The Cost of Driving Across Town

How much would you expect to pay if you needed to go from Chelsea to Fulham? Well, if you go via the bus it would cost £1.30, on the tube using your Oyster could cost £1.90 or even a staggering £4 if you buy a standard single. If you cycle it may cost you nothing unless you use the Barclays Cycle Hire scheme. We’ll rule out flying and a helicopter for now but may end up having to come back to this as the cheaper option ironically.  It seems the more expensive option is driving! The rising cost of fuel That’s right, if you happen to own a Bugatti Veyron, reasonably priced at $1.7 million then it seems the cost of driving from Chelsea to Fulham is £192. That is how much it cost someone this week filling up at a petrol station in Chelsea to fill up his gas guzzler. Because of the fuel consumption of this vehicle the owner would need to fill up again once he got to Fulham – so it appears the most costly way of travelling from Chelsea to Fulham is by car; assuming of course that we all have a Bugatti Veyron stashed away somewhere. Why are fuel prices so volatile? When looking at future oil prices it is important to understand some of the peaks and troughs we’ve experienced of late. The OPEC Reference Basket (ORB) of crudes peaked at $141/barrel in July 2008 and fell to as low as $33/b by the end of that same year as the global financial crises hit. But how can such turbulence in prices actually be justified and how does it manifest itself into the prices we see domestically in UK when we buy petrol? Price increases generally occur when the world crude-oil market tightens and lowers inventories. Price increases (and decreases) in petrol prices in the UK will be linked with the world crude oil market. When the inventories are restricted by the Organisation of Petroleum Exporting Countries (OPEC) then this reduces the supply of oil (and then namely petrol for the consumer) in the respective countries. Since Petrol prices can change day to day it means that if the supply is kept the same or even reduced and the demand does not change that the price will increase, and as we’ve experienced of late – quite drastically. The problem essentially stems from the fact that supply and demand of oil are fairly inelastic. That means if the demand cannot be met, keeping in mind that it unrealistic to expect production of oil to increase dramatically day-to-day, then the supply will also be unable to meet that demand and thus cause oil prices to rise. Another problem is that demand cannot be easily changed in the short run if there is a reduction in supply as consumers have commitments and habits that determine their energy usage and these understandably take time to adjust. Similarly supply is fairly expensive to try to adjust both in terms of time and constrains and cost as well. What the future holds

Figure 1: Projected demand for crude oil in millions of barrels per day – Monthly World Oil Report OPEC January 2011 Figure 1 above indicates how demand is forecasted to rise at a rate that supply will not be able to keep up with. Current the feeling is that 75 million mb/d is the optimal production capacity above which it actually returns negative marginal utility for the oil producing countries. In addition to that, the problem of adding additional capacity also adds fuel (no pun intended) to the fire that the current high costs we are seeing are a precursor of what’s to come. The cost of additional capacity is highest in the Organisation for Economic Co-operation and Development (OECD) countries where it is twice as expensive to add capacity compared to average OPEC figures.  The suggestion, as is highlighted above, is that this difference will get progressively larger overtime. The amount of investment needed to be able to support the rising demand is estimated to be approximately $2.3 trillion dollars in 2012 alone. The world is growing Expectations for world oil consumption will be dependent upon economic activities. The magnitude and the speed of the world economic recovery will have a remarkable impact on world oil demand this year. A change in weather in the northern hemisphere could, according to some geoscientists, cause an increase in heating oil and fuel demand. Nevertheless, the fuel substitution to natural gas is reducing the demand for fuel oil.

Figure 2: Mintel Wolrd Oil Forecast – December 2010 The graph above probably gives the clearest indication to why supply cannot consistently meet demand and also why such formidable demand exists in the first place. The natural growth in population is a huge factor in this. A 1.25% increase in China’s population per year results in an extra 12.5 million consumers per annum, and that’s just China – add India and the rest of South Asia to the equation and the OPEC countries come under pressure to produce. So why not just invest more in increasing production? The table below shows the price for crude oil futures contract over the last 6 months.

Figure 3: Nymex WTI Crude Oil Futures Contract Pirces – Wall Street Journal One of the reasons why OPEC has found itself in such a predicament, especially in terms of fronting up the necessary investment to meet such demands, is ironically because of investors. Futures contracts in oil are one the highest yielding commodities traded on the futures market. However, the radical fluctuations in oil prices have proved difficult for many an investor to predict. You only have to look at the example that follows to see just how much, and quickly, the price can change. But this only part of the problem and a large part of what caused the financial crisis in 2008 was the major losses that some of the private equity companies made when investing large amounts of their portfolios in crude oil futures only for the price to fall to $33/b and their future contract to be worthless – or so they thought as they sold the futures at whatever price they could only for the price to return to a profitable state 12 months later. In the end increasing investor appetite for crude oil futures continued to lend support to rising prices. So it seems that the problem is actually us – the consumers. We demand too much and the poor old OPEC countries cannot produce enough so to deter us they limit production which sets the price at what seems like a price that only the Bugatti drivers can afford. More investment is needed to increase production but investment money is in short supply because of the current volatility of the oil prices.  It seems that the problems that the oil industry will face are somewhat their own undoing. Maybe we will all be cycling to Fulham soon.