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Oil Prices Keep Swinging: The Search For Stability

by John W. Anderson
Journalist-in-Residence

September 15, 2004

When the Arab oil exporters embargoed oil shipments to the United States in 1973, many Americans including President Nixon called for energy independence. At that time the United States burned 17 million barrels of oil a day, 36 percent of it imported.

Thirty years later the country was burning 20 million barrels a day, 61 percent of it imported.

What happened to all those vehement resolutions to cut oil imports? By large majorities, over the years American consumers and politicians decided that any forceful attempt to reduce consumption or significantly boost production would be too disruptive and too costly. Economic analysis suggests that they were right.

RFF senior fellows Ian Parry and Joel Darmstadter argued in a February 2004 RFF Web Feature that "calls for radical policies to make the United States self-sufficient in energy within a decade are wholly unrealistic and misguided" (see How Should Policy Makers Respond to Growing U.S. Oil Import Dependence?).

Link to Feature and Discussion Paper on Energy Dependence
How Should Policy Makers Respond to Growing U.S. Oil Import Dependence?
RFF Web Feature
February 6, 2004

But, they added, oil dependency is a legitimate cause for concern and a case can be made for higher energy taxation, as well as for more research and development to diversify the country’s energy sources.

"It is the dependence of the world's transportation system on petroleum that causes the greatest local and global environmental impacts," senior fellow Ray Kopp wrote in the summer 2004 issue of RFF's Resources (Rethinking Fossil Fuels: The Necessary Step Toward Practical Climate Policy).

That won't be changed easily. "From a technical point of view," Kopp observed, "there is no alternative fuel ready for prime time."

Although many Americans complain about the unpredictable leaps and drops of prices in a world oil market that appears to be increasingly instable, the current attitude seems to be to put up with uncertain prices in the short run and, for the longer future, look to technology to provide alternatives to oil.

Technology may well produce an alternative, but it isn’t likely to happen soon. The likeliest candidate at present is hydrogen. But moving to the hydrogen economy will take, by most estimates, a matter of decades.

Link to Resources article
Rethinking Fossil Fuels: The Necessary Step Toward Practical
Climate Policy
Resources, Summer 2004

                         

In American political life, every surge in oil and gasoline prices brings cries for federal action to hold prices down. In the immediate future, there is very little that the government can do.

One perennial proposal is to increase drilling in the United States, where production has been steadily falling since 1970.

But the key to improved energy security is reducing oil intensity, Michael Toman, then of RFF, said in early 2002 (See Issue Brief 02-04 International Oil Security: Problems and Policies). Oil intensity is the ratio between oil consumption and economic output–the amount of oil used to generate each dollar’s worth of GDP.

The cost of replacing imports with domestic production would be “prohibitive,” another RFF researcher, Heather Ross, observed.

Lower consumption of oil means a lower impact on the economy when prices rise, she pointed out. Higher domestic production does not greatly affect the economic impact or energy security, since prices are set on the world market. (See Producing Oil or Reducing Oil: Which is Better for U.S. Energy Security? in the Summer 2002 issue of Resources.)

Link to RFF Issue Brief
International Oil Security: Problems and Policies
Issue Brief 02-04
January 2002


Another frequent suggestion is to tighten the CAFE (corporate average fuel efficiency) standards, raising the distance that American cars can travel on each gallon of gasoline.

Four RFF scholars – Paul R. Portney, Ian Parry, Howard K. Gruenspecht (now a government official) and Winston Harrington – examined CAFE in a discussion paper in late 2003 (The Economics of Fuel Economy Standards).

They noted that while more stringent standards would reduce gasoline use per mile driven, they would also make it cheaper to drive each mile. That would encourage somewhat more driving, possibly with social costs at least equal to any beneficial effects.

"It’s quite possible," they found, "that tightening CAFE could do more harm than good."

Another option, discussed in several RFF papers, is the use of the federal government’s Strategic Petroleum Reserve, which currently holds a stock of about 660 million barrels of oil in underground caverns as insurance against an emergency.

Link to Resources article
Producing Oil or Reducing Oil: Which is Better for U.S. Energy Security?
Resources, Summer 2002

                      

There has been a continuing debate over whether and how this oil should be used to offset price rises.

The reserve was established after the 1973 embargo as a protection against a dire shock. It can also be used effectively to punish speculators if they manage briefly to drive prices above the market-clearing price.

But over a longer period, withdrawals from the reserve could have only very modest effects on prices in a world market that currently consumes more than 80 million barrels a day, Joel Darmstadter  said in an April 2004 RFF Web Feature (Surging Gasoline Prices: A Longer Perspective Needed).

Spikes in pricing – abrupt rises rapidly followed by drops – will pass without permanent damage to the economy.

A more worrying prospect, Darmstadter observed, is a price increase that persists for the long term. That’s all the more reason to concentrate on long-term solutions rather than quick fixes, he said.

