Image: John Schoen
By John W. Schoen Senior Producer
updated 3/8/2011 1:53:55 PM ET 2011-03-08T18:53:55

Let’s get this straight: At the moment, the U.S. has plenty of oil.

Let’s get another thing straight: The price of oil is likely to keep rising because of market psychology and buyer panic about Mideast turmoil. And there’s nothing you can do about it.

To understand why, start with the fact that the price of a barrel of oil or a gallon of gasoline has little or no connection to the cost of producing it.

As of last week, there was some 346 million barrels of oil in American storage, according to the Department of Energy, comfortably above the five-year average range for this time of year. Reserves represent about a 25 day supply for the U.S., a comfortable cushion by historical standards. But, that has done little to keep prices from surging. On Monday, amid news that Libya’s civil war posed a new threat to that country’s oil exports, the benchmark price of U.S. crude hit $107, the highest level in over a year and a jump of nearly 30 percent in less than a month.

Story: Rising gas prices could hamper spring, summer travel plans

Gasoline prices have also surged in the past month, even though roughly 234 million barrels of it were sloshing through the system as of last week, well above five-year averages. The average price of a gallon of regular gasoline hit $3.51 last week, up 13 percent in a month.

The loss of Libya’s oil output — even all of it — would remove a relatively small percentage of total global supplies. In any case, Saudi Arabia is believed to have enough spare capacity to cover any shortfall.

But that’s where the oil market’s nightmare scenarios begin. With virtually no other spare capacity, the global oil market is running on fumes. And no computer model can predict whether — or how far — the turmoil will spread in the richest oil production region in the world

“A little over two weeks ago, we were trading below $85 a barrel,” said Addison Armstrong, research director at Tradition Energy. “This price move that we've seen over the past 14, 16 days is all related to what amount to concerns over what could happen."

Story: Price of oil retreats as OPEC mulls raising output

So why are prices skyrocketing?

For starters, there’s a huge range of cost from one oil producer to the next. Saudi Arabia can pull a barrel of oil out of the ground for just a few dollars; that same barrel extracted from tar sands in Alberta, Canada could cost $60.

Further, not all crude is created equal. Oil comes in a wide range of blends with properties that can have a big impact on price. Gasoline is cheaper to produce from “light” oil, which flows better, so refiners have to pay more for it. The same is true for “sweet” oil, which comes out of the ground with lower sulfur content; the “sweeter” the oil, the more gasoline refiners have to pay for it. (Not all refiners can handle heavier, sour grades of oil.)

Though oil prices are widely reported based on the costliest “light, sweet” blends, oil sells for a wide range of prices.


On top of these variations, oil and gasoline prices depend heavily on just how much the last buyer is willing to pay. It’s pretty much like the last-minute airline ticket buyer who is willing to pay a big premium to sit next to a passenger who paid substantially less for the same flight.

As oil prices have become more volatile in the past decade, more buyers have tried to lock in the cheap seats to guard against future spikes in those last-minute fares. Ironically, that increased demand for “paper oil” — from airlines to Wall Street hedge funds — has had the perverse effect of adding to the upward pressure on prices.

“The size of the oil industry — in terms of demand — has increased by 15 percent in the last eight years, while the size of the oil market as a financial instrument has increase by 600 to 700 percent,” said Tom Kloza, publisher of Oil Price Information Service. “The number of companies that trade oil in the paper market has increased many times from what it was 10 years ago.”

The latest price surge comes as paper oil buyers, fearful of even higher prices, have swarmed the market. Kloza says the price squeeze has been made worse by a dearth of oil companies willing to offer up contracts to sell at current prices.

“What happens if the price goes to $150?” he said. “With those paper losses, I’m going to the board room and get beaten up because I sold at $100.”

And it's hard to see how tapping into the U.S. Strategic Petroleum Reserves will help. Investors know the U.S. government is sitting on 727 million barrels — about a 38-day supply. And it still doesn't make them feel any more in contol of the Mideast's future.

Dealing with volatility
As painful as the latest price spike may feel to consumers, gasoline prices — adjusted for inflation — are lower than they were in 1980. Consumers, businesses and the economy at large feel little or no impact from gradual price increases. It's the sharp sudden spikes that set drivers howling in protest.

So why can't someone figure out how to get rid of those spikes? It's not for lack of trying.

For decades, the job of maintaining stable oil prices fell to the Texas Railroad Commission, which stepped in after a 1930s oil boom sent prices plunging.

Since the 1973 Arab oil embargo, the U.S. government has gone to extraordinary lengths to try to maintain stable oil prices and adequate supplies. Hundreds of billions of dollars have been spent to station troops through the oil-rich Middle East; billions more have been spent in tax breaks and direct subsidies to promote domestic oil exploration, boost dwindling supplies and reduce reliance on imports.

A 2009 report by the Environmental Law Institute found that from 2002 through 2008, some $72 billion in tax breaks and subsidies was spent to support development and production of fossil fuels. The recent turmoil in the Arab world has demonstrated that investment has done little to dampen the volatility of prices at the gas pump.

But as oil prices have surged, those subsidies have been harder to maintain. From China to Iran, gasoline subsidies have been rolled back recently, often sparking protests from cash-strapped consumers.

Other developed countries have taken a different approach, adding a heavy tax on gasoline to try to reduce consumption. For consumers, it’s a costly solution — one that holds little political viability in the U.S. But it can provide European consumers and business with an important safety valve that helps dampen the painful impact of quick price surges, according to Jaydee Hanson policy director the International Center for Technology Assessment.

“Japan and Europe have much higher taxes on fuel,” he said. “But they’ve been able — when the spike come up — to reduce temporarily the taxes to keep the prices more or less steady.”

