Why are oil prices so high?

(Posted by John.)

Anyone who's paid attention in the last few years has heard all the stock answers for the price of oil - China, India, Katrina, etc. Others offer Peak Oil has the explanation (we're pumping out as much oil in a given day as we ever will) and that's why prices are going through the roof - $75/barrel yesterday.

There's another element to pay attention to: James Fraser points out that production of light sweet crude has been in decline now for a few years. (Chris Vernon mentioned this last August.) This has a number of implications for the industry.

The first problem is simply communications. When the media report "oil prices", they're really reporting the price of a delivery contract - delivery of a particular blend of light sweet crude (West Texas Intermediate, or WTI) on the New York Mercantile Exchange. The news doesn't often report the average price of a variety of blends, or the price in various countries. These aren't unimportant details. When you hear "oil prices are up" what you're really being told is "the price for a delivery contract of WTI blend on the NYMEX is up."

Light sweet crude (oil that flows more easily, and has a lower sulphur content) is the preferred food for refineries. Most American refineries can handle higher amounts of sulphur, but it makes refining more difficult - sulphur levels are tightly regulated in transport fuels - thus increasing gasoline costs further down the road. Which is why refineries usually pay a premium for light sweet crude: it lowers their operating costs and increases their profits.

There is, however, a finite amount of light sweet on the market, and that amount is shrinking. The rest of global demand needs to be made up with heavy sour crude. This means that the premium refiners pay for a blend like WTI has shot up. James Fraser in the link above estimates that in some cases the margin between light sweet crude and heavy sour is as much as $16 per barrel.

I haven't seen any analysis on whether the recent decline in light sweet crude production is a short- or long-term problem, but my money's on the latter. Yes, I do side with those who believe we are right about on top of Peak Oil - I find it very difficult to believe we'll ever get much more then the current 85 million barrels per day of oil we get today. Certainly, the projections that call for 100+ mbpd are really a form of fantasy, and nothing more.

That said, the current run-up in prices for light sweet crude gives us a small picture of what Peak Oil will look like when it arrives. Even as demand stays relatively constant (China has recently slowed it's oil consumption growth) the price will increase pretty steadily, and occasionally skyrocket when something upsets the delicate balance - say, an Iranian President threatening to wipe Israel off the map.