Oil and Gas

API's John Felmy discusses reasons for record crude prices

With crude oil prices nearing $75 per barrel last week on the New York Mercantile Exchange, and energy analysts predicting a costly summer for motorists, is there any relief in sight on fuel costs? During today's OnPoint, John Felmy, chief economist with the American Petroleum Institute, discusses some of the factors roiling world oil markets, including nuclear negotiations with Iran and supply disruptions in Nigeria. Plus, Felmy discusses the domestic outlook for gasoline prices and ethanol use, and what the oil industry is doing to increase supplies and boost refining capacity.


Brian Stempeck: Hello and welcome to OnPoint. I'm Brian Stempeck. Joining me today is John Felmy, chief economist with the American Petroleum Institute. John thanks for coming back on the show.

John Felmy: Thanks for having me.

Brian Stempeck: Right now oil is at a near record level, $73 per barrel it's been trading at during the past week, basically on supply concerns from Iran, from Nigeria. And there's some of the analysts out there who are saying that when you actually look at the supply-and-demand ratio this price should be about $20 lower than it currently is. What do you make of that assessment?

John Felmy: Well, I don't agree with it because we have very real supply impacts that are being felt right now. Some estimates are that there's about 2 million barrels a day of capacity off-line in places like Venezuela, Nigeria, Iraq and Russia. So there's a very real supply limitation that's going on, along with continued demand increases.

Brian Stempeck: At the same time though the recent report in the Wall Street Journal showed that the U.S. crude oil stocks are at their highest level in eight years. With that said, shouldn't the price be coming down a little bit? I mean it seems like it's continually going up every day for the past few weeks.

John Felmy: Well, it's good news that we do have those inventories at that level, particularly with discussions about what could happen with Iran and so on. But you've got to put it in context, 340 million barrels of crude oil is not a lot of oil given that we consume 20 million barrels a day of petroleum products. So it's a very, very thin cover in terms of future days of supply.

Brian Stempeck: What do you see is kind of the key factor is driving the overall crude price right now? Obviously I mentioned Iran, I mentioned Nigeria. Are those the biggest factors? Are there other things we're seeing, just overall demand from China and India as well?

John Felmy: It's a combination of demand factors, China, India, also supply. You know, we're still restoring production in the Gulf of Mexico. We have over 20 percent of it still off-line, although that's promising. Shell's announced a restart of one of their big facilities. We've got half a million barrels a day of Nigerian light sweet crude-off, which is very important because of the ability to be able to refine that. And then Iraq, Venezuela and all these other hot spots, including Chad. So it's a very tight market.

Brian Stempeck: What do you think should be kind of the future there? We actually had the president of OPEC on the show and he was talking about the need for kind of enhanced security at a lot of these sites. What's the role for the oil industry in terms of kind of beefing up security at these sites around the world where you have some of these attacks prominent? Something like Nigeria, where you had the rebel groups attacking some of the pipelines.

John Felmy: Well, we have long taken security very, very seriously. We've been operating in hostile areas since practically day one of the industry. And so we've developed security plans, security protocols, hardening facilities, having proper training, having surveillance. We've been doing a lot both internationally and domestically.

Brian Stempeck: The spending on that has really gone up astronomically. I mean do you have an idea of what the industry is actually spending right now in terms of as a whole on some of the security concerns?

John Felmy: It's really impossible to say because we'd have to break out between what was your normal level of security, guns, gates, guards and so on, versus what kind of enhanced levels you've had that are both things you want to do to just improve your situation, learning what you've done and so on. So it's very hard to quantify.

Brian Stempeck: One of the other factors that's been affecting the price, that's been mentioned kind of recently, is seeing more investment funds kind of getting into the business of oil futures which is making, it seems like, the price more volatile. How much of a factor do you think that is in terms have seeing a shift from some of the traditional supply and demand and terrorism concerns, now shifting over to where we're seeing more investments funds actually get involved in this?

