David Wood - David Wood & Associates, Lincoln, UK

Saeid Mokhatab - University of Wyoming, Laramie, Wyo.

EDITOR’S NOTE: This 5-part series of articles explores how different sectors of the oil supply chain are generically controlled by different international groups and how these controlling factions influence prices and fuel geopolitical tensions. This second article reveals how oil producers and consumers have different potential for extracting value from the upstream and downstream sectors of the oil industry.

The separation of control of the upstream and downstream sectors of the oil supply chain has influenced the oil pricing mechanism, which corporate entities and countries extract most value from produced oil, and which nations have benefited most from investment, infrastructure development, and employment.

The downstream sector of the oil supply chain is labor intensive. Refineries, petrochemical plants, and product storage terminals have traditionally employed almost an order of magnitude more people than the upstream oil sector and remain operational for many decades not linked to the reserves life of a petroleum-producing province.

Clearly it is the consuming countries that have reaped most of these benefits, and the governments have been able to extract billions of dollars annually in high downstream taxes on the “value-added” petroleum products, particularly retail gasoline and diesel fuels. On the other hand, economic under-development, limited employment opportunities, slow inward investment, and limited taxation revenues in the downstream oil sector have prevailed in the main OPEC and other developing world producing nations through to the end of the twentieth century.

Because of the polarized structure of the industry dominated by the influence of the upstream and downstream cartels or oligopolies (OPEC and IOCs / major consuming nations, respectively), global oil price does not always behave in accordance with conventional free market supply and demand theory (Figure 1).

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Figure 1: Economic theory for a commodity in a free market indicates that the interaction of supply and demand influences the market to trend towards an equilibrium price (PE): When supply exceeds demand, price falls; and when demand exceeds supply, the price rises. But crude oil prices do not follow such a simple rule. Influences from cartels of producers and consumers, together with geopolitics and market perceptions, often interfere with free market behavior.
- Illustration courtesy David Wood & AssociatesClick here to enlarge image

In a free market, oil price should be brought to equilibrium by competitive forces with individual sources of supply and demand marginalized from holding undue influence. OPEC ensures that specific sources of supply have undue influence on global oil prices. IOCs and OECD ensure, by directing supply through downstream infrastructure they control, that the demand of their domestic markets has undue influence on oil prices.

In the case of oil price, the equilibrium is contingent upon OPEC, OECD, and IOC control of supply-chain sectors and their respective strategies and policies, geopolitics, market sentiments, and consumer nation perceptions of supply and demand, which make it unstable, volatile, and subject to a complex series of influences and from time to time manipulations.

OPEC and the IOCs / major consuming nations (OECD) frequently blame the unjustifiably high and sharply rising prices that prevail at the consumer end of the supply chain on each other or on unscrupulous traders and speculators.

Crude oil price and value extracted

In such circumstances, forecasting oil price using either simplistic demand-based or supply-based models is inadequate. Also, there has been a decoupling between oil price and which parties are able to extract value from the oil supply chain.

High oil prices at the extreme downstream end and low production costs at the extreme upstream end of its major supply chains underscores this point. OPEC governments through PSC terms, major consuming nation (OECD) governments through downstream taxes, and IOCs operating along the entire supply chain, with greater control downstream, implies that these three groups are extracting the most value from oil with traders and speculators benefiting at the margins from price volatility.

Growth in global primary energy and oil consumption

Global demand for oil has steadily increased over the last 50 years. Economic growth requires energy and oil continues to make the largest contribution to primary energy consumption. Recent statistical data show that world energy and oil consumption continue to grow at a steady rate. It is instructive to compare statistics from the 1970s with the present day, and Figure 2 and Table 1 data for 1977 with 2005.

