Peter Jones: Oil price fall pumps up speculation

Brent crude prices have fallen by 55 per cent, but fuel has only come down by about 20 per cent. Picture: Phil Wilkinson

Why haven’t petrol pump prices fallen as fast as the crude oil price has? There is a simple answer, and another more complicated answer, to this question. The complex one raises a rather different and more worrying question – could the crude price crash be about to cause a financial crisis?

Let’s deal with the first and easier answer. At first sight, it looks as though the big oil companies have a great deal of explaining to do. Back in 2012-13, Brent crude was averaging $110 per barrel and, in the UK, petrol was costing around 140p per litre. Now Brent crude is hovering just under $50 per barrel, which is a 55 per cent price slump.

But pump prices have come down to only about 110p per litre, only about a 21 per cent price reduction. So what’s going on?

Mainly, as I think most readers will know, tax is the culprit. The motoring organisation AA publishes a regular breakdown of the various cost elements of the pump price. Fuel duty is the biggest single element and, at 57.95p per litre, it is exactly the same now as it was in 2012. VAT is the other bit of tax and, because the value of the fuel being sold at the pump has fallen, the VAT take has also come down from about 23p per litre in 2012 to 18.4p per litre now.

This, incidentally, shows that a Brent crude price fall does not only hit offshore production tax revenues, it also hits onshore revenues. Assuming that fuel consumption remains constant, the VAT from fuel sales has shrunk by about 20 per cent. Overall, it means that the tax yield per litre of petrol is down from about 81p in 2012-13 to about 76.4p now, a total reduction of about 5.7 per cent.

Taking this tax off the pump price leaves you with pre-tax costs at the pump of 59p per litre in 2012-13 and 33.6p per litre now. According to the AA data, the wholesale price of fuel when it leaves a refinery was about 51p per litre in 2012-13 and now it is about 24p (the remaining 8-10p includes the costs of fuel distribution and running petrol stations, plus the retailer’s profit).

It means that the wholesale price of fuel has fallen by 51 per cent, pretty close to the 55 per cent fall in Brent crude prices. While there might be questions to be asked about why consumers haven’t received that 4 per cent price reduction, it amounts to a missing 2p per litre, which doesn’t exactly substantiate a claim of price gouging by the big oil firms.

The second and more complex answer to the question posed at the start lies in how the fuel market works and what the oil companies and other players in the price chain, such as refiners, do to protect themselves against big crude oil price swings.

Big price swings are not uncommon. According to HSBC research, a price fall of more than 30 per cent inside four months has occurred 12 times since 1988, this current reduction being the biggest single fall by far. That’s a slump, on average, once every two years.

Of course, there are also price rises, but the point is that the oil price is volatile. Oil firms, like all companies, don’t like uncertainty, so they try to smooth out some of the volatility by taking out a type of insurance against the ups and downs.

This is called hedging, which can take several forms. The simplest one is a futures contract – agreeing to sell some production at various points in the future. Commitments to do this can be obtained up to six years in advance, but most are for up to 24 months.

Up to June last year, you could get deals to sell oil for up to a year in advance for between $80-90 per barrel. Nobody sells all their expected production in advance because there is always the potential of hitting an unexpected problem which cuts your production. If that happens and the market price on delivery day is, say, $110 when you have to fulfil a contract at a pre-agreed price of $90, you have to buy on the spot market at $110 and take a $20 loss on every barrel.

On the other hand, if there were no such production problems and you had agreed some year-ahead deliveries at, say, $80 last June, with the price at $50 you would now be thanking your lucky stars. But who loses out?

This hedging, which is done using a variety of financial derivatives, is mostly traded through the big investment banks. In effect, they sell forward-priced contracts to oil producers. The banks also try to sell the contract to crude oil users, such as refiners.

When crude was $110 and had been for three years, forward contracts at $80-90 would have looked pretty attractive.

Any refiner who bought these contracts six months ago would now be cursing the markets at having to pay $80-90 when the spot price is $50. If that was the case, then you would expect the wholesale price of refined fuels to have fallen less slowly than it has done.

As it has fallen pretty much in line with crude prices, then either refiners are taking a big hit just now or the banks are sitting on a lot of over-priced financial derivatives, just like they were when US homeowners started defaulting on mortgages and house prices fell, precipitating the financial crisis in 2008-09.

Surely the investment banks have learned their lesson? Since greed has not been expelled from investment banking, I’m not betting on it. A Reuters analysis last year estimated that the big Wall Street banks alone had $3.9 trillion worth of commodity derivatives on their books. Even if only a tenth of those are in oil, that’s $390 billion which is now worth only $180bn, a loss of $210bn.

And other commodities, from copper to cotton, have also tumbled in price.

Hmm. I’m assured by folk who know a lot about this business that there ain’t going to be no crisis caused by this stuff. But that’s what they said about housing derivatives. Fingers crossed that there isn’t another Lehman Brothers out there.