John Felmy: Well, we have had an increase in investment funds. And you had those folks who are now participating in the markets. But a key factor is you have to say, well, how are they investing? Well they're probably investing the way everybody else in the market is. What's their expectation of the market fundamentals? On a short-term basis, daily say for example, you can have prices move many different directions that may not be tied to fundamentals, but its perception of fundamentals. Ultimately supply and demand will win out and somebody's going to win, somebody's going to lose. And so you have to say how are these guys doing versus the more traditional traders?

Brian Stempeck: Is it causing more volatility though, the fact that you have some of these investment managers trying to offset some of their gains or losses in the stock market by investing more in commodities?

John Felmy: It's hard to say. There have been a couple studies by NYMEX itself, along with the Commodities Futures Trading Commission, which regulates NYMEX. They've tended to indicate that these funds tend to follow the market. And that what they do is they add liquidity, which can actually reduce volatility.

Brian Stempeck: What do you make of the role for OPEC right now? There's been a lot of the articles talking about supply and demand that kind of suggest that OPEC is really a lot more powerless than it used to be. They have a lot less sway over the overall price of oil.

John Felmy: Well, by all indications of OPEC, and for that matter any producer worldwide, is selling every drop of oil they can. As long as they're doing that they're not exerting any kind of a price influence.

Brian Stempeck: The other thing we're basically keeping an eye on is gasoline inventories. Last week EIA reported there was a pretty significant drop in terms of the overall U.S. inventories of gasoline. A lot higher drop than expected. As we go into the spring and summer what are kind of the key factors you're looking at in terms of judging the price of gasoline as related to the price of crude?

John Felmy: Well, we're following the inventory of gasoline very closely just as we do crude. But there again you also have to say how much gasoline would that actually supply in days forward cover? And it's basically 200 million barrels and we consume nine plus million a day. So it's only a couple of weeks of supply. I think much of the gasoline inventory decline this week was overstated because we're going through a transition from first winter to summer fuels. We're also switching, in parts of the country, the mid-Atlantic, Texas, to gasoline that's blended with ethanol rather than TBE. To be able to put in the new blends you have to draw your existing inventories down to very low levels because you can't mix the two. So a lot of that may have just been a transition and just a weekly phenomenon.

Brian Stempeck: Where do you see prices headed this summer? We've seen AAA come out and say average prices are around $2.80; EIA, I think, around $2.65. Where do you see prices headed the summer?

John Felmy: It's going to be very much a factor of what happens with crude. In other words crude has now like reached an intraday high of $73.50 on the market. What will happen with crude, because that's the most important component of gasoline? And then how will this transition that we're going through in terms of winter to summer and the transition from MTBE to ethanol go? There's a lot of complicated refinery adjustments you have to make. And finally what's going to happen with the price of ethanol? The price of ethanol has more than doubled over the past year. And since being used more and more, as required by law, that adds cost to the price a gallon of gasoline.

Brian Stempeck: How much of a factor is that though? We've heard a lot of talk in Washington the past few weeks and have the oil industry and ethanol industry going back and forth over this talking about how much of an effect of ethanol is really having. Most analysts, EIA for example, say this is only a couple of pennies in the price of gasoline. The price of crude is a much more dominant factor than the price of ethanol. Would you agree with that?

John Felmy: Well there's two factors. First of all is the price of ethanol itself. And ethanol right now is selling for about $2.75 a gallon. But when you do a [British thermal unit] adjustment, because you only get 70 percent of the Btus in a gallon of ethanol as you do compared to gasoline, the price of ethanol is north of $3.50 to $4.00. So that's much higher than gasoline is right now. Now you only blend 10 percent in ethanol, so that does mean that in terms of comparisons you're talking about a few pennies. But you also have to blend the base gasoline to a different version so that you can blend of ethanol in and that's additional costs in. So there's no question it's higher cost, how much, you know, we could argue about for a long time.

Brian Stempeck: In the past times you've been on the show we talked about basically the effect of crude oil prices and gasoline prices on the overall economy. And I think what you said is for every $10 per barrel that crude goes up you tend to see a loss of a half or a whole percentage point in GDP. Is that happening right now as we've seen crude go north of $70 per barrel?

