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Verleger: Oil Prices Peaking, But Hurricanes or Other Events Could Send Them Higher

Interviewee: Philip K. Verleger
Interviewer: Bernard Gwertzman, Consulting Editor
May 4, 2006

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Philip K. Verleger, a well-known expert on the economics of oil, says that the current price of oil, which has dropped below $70 a barrel, has probably peaked for the moment, but he warns that any problems in refining oil, or another Katrina-like hurricane season, could push prices well above current levels.

"If we have a severe hurricane season, it's quite likely that we will see another round of oil production lost like we saw last year," says Verleger, an energy consultant who is also a Senior Fellow at the Institute of International Economics. "And given the current state of the economy, that'll have rather disastrous implications for the oil market. Prices will go much higher, whether they get to a hundred dollars a barrel I don't know, but it's going to be really, really difficult."

He has advocated a much higher gasoline tax in the past, but now sees widening use of ethanol and reduction of EPA requirements on refining as ways to increase oil supply.

Have oil prices more or less peaked for the moment?

I think we probably have hit a peak. This is probably the highest it will be between now and Memorial Day. What happens as the summer progresses depends on consumer demand during the summer, whether government regulations on pollution controls are waived, and most crucial of all, whether we can keep the refining system running smoothly. We don't have a crude oil problem in the world but we do have a refining problem, and if one of the major refineries were to have a big fire—for example, last year there was a fire at BP's Texas City refinery that knocked it out—we could have serious problems and prices could go way up.

You did an interesting report for your clients on May 1 raising the possibility that if Congress were to suspend environmental regulations concerning oil refining for a period of about six months, that could bring the price down to about forty dollars for a barrel of crude oil from the current price of around seventy dollars a barrel. How is that possible?

In the first place, petroleum products change over time. The characteristics of gasoline and diesel fuel, for instance, have changed. The best place to see the effect of [this] is in southern California. Thirty years ago you had the brown cloud around most of the summer from gasoline consumption and today you don't have that very much, despite the fact that there's probably twice as much gasoline consumed in southern California.

What has happened is the environmental authorities—in California, it's a state organization, in the rest of the country it's EPA—have worked to get those components of gasoline that were particularly bad actors out of the product. One of the bad actors is benzene, which is a carcinogen, and another of the bad actors has been sulfur. Gasoline sold in other parts of the world tends to have a little more sulfur. The regulations are very stiff on the east coast. Here in the Rocky Mountains where I live, they're a little more lax because the refineries just couldn't meet the new standards in time. One way to increase gasoline supply is to relax those regulations, and for six months, that would increase supply and bring prices down. What's happened over the last two years is crude oil's been pulled up to seventy dollars a barrel by limited supply of refining and the need of some of these refiners for the crude oil we call 'sweet,' to produce a lot of gasoline without much work.

Sweet crude oil has very little sulfur, is that right?

That's right. And crude oils come in all mixes. It's like going into I suppose the ice cream bar at Ben and Jerry's where there are all sorts of flavors of ice cream. There are literally probably a thousand types of crude oil. They range from crude oil with very low sulfur that easily produces a lot of gasoline, to oils that have a great deal of sulfur and basically cannot produce gasoline unless it is processed in a very complex fashion in refineries that are very expensive.

When Hurricane Katrina occurred, President Bush allowed companies to sell winter-grade gasoline, which has more butane in it, and that increased supply. But you had people in St. Louis who had several ninety-degree days afterwards who reported significantly more smog. So there's a tradeoff.

But the price came down?

The price came down a lot: a dollar a gallon at retail. What is not generally acknowledged is that the specifications for petroleum products have been negotiated almost in a conspiratorial fashion between oil refiners and [the] EPA. Economists for years have been trying to suggest that if EPA regulations had a little flexibility, and for example allowed gasoline to be sold that had a little more sulfur, but with a payment of a penalty, you could limit the price increases. But [the] EPA has resisted these rules and U.S. refiners who made the investment to produce the clean fuel are very outspoken about the fact that these rules should not be relaxed.