Link to RFF Discussion Paper
The Economics of Fuel Economy Standards
Discussion Paper 03-44
November 2003

The present dependence on oil carries substantial risks and costs of its own. When the price spikes upward and stays there for more than a few months, it slows world economic growth. When it drops, it discourages long-term investment in the highly capital intensive facilities to produce, refine, and distribute the oil that will be needed in the next growth cycle. Price drops also discourage the investments required for alternative energy sources.

For the United States an oil price increase of $25 a barrel – roughly the increase between December 2001 and midsummer 2004 – is the macroeconomic equivalent of a tax increase of $110 billion a year, about one percent of GDP. That is not a crippling burden for a healthy economy, but it is certainly big enough to have a visible effect on the growth rate and employment.

Worldwide, the "disappointing" pace of the economic recovery since the slowdown in 2000-2001 is "at least partly due to rising oil prices," the International Energy Agency (IEA) concluded in May 2004. According to its analysis, "global GDP growth may have been at least half a percentage point higher in the last two or three years had [oil] prices remained at mid-2001 levels" – that is, around $24 a barrel. By the spring of 2004 when the IEA report was published, they were up to $34 a barrel. By midsummer, oil was selling at well over $40 a barrel.

Link to RFF Web Feature:
Surging Gasoline Prices:
A Longer
Perspective Needed

RFF Web Feature
April 13, 2004

Although oil intensity has been cut by half throughout the industrial countries over the past 30 years, a sustained rise in oil prices still has a significant effect. In the industrial economies, the IEA’s models show that a rise of $10 a barrel, persisting for a matter of years, would reduce GDP by 0.4 percent, raise inflation 0.6 percent, and raise unemployment by 0.1 percent.

In the developing world, the effects are much harsher because oil intensity is higher – that is, oil is used less efficiently. That same sustained increased of $10 a barrel, the IEA calculated, would reduce GDP by 0.8 percent in China and 1.0 percent in India – twice or more the impact in the richer countries. Oil intensity is rising in China as more people buy cars.

One daunting issue for economists is assessing the risk of a major disruption in oil supply – a drop of several million barrels a day sustained over a period of years. The last time that happened was in the Iranian revolution of 1979-81. The futures market shows that traders currently consider that kind of upheaval unlikely and apply only a minimal risk factor. But it is not clear that public policymakers, with their broader responsibilities, should blindly follow the market’s judgment.

Oil prices are basically set by global supply and demand, but neither of those factors is easy to forecast from month to month, let alone over longer periods. The underlying reason for the rise since 2001 has been rapidly growing demand from two countries, the United States and China. But it’s not only the huge economies that move the market. The price dropped also sharply in 1997-98 because of a financial crisis in several East Asian countries, most of them developing countries. It then shot upward over the next two years because the producers underestimated the speed with which those countries would recover.

The supply side of the equation is even harder to foresee, because it is more heavily influenced by the domestic politics of the exporting countries. Venezuelan exports dropped precipitously at the turn of 2002-03 because of a struggle for power there. A struggle for power has more recently cast a cloud of uncertainty over Russia’s exports. Warfare in Iraq has repeatedly disrupted shipments from a country with immense reserves.

For several decades the Organization of Petroleum Exporting Countries (OPEC) has repeatedly sought to stabilize prices by adjusting its production. That has never worked reliably, partly because of errors in forecasting demand and partly because of cheating by members reluctant to reduce their export earnings. But by 2004 OPEC was facing a larger challenge. It no longer had much excess production capacity it could use to push prices down. Like most other countries, most of OPEC’s members were simply producing at their maximum capacity.

The chief exception, Saudi Arabia, promised in the summer of 2004 to raise its production, but it was not entirely clear how much excess capacity it actually commanded. Throughout the world, excess production capacity in late August 2004 was between 500,000 and 1 million barrels a day, 1 percent of production or less, according to an estimate by the U.S. government’s Energy Information Administration (EIA).

Assuming no prolonged disruption of the sort that would be caused by war or revolution in a major exporting country – and that is no small assumption – it looks as though the world’s oil policy will continue, as in recent years, to be left sometimes to Adam Smith and his invisible hand and sometimes to OPEC.

But neither Adam Smith nor OPEC provides stable prices. Far from it.

“With demand growing rapidly this year, and estimates that strong growth will continue into next year as well, there are concerns that production capacity, which is barely ahead of demand requirements, will struggle to even keep pace with demand growth over the next several quarters,” the EIA said in its weekly survey This Week in Petroleum on Aug. 25, 2004.

That leaves the world’s overstretched oil markets vulnerable to shocks from any interruption in supply anywhere – shocks that would mean higher and more instable prices.

To be realistic, there is no escape from those shocks in the near term. The only remedies in sight are technological advances that may lie a generation in the future.

Oil Consumption Chart

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