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Table 1: Primary energy statistics in this table include commercially traded fuels only and exclude biomass, biofuels, and renewables that account for no more than a few percent of total consumption on a global scale. Values are expressed in million tons of oil equivalent (mmtoe). Note the approximate 10% drop in the relative contribution of oil from 1977 to 2005. - Table courtesy David Wood & AssociatesClick here to enlarge image

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Figure 2: World primary energy consumption fuel mix compared for 1977 and 2005. Data is from BP Statistical Review, June 2006. Note petroleum’s (i.e. oil plus gas) contribution has fallen from 66% to 60% during this period. - Illustration courtesy David Wood & AssociatesClick here to enlarge image

The values in Table 1 show that oil consumption has grown at a compound annual growth rate (CAGR) of some 0.95% since 1997 compared with 1.85% for total primary energy (i.e. oil has grown at only about 50% of the growth in primary energy consumption). As a consequence oil’s contribution to primary energy mix has dropped substantially over that period, but it still makes the largest single contribution to primary energy by some margin.

The oil price shock of the late 1970s and early 1980s persuaded many countries to amend their energy strategies and lead to greater investments in other fuels - gas and nuclear in particular. Note, however, that gas still ranks third behind coal in the global primary energy mix, and coal has more than held its own over the period (Figure 2), showing renewed growth in the last two years in response to high oil and gas prices. This is causing concern for environmental policies aimed at cutting pollution and greenhouse gases by reducing coal consumption which clearly are not working.

Location and sophistication of key refining capacity

Future growth of oil supply remains constrained by its ultimately depleting reserves (i.e. its non-renewable character), historic lack of capital investment in field development, and production infrastructure, associated costs of production / supply, the control exerted upstream by OPEC and other producing nations, and the OECD / IOCs control of downstream infrastructure. This latter point is exemplified by the location and quality of refining capacity (Table 2).

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Table 2: Ten countries hold more than 50% of global refinery distillation capacity and some 65% of global refinery conversion capacity. Most of those 10 countries are located within the OECD, and none are located within OPEC. CDU means crude distillation unit. Most of those refineries are operated by the IOCs. - Table courtesy David Wood & AssociatesClick here to enlarge image

In 2004, 73.2 million b/d of the world’s 82 million b/d of crude oil refinery capacity (89%) was located in non-OPEC countries. Countries with high product demand tend to have large refinery capacities. North America had 153 of the world’s 717 refineries (132 in US) with a crude oil refinery capacity of about 16.7 million b/d. Only three other countries had refining capacity exceeding 3 million b/d: Russia 5.4 million b/d; Japan 4.7 million b/d; China 4.5 million b/d.

In addition, several countries are strategically important to world refining to enhance supplies primarily to OECD countries. For example, Caribbean nations (including US and European territories) have limited indigenous oil production (213,000 b/d in 2003) but have a combined refinery capacity of about 1.7 million b/d with much of the refined products being exported to the US. Other countries with high refining / domestic production ratio, such as: Netherlands; South Korea; Singapore, are located within the OECD.

The more sophisticated refineries with cracking and deep conversion facilities that can process lower-quality crude oils and extract more high-demand products from them (i.e. gasoline and diesel) and meet the toughest product specifications are even more concentrated in the OECD, particularly the US.

There are, however, two emerging investment trends that suggest this disparity in downstream infrastructure distribution and control is set to change: 1) several Middle Eastern OPEC nations are investing heavily to build large, modern refineries and petrochemical plants (e.g. Kuwait, Saudi Arabia, and Qatar); 2) Several IOCs are investing heavily to build large, modern refineries and petrochemical plants in the largest non-OECD developing energy product demand economies of China and India (e.g. BP is selling some refinery capacity in the UK to reinvest in Asia).

One possible view of the second trend, and that taken by some within OPEC, is that the IOCs are merely trying to retain their control over downstream infrastructure and to minimize the global influence of that being developed in OPEC countries.

About the authors

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David Wood [woodda@compuserve.com and www.dwasolutions.com] is an international energy consultant who specializes in the integration of technical, economic, risk, and strategic information to aid portfolio evaluation and management decisions. He holds a PhD from Imperial College, London. He is based in Lincoln, UK but operates worldwide.

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Saeid Mokhatab [saeid_mokhatab@hotmail.com] is an advisor of natural gas engineering research projects in the Chemical and Petroleum Engineering Department of the University of Wyoming. He has published more than 50 academic and industrial papers, reports, and books. In addition to his technical interests, he has written extensively in wide circulation media in a broad range of issues associated with LNG, LNG economics, and geopolitical issues.

Control & influences on world oil price - Part 2: How value is extracted from oil along its supply chains

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