I see, because the refineries fear if the requirements are relaxed they'll have to sell the product cheaper?

That's right. They say "we have made the investments, we deserve to earn the profits."

Do the refineries now make big profits?

They're making huge profits. Valero is the biggest U.S. refinery, and it has reported extremely large profits. Other companies, such as Sunoco, reported smaller profits, but in the second quarter with this big run-up in gasoline prices, they're literally going to be making billions.

I think the popular vision is that it's the oil companies that are making the big profits. Are they also making big profits?

Well, it's interesting. The integrated oil companies are making large profits. But the real profit right now is in refining, most of the refining capacity in this country has moved from the integrated companies like ExxonMobil, or Chevron, or Shell, to the smaller companies. Valero, which in 1990 was a very small company, is I think now the nation's largest refining company. The integrated companies nevertheless are doing very well because they own a lot of crude oil, and if they own the crude oil in the United States or in Canada they get to keep most of the money from it, and so they're making fifty dollars a barrel.

Because of tax breaks here?

Well, that's right. In the rest of the world, for instance in the North Sea, the governments adjust petroleum taxes so that above a certain point, they get a large share of the revenue.

What about the term "speculators"? What does that mean?

Well, that goes back a hundred years. We have these commodities future markets, they were created first in grain and they were created for a reason. The farmers may sell crops on the futures market and grain millers may buy them. Within these markets, there are always "speculators," that is, people who have no intention of either delivering the commodity or taking the delivery of the commodity. They'll buy because they think prices are going up or they sell because they think prices are going down. There's been a debate for decades in the economic literature as to whether speculation is stabilizing or destabilizing. I think the general view is that it tends to stabilize prices.

Oil futures got created in 1983. There was one before that for heating oil but the big one is the crude oil market.

So it only started in the eighties?

The first trade on the crude oil futures was March 30, 1983. A market had started in London a little earlier; ironically Prime Minister Margaret Thatcher's tax created the market by giving the producers—at that point Exxon, Mobil, it's two separate companies, Shell, BP—a need to actually conduct transactions and sell the oil for tax reasons, otherwise they faced marginal tax rates of 110 percent to 120 percent.

I see. All right, so say I have a $100,000, and I want to invest in oil, what do I do?

Goldman Sachs has been advocating that you do that as part of your retirement portfolio.

Oh really?

Yes. The argument is that you, Bernie Gwertzman, or I, Phil Verleger, should have about 3 percent to 4 percent of our retirement portfolio in commodities. And the argument goes as follows: Returns on futures are negatively correlated with returns on stocks and they're negatively correlated with returns on bonds. The average return is about the same over twenty years. What this means is that if you put some of your money in futures, you'll have successfully diversified your portfolio so you have reduced the risk associated with your portfolio and you've increased the average expected return.

I see. So a company like Goldman Sachs actually has an oil futures—

Well they have an index. They have a Goldman Sachs commodity index, a diversified commodity index, it's in oil, it's in cotton. It goes by the nickname GSCI. There's a future on the GSCI that trades on the Chicago mercantile exchange, and you can actually go to them or go to somebody else and say, "look, I want to put money into a commodity fund." Pimco offers the same thing. The best way to do it is to do it that way. I've been tracking this, and over the last two years something like $75 billion has now been injected into oil, mostly by ordinary investors.

These are the ordinary investors, who have some money obviously, who are trying to diversify their portfolio?

Yes. And usually they go through an intermediary rather than go directly.

What happens is that if you take a retirement fund like TIAA-CREF which may put say a billion dollars into commodities, a large portion goes into oil. The managers buy oil futures. Their purchases of oil futures provide an incentive for what we'll call commercials, or market participants, to actually add to inventories. Because today I can buy crude oil for say seventy dollars a barrel and I can sell to these people for say seventy-two dollars a barrel to be delivered in two months. And in that transaction what I have done is literally achieved a risk-free return. And some people do it. And so tanks are full.

