Tuesday, October 14, 2008

Money Miss Road.... Part 2



Dre & I were having drinks today and we got talking….. he went off on another one of his rants after I said “the actual cost of producing a barrel of oil is less than seven dollars”

How on earth does the cost per barrel reach $100?! These oil companies are milking us like crazy, it’s unbelievable!
Well… yes & no
Why do you say no
There is very little profit in gasoline, the other products like kerosene, fuel oils, etc. these are considered “value added products”
But since there is profit overall, why not balance it out with other products? Plus we are moving away from the main subject. If the drilling costs are so low, why the high cost of the raw crude?
Futures
You mean futures trading?
Yup!
I saw a show on TV and some analyst dude said futures have very little to do with high oil prices.
Really?
Yeah, I saw it on CNN
Do you know how the futures exchange works?
Not really, I’m thinking long term contracts to purchase oil for lower prices.
That’s sort of true, but it got complicated along the way
How?
Imagine you’re a corn farmer and I farm potatoes, corn grows May to August, I plant potatoes in October and harvest in April. We have an agreement that during the summer, ill give you half my potatoes in exchange for half your corn harvest for the winter months. This deal seems fair & strait-forward except that sometime in July, a hurricane swept through the farm and destroyed half of the corn field. In one evening your corn just became twice as expensive. Now if you handed me the other half as per our agreement, you would starve in the winter. It would be impossible to come to an agreement on how to split the remaining corn without someone loosing.
Now come into modern day futures trading, we know that June/July is hurricane & forest fire season and you are planting in an area prone to such disasters…. The agreement should include a probability of the crops getting damaged and how to manage costs in that case. So instead of me giving you half my potatoes, ill give you a quarter, sell another quarter for gold & have a third party hold on to it (holding corporation). If your corn survives the hurricane season, you’ll give me half as we agreed, Ill square you the gold bars and we are even.
You see the price of potatoes for you in the summer doubled, but you made up for it in the winter, that’s similar to oil prices going up and down. People are making deals based on the probability of delivery in the future, so when someone bombs an oil pipeline, a shrewd dictator cuts oil supply or similar threats are made to oil infrastructure, the guarantee of delivery is threatened so the price of oil jumps. When everything is cool, the price goes down.
You are making half this stuff up
Ill agree don’t know it all in detail but this is the jist of it
Cool….. I’m not buying the holding company part though.
Fine, a holdings company might offer to buy the risk part of our deal for cash and we give them a portion of our profits. If we suffer some losses, they will carry us through till things get better, or sell off their part, cash in whatever assets they can lay their hands on and leave us hanging to dry.
That’s what a holdings company does?
Have you heard of Warren Buffet?
Who hasn’t?
Well, he doesn’t make microchips or Ikea garbage. He buys part of an insurance company, invests with policy premiums until the company has to payout a claim. Does this sound like what im taking about?
Yeah…. You’re right. How do you know all this stuff?
I do a lot of reading, but just enough to be educated on a subject but never enough to be an expert, unless you’re talking engineering & robotics. Anyways, when next you’re filling up at the pump, you’ll know the real reason for sending troops to Iraq. You need security to stabilize the price of oil.... or be the cool guy everybody wants to hangout with….. like China.
I want to agree with you but I still don’t see why the farmers can’t use cash to replace the barter system.
Here's a modern day example where you have cash. Say you’re a bank, or a holdings company & you just paid for the construction of a multi-billion dollar facility that will produce a gazillion barrels of crude oil off the Caspian coast. It such a huge project, it attracts discovery channel, national geographic and green peace. Customers are lining up.
Time for project completion & first oil – say 4-5 years
Time to payback loans & start chewing profits – 3-4 years
Now you have a dilemma, do you wait 8 years before you start to see your bank balance get fat or you’d like to see it sooner?
If you answered sooner, you’ve walked into the futures exchange.
Even before your engineers buy a bag of cement, you can start selling the oil the rig will output. How do you set your price?
Yeah…. Yeah… you have to consider the project going over budget, accidents, delays, chances demand will drop….. A whole bunch of stuff to consider….. I get it.
In order to be safe you just make the price so high, there’s no way inflation and these other factors can make you loose money, everybody should be just fine…. Except the consumer.
Boy this shit is crazy, so how come you’re not CEO of one of these companies?
In due time kiddo…. In due time…..

1 comment:

Mamarita said...

DUDE!! Update, Yes?