Bill O’Reilly has been on a rampage recently complaining that because oil supplies are now ample, prices should be low. He’s had a couple of guests try to explain it to him, but he’s not one to sit still for a long explanation — or for a short explanation either. There’s not much chance Mr. O’Reilly will read my explanation, but I suspect many other people have similar misunderstandings so I’ll go ahead explaining anyway.

Prices are set by markets

The first important thing to understand is that the price of crude oil is set by the world market. There are small difference due to shipping costs, but other than that the price is the same in Beijing, New York, and Dubai. Mr. O’Reilly claims that US companies are exporting oil because they can get more for it in China than here. That’s false, it’s the same everywhere.

The second thing to understand is the business of oil refining is distinct from crude oil recovery. Refiners buy crude oil at the world market price and convert it into gasoline, diesel fuel, home heating oil, and many other products. Each refinery product has a separate market. Refineries have some flexibility in changing the mix of output products so, for example, they can produce more home heating oil in the winter. Nonetheless, their are limits to the variations.

The US mainly exports diesel, not crude

An important market factor is that Europe and the rest of the world use proportionately more diesel fuel and less gasoline than does the United States. That means that the U.S. exports diesel and imports gasoline. Most of the “oil” that the U.S. is exporting is actually diesel fuel, and that’s been going on for some time. The diesel demand is such that U.S. refineries have been making relatively little money on gasoline and a lot more on the exported diesel.

There is a lessor factor in the small differences in shipping charges. sometimes it pays to sell crude oil to the Far East and at the same time buy from foreign sources for delivery on the East Coast. Doing so saves consumers a few pennies and has no net effect on foreign oil dependence.

U.S. exports of crude oil are about one or two percent of total exports. ref 1 We are not selling American crude oil overseas, it’s refined products.

O’Reilly proposes taxing U.S. oil exports. That would increase U.S. consumer prices because refineries would have to charge more for gasoline to make up for the substantial loss of income from selling diesel to the Europeans. Consumers would also pay more for unnecessary extra shipping.

Demand in the U.S. is relatively low because of the lingering economic slowdown. The capacity to refine crude oil adjusts slowly. The problem is then what to do with excess refinery capacity. The alternative to shutting down refineries is to sell the refining service by importing crude and then exporting the refined products. O’Reilly insists the U.S. should not export any oil products and would apply taxes to make exports unprofitable. That would shut the refineries down.

Refineries are too expensive to maintain for long as idle properties, so when demand picks up, consumers would end up paying for offshore refining.

Price is determined by market expectations of future supply

At this point, O’Reilly would be insisting that despite all else prices should be low because supplies are ample. Prices are not set entirely by current supplies, but rather by the expectation of future supplies. For example, airlines worry about the price of oil next year, because they know they would need oil then. The market for oil delivered in the future is called speculation, but the long term market is made by users of oil.

There are many speculators hoping to make money on short term fluctuations in prices, but for every one of those hoping prices will go up there is one hoping the prices will go down. Even buyer of futures has a corresponding seller from whom he bought. Perhaps the market would be more orderly if there were higher margin requirements or limits on position size, but that’s not at the heart of current high prices.

There is buying in anticipation of future shortages. Compare it to the price gold. Most gold sits in vaults doing nothing. By O’Reilly’s logic the price should be low because inventories are high. It’s not cheap because people buy it in anticipation of it being worth more in the future.

The futures market is subjective. People do not know what supply and demand will turn out to be, but they form ideas on how the market might go. Currently there are many worries about future price increases. China is making 18 million autos a year that will increase demand, as will growing economies in India, Brazil, and elsewhere. Middle East oil supplies may be interrupted by conflict with Iran. President Obama has refused the Keystone pipeline, and has slowed oil production in the US much below what it could be.

It’s hard to say exactly how much of the price increase is due to worries about future supplies. We have a precedent when President Bush countered high prices by opening up large new areas to drilling. Prices dropped dramatically within months. President Obama subsequently rescinded the off-shore leases and locked up most of the government land in the West. The precedent is that a change in policy would dramatically lower prices. New oil supplies would not come on line quickly, but the market depends upon expectations.

U.S. production is rising despite government

It’s true that oil production in the U.S. has been rising, but that’s in spite of current government policy. New technology and new discoveries on private lands were beyond the ability of government to stop. Production is down on government lands.

That brings us to another O’Reilly contention: There is no point in developing US oil if it’s going to be shipped to Beijing. Even if it were all shipped out, there is no net loss in supply, so O’Reilly’s premise is wrong. Some is shipped out, but that more than offsets the additional imports.

Oil is worth money

Let’s suppose that lot’s of crude oil is shipped out. What would then be the point in development then? The point is that the US then gets money. Norway, Saudi Arabia, Canada, and many other countries produce more oil than they need. They do it for the money. Money is a good thing for a country. I think Mr. O’Reilly could ultimately come to the understanding that money is good thing. Saudi Arabia has done well with the concept. The Left is not so easy to convince, of course.

O’Reilly claims that the oil in the U.S. is owned by the people, so the people have a right to say where it is sold and at what price. The government has already sold the oil being produced on public lands to the oil companies through leasing contracts. In return, the government gets huge royalties. So, no, it’s not owned by the people any more.

Future leases could be sold subject to the provisions that the government can control who it is sold to and at what prices. That would reduce the value of the leases to nearly nothing. There is a very large investment required to bring an oil field into production, and companies won’t make the investment without an assurance they can profit from it.

O’Reilly says that the oil companies are making big profits, and that’s true. He wrongly claims that proves they are ripping people off. Exxon’s profits are about two cents per gallon. The sell so many gallons that adds up to billions of dollars. By comparison, the average government tax on gasoline is over 48 cents. ref 2

The main use of oil company profits is to invest in new oil fields. When profits are squeezed, they slow down the development of new supplies. Some of the profits are paid out as dividends to shareholders, predominantly institutional investors like pension funds. If the government guarantees that profits are too low, it makes sense to leave the business and instead buy tax-free bonds with the capital.

Okay, so the explanation isn’t well-suited to four minute television segments. But it’s worth understanding anyway.