Give me a projection for the rest of the year. What do you think is going to happen?

Well I've been told on good authority we're going to have a hurricane season, and most of the forecasts [suggest] it's going to be a pretty severe season. That doesn't mean that's going to happen, but the forecasts from the weather people tend to be better than the economists' forecasts. If we have a severe hurricane season, it's quite likely that we will see another round of oil production lost like we saw last year. And given the current state of the economy, that'll have rather disastrous implications for the oil market. Prices will go much higher, whether they get to a hundred dollars a barrel I don't know, but it's going to be really, really difficult.

I see. So, earlier in the interview when you said prices had peaked, you only meant until Memorial Day.

I said also that that depends on whether there were refinery problems. Hurricanes cause refinery problems. Had Hurricane Rita arrived six hours later, we would be dealing in a six dollar a gallon gasoline market. That's how close we came, because there were two refineries in Beaumont where the storm surge almost breached all the dikes, and it would have wiped the refineries out, if it came ashore right at them. And Rita came ashore at low tide.

You wonder why all those refiners are sitting out in the gulfs, open to hurricanes but I guess that's the easiest place to put them.

Well, that's where all the oil was.

The oil's out in the Gulf of Mexico and it's in Texas. Historically, you build refineries where the oil is. You're going to refine the oil there, put it in pipelines to take it up to the east coast or off into the Midwest. From a logistical point of view it made a lot of sense. What we didn't count on was losing some of the barrier islands, hit by the last several big storms, and we also didn't count on these huge storms.

But do you think that this is going eventually force the end to these EPA regulations?

Fifteen years ago, it was 1990, Congress passed some amendments to the Clean Air Act seeking even cleaner gasoline—we call it reformulated gasoline—and it's made air quality much better in New York [and] on the east coast; it did for those areas what California's done on its own. And California, you know we call it a separate "country," because our EPA regulations don't apply to California because [it] has stiffer regulations.

These regulations require something called oxygenated gasoline. This can be done by adding ethanol to gasoline. However, refiners hadn't been using ethanol, they'd been using a product called MTBE. This is a product that has poisoned groundwater around the country. There are lots of suits against the oil industry. The companies asked for permission, the refiners asked that the Congress grant them a waiver so they couldn't be sued. First refiners asked that Congress let them out from under the oxygenate requirement, then they said, "oh, by the way, this damage we've done over the last fifteen years, we want to have a waiver."

And that was a huge debate and Congress wouldn't do it. So immediately after the passage of the bill the refiners, a little like petulant children, said "we're just going to stop using MTBE immediately," and that cut supply, and it also created a logistical problem because it's hard to get ethanol around. This year we are caught short, and the shortage is artificial in the sense that refiners decided to stop using the MTBE.

What's going to happen out of this, I think, is good because people are mad enough now that they're going to really push to use a lot more ethanol. And from a long-term energy policy point of view, I think that's a good solution. The reason is that it achieves the same effect as a gasoline tax in that it cuts our demand for petroleum. I've been this on wicket since 1971 when I wrote some academic papers saying you know, we really need to get our gasoline tax up and it need not have any impact on consumers if we redistribute the revenues properly. I have no supporters in the U.S. House of Representatives; I have no supporters in the U.S. Senate for my idea. But one interesting thing is that we can achieve the same effect as a gasoline tax by dramatically increasing the use of ethanol.

What would be your optimum use of ethanol?

If I could, I'd go to 25 percent. That would reduce consumption by two-and-a-half or three million barrels a day of crude oil. That would put downward pressures on crude prices.

And ethanol doesn't cost that much?

You have to have some government subsidies probably right now. It may eventually not cost that much. But if the net benefit's a lower oil price, I think it's worth a subsidy.

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