and consulted for major and independent companies in the international oil and gas industry.