John Felmy: At this point it's really hard to say. I mean that was a rule of thumb that we developed over the last 25 years when over that period we have used less and less oil as a share of our GDP. So the impact, presumably, could be less. I believe there is an impact, but the economy is booming so strongly right now that it's difficult to measure.

Brian Stempeck: Is it possible we're seeing a lag time there? I mean the International Monetary Fund basically came out and they said that right now they're maintaining their current growth estimates for the economy. But what they also said was there could be a lag time in terms of when we see these energy prices actually hit home. Is that a possibility?

John Felmy: It clearly is. One of the things that happens is that while increased crude prices to raise your costs of say doing business, if you're constrained by international competition, say from China, and you can't raise your prices, the initial reaction is you don't have a price impact that spreads throughout the economy. So the effect is blunted quite a bit. We'll have to see if that continues though.

Brian Stempeck: What kind of investment decisions are we seeing these prices drive in the oil industry? I think there was a recent report last month where we saw Chevron make some major expansions in terms of the oil sands up in Canada. What other types of investment decisions are we seeing based on the high oil prices right now?

John Felmy: Well, first it's important to note that we're making vast investments this year. Surveys have indicated that the industry will spend $106 billion on upstream, in other words finding and producing oil. They're also going to spend another 20 plus in terms of downstream; refining, marketing, distributing. So we're making vast investments first on finding more oil, but we're also making investments in alternatives. For example things like cellulosic ethanol our companies are investing in. They're investing in wind, solar, geothermal, biomass, basically a lot of different energy sources. Longer-term they're looking at things like shale oil. Can we produce oil from shale, which is a vast resource, you know, its a trillion barrels. So we're looking at a lot of different future energy sources.

Brian Stempeck: What about in terms of the near term on the refining side? This is obviously the other part of the big picture here, is refining capacity being so tight in the United States. This is a big factor driving up gasoline prices. What's happening there in terms of some of the efforts of trying to launch a new refinery in the U.S.?

John Felmy: Well, what we're doing right now is the companies have announced expansion decisions for existing refineries. We haven't built a refinery in 30 years and it's a real challenge to site a new refinery anywhere. You're going to be opposed by a lot of folks who don't want industrial facilities. You're going to face permitting challenges. But for the existing refineries we already expanded them over the last 10 years the equivalent of a new one every year. Over the next five that's going to continue and we're adding another 1.3 million barrels a day of capacity.

Brian Stempeck: What you expect to see from Congress on that? There was some refining legislation that was talked about. It pretty much fell off the map after it didn't get through the Senate EPW Committee. Any chance on that moving any further this year? Is that something you guys are pushing for right now?

John Felmy: Well, some of that we like because streamlining the permitting and so on can really be helpful. The suggestion about using closed military bases actually has some promise because those are facilities, particularly if they're naval bases on water that may be a good candidate. We don't support the notion though of having government intervene and actually operate refineries. So we've got a mixed view of that, but we think clearly and we need to move forward on this and a lot of other energy policy issues.

Brian Stempeck: What do you sense will be the political fallout from some of these high oil and gas prices? Obviously seeing Democrats really on the attack right now, talking about price gouging legislation, things of that nature, ways to basically go after the oil industry. What do you think, you know, towards the end of the summer and this fall as the midterm elections come up, we'll actually see from Congress, if anything?

John Felmy: It's really hard to say. In an election year it's hard to see how much legislation actually moves forward. I would think that you can have a lot of political rhetoric, but when you actually sit down and look at the facts the reason why gasoline prices have gone up are crude prices and the cost of producing gasoline as the main components. And as long as people understand that it's difficult for me to see how they would actually move forward with legislation that would be punitive.

Brian Stempeck: All right John, we're out of time. Thanks a lot for being on the show today.

John Felmy: My pleasure.

Brian Stempeck: I'm Brian Stempeck. This is OnPoint. Thanks for watching.

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