The reason that oil company profits are so volatile is that sometimes the price of oil becomes pretty disconnected from the cost to produce it and convert it into finished products. This is because oil is a globally traded commodity, and like other commodities such as corn, iron, and pork bellies, the price is set by how much people are willing to pay for it. This is an important point that is often lost on people who seem to believe that commodities are priced the way Ford prices trucks: Determine the cost of production and a return on the investment, and you arrive at a price. Unlike most trucks, a barrel of oil may see its price change dramatically without any real change in the underlying cost of production, leading to volatile profits.
Any time oil prices spike up as they have recently, you will hear people say “They are charging too much for oil.” I heard this when oil was $40, $80, $100, etc. That brings up an interesting question: How much is oil really worth? This is obviously a complex question, and the answer is going to be different for different people. But let’s try to put some parameters around the problem with a thought experiment.
For a producer, at a minimum oil is going to be worth what it costs to produce it plus some profit margin. That would seem to be the lower end of the actual value of oil, related back to the cost of production. But the cost to produce it is going to vary a lot around the globe. The cheapest oil to produce in the world can probably be found in Saudi Arabia, where some can still reportedly be produced for under $5 per barrel. If global demand was incredibly weak, and was expected to be weak indefinitely, then you might expect to be able to get oil for $5-$10 a barrel, and wholesale gasoline for $0.30/gallon.
Of course global demand isn’t weak, so most of us don’t have access to oil at anywhere close to the cost of production. So in a supply-constrained world, where oil is going to the highest bidder, how high might it go? To establish the upper end of oil’s value we have to consider exactly what it is that oil is doing for us, and the alternatives.
Consider the energy value of oil. On flat surfaces, people expend about 170 BTUs of energy per mile walked. A gallon of gasoline contains about 115,000 BTUs. You would have to walk about 700 miles, which at 3 miles per hour would take you 233 hours to expend the amount of energy contained in a gallon of gasoline. If you drive a fuel efficient car, a gallon of gasoline might take you 40 miles. If your alternative is to walk 40 miles — which might take you 13 hours — then a gallon of gasoline might be worth $50 or even $100 to you. In fact, if you were paid minimum wage in the U.S. you could earn almost $100 in the time it would take you to walk 40 miles.
Of course if you have a bicycle as an option, or are living in a country in which wages are low, that gallon won’t be worth nearly as much to you. On a bike, you could cover a 40 mile distance in 3 hours comfortably, potentially making a gallon of gasoline worth 3 hours of your time instead of 13 in the case of walking. Still, that gallon of gasoline might be worth $20 to you if the alternative is to bike that distance. That equates to an oil price of over $800 a barrel. (As a raw material for the chemical and plastics industries, we might come up with a value even higher than $800 a barrel).
The average person probably can’t imagine paying $10 or $20 a gallon for gasoline, but if demand continues to rise then it is certainly possible that we will pay those prices. If our alternatives are walking or biking to our destinations, most of us would probably opt to pay $20 for that gallon to make our 40-mile trip. We would just drastically cut down on those 40-mile trips.
Even today in Europe there are places where gasoline is $10 per gallon, and the cars are still on the road. I suspect we will see the same in the U.S. There will be a shift toward more public transit and more fuel efficient cars, but I think over the long term fuel prices will continue to rise, and we will continue to pay for it far beyond levels that we currently deem “too expensive.”
By. Robert Rapier
Source: R Squared Energy Blog