Though many Americans chafe at the suggestion, the most effective solution may be to simply use less gasoline. That process is already underway. Though gasoline demand continues to follow a seasonal pattern — rising in summer, falling in winter — consumption peaked the week of July 6, 2007 and has been trending lower since then. That trend will likely continue over the longer-term if the price of gasoline continues a gradual move higher.

Industry watchers like Kloza say that’s the most likely scenario. But with the recent volatility in the Arab world upending everyone’s forecasts, they can’t rule out painful price spikes along the way.

“At a meeting today, I asked if our programmers wanted to make sure that we have the ability to show gasoline prices that were above $9.999 a gallon,” he said. “I don’t think it’s likely. But its certainly in the realm of possibility in this decade — or dare I say this month or this year.”

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Photos: Gas Turmoil

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Video: Why are gas prices so high in California?

  1. Transcript of: Why are gas prices so high in California?

    MATT LAUER, co-host: Let us begin, though, on this Tuesday morning with the soaring gas prices . According to AAA , the national average now $3.52. That's up 40 cents in just a month. In California , where prices are highest in the country, the average is a staggering 3.96, that coming from San Francisco . NBC 's Miguel Almaguer is there. Miguel , good morning to you.

    MIGUEL ALMAGUER reporting: Matt, good morning. If commuters here in California were paying the national average for gas, it would be a bargain. Here at this Chevron in San Francisco , it is 4.29 for a gallon of gas. Drivers here in San Francisco are paying the highest price for a gallon of gas anywhere across the country. February was a brutal month, not just here in California but all across the country. I want to show you a graphic of just how drastically gas prices spiked in the month of February. In New York , they had gas prices rise 28 cents a gallon in February alone. In Illinois , up 34 cents. Michigan spiked 38 cents. And last month the jump at the pump here in California was nearly 50 cents . Now, why are we paying so much money for gas in California ? Well, there's two answers. Strict emission laws mean that California requires a special blend of gasoline, a more environmentally friendly blend of gasoline, so it's more expensive. And number two, Californians are taxed at the highest rate for gas. Add those two things together and drivers here in California , and specifically here in San Francisco , are paying the most at the pump. Matt:

    LAUER: That is a hefty price tag. Miguel Almaguer in San Francisco . Miguel , thank you very much . Four minutes after the hour. With more on this story, here's Meredith .

Explainer: Overview of Libya's oil resources

  • Image: A Libyan oil worker, works at a refinery inside the Brega oil complex

    OPEC member Libya is the 17th largest producer in the world, third largest producer in Africa and holds the continent's largest crude oil reserves. It normally pumps around 1.6 million bpd, 85 percent of which is exported to Europe and its output is equivalent to about 2 percent of global oil consumption.

  • Libya's place in the oil producing world

    How the country measures up in crude supplies and production.

  • Exports

    Before the war, Libya was a net exporter with domestic consumption estimated at only around 270,000 bpd.

    Europe was most affected by Libyan oil export disruptions. About 28 percent of Libya's oil went to Italy, 10 percent to Germany, 11 percent to China and France and 3 percent to the United States.

    Libyan oil accounted for about 23 percent of Ireland's oil and about 22 percent of Italy's, according to the IEA.

    Around 13 percent went east of the Suez Canal to Asia.

    The shortfall from the loss of Libyan output was covered by alternative sources such as Nigeria and Azerbaijan, which produce similar light crude oils to Libyan oil.

    Saudi Arabia also brought some it its spare capacity online, according to Saudi sources. The kingdom promised to fill any supply gap caused by the unrest in Libya although it produces heavier crude with higher sulfur content than Libya.

  • Infrastructure


    Oil fields
    Most of Libya's oil fields are located in and around the Sirte Basin, in the northeastern part of the country, which contains around 80 percent of the country's proven reserves.

    Other key areas include the Ghadames Basin, about 240 miles south of Tripoli and Cyrenaica Basin in the northeast and the Murzuq oil field in the desert in the south of the country.

    Libya has five domestic refineries with a combined capacity of 378,000 barrels a day:

    Azzawiya Oil Refining Co
    Sarir Refining
    Sirte Oil Co
    Tobruk Refining
    Ras Lanuf Oil & Gas Processing Co

    Libya exported various grades of light crude from six major terminals, five of which are located in the eastern part of the country, where protests erupted near the second city of Benghazi.

    Following are the eastern terminals with pre-war loading volumes in January, 2011 provided by the IEA.

    Es Sider 447,000 barrels per day
    Marsa El Brega 51,000 bpd
    Ras Lanuf 195,000 bpd
    Tobruk 51,000 bpd
    Zueitina 214,000 bpd
    Zawiyah 199,000 bpd (January exports)
    Oother unspecified terminals 333,000 bpd

  • Companies

    Image: Libyan oil worker, works at a refinery inside the Brega oil complex

    Libya's state company
    Under the Gaddafi regime, Libya’s oil industry was run by the state-owned National Oil Corporation (NOC), which was responsible for managing exploration and production sharing agreements with international oil companies. Along with smaller subsidiary companies, the NOC accounted for around 50 percent of the country's oil output.

    Foreign players
    Major oil companies operating in Libya include:

    BP (Great Britain)
    ConocoPhillips (United States)
    Eni (Italy)
    ExxonMobil (United States)
    Hess Corp (United States)
    Marathon (United States)
    Occidental Petroleum (United States)
    OMV (Austria)
    Repsol (Spain)
    Shell (United States)
    Statoil (Norway)
    Wintershall, a unit of BASF (Germany)


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