August 11, 2004
What is happening to oil prices, and will these high
prices hurt the economy?
At the beginning of this year, I was lambasted by oil
industry analysts when I suggested that oil might average more than $30 per
barrel. They were sure that new
pipelines from Russian fields, a rebound in Venezuelan and Nigerian
production from the previous year’s disruptions, and improving deliveries
from Iraq assured ample supplies.
I was concerned that reduced yields from natural gas
exploration and the continued increase in natural gas fueled electric
generators could result in supply shortages that might require higher oil
use for other than gasoline use. I
was wondering about the energy intensive growth in China and a rebound in
world economic growth. Of
course, I also was looking at weather services that guessed the summer would
be hotter than normal.
As it turns out, production has been stronger from
Venezuela and Nigeria than in the previous year.
The Russian pipelines are not yet operational but are approaching
completion. Of course, Iraq has
been a major disappointment, but supplies from that country are up from the
World demand has jumped, as nearly 10 percent economic
growth in China has led to almost 19 percent gains in energy material
imports by that country. Oil
demand also is up sharply in India while consumption in the U.S. was
originally estimated as growing faster than economic activity.
(Revised intelligence from the Department of Energy slashed about a
percentage point from gasoline growth in their latest estimates.)
However, the weather has been unusually mild.
Those long term weather forecasts certainly make economic forecasters
While I did steer investors that I advise into oil
production and oil service investments, the best performing investment
sector so far this year, I never thought oil would reach $40 per barrel.
In fact, if we do not get relief soon, oil might average that amount
for the year.
Initially, analysts were concerned that the 51
varieties of summer gasoline required by the Environmental Protection Agency
would tax our aging refining capacity.
Some analysts remain concerned that refining capacity is insufficient
to allow normal maintenance and meet product needs.
Nevertheless, the latest gasoline inventories are
sufficient to meet the needs for the remainder of this driving season.
We need to lower the varieties of gasoline by next summer so that
refinery surpluses in one geographical area can more readily meet shortages
that might develop elsewhere. We also need some additions to our refinery capacity.
Frankly, our inventory of crude petroleum remains in
the middle of the range that has been adequate in the past few years.
Yet, crude prices continue to push upward for four reasons.
First, industrial use of oil has been growing 5 percent
and this is the product that most clearly can substitute for natural gas if
a cold winter threatens supplies. (Because
of the mild summer, natural gas in storage currently is at 2 year highs.)
While problems are unlikely this winter, they certainly remain
Second, almost everything that could go wrong has done
so at some point this year in world oil production.
Norway had a short strike. Nigeria remains unreliable.
Iraq’s delivery system remains under attack.
The engineers needed in Saudi Arabia to expand that country’s
capacity have been put at risk. A
tax battle in Russia threatened the loss of 2 percent of world oil
Third, world demand is rising more rapidly than world
capacity, especially if all energy materials, including natural gas, are
considered. This could change
with increased investments, especially for natural gas delivery systems; but
a minimum of two years will be needed to generate ample capacity improvement.
Fourth, low interest rates have allowed speculators to hold inventory off the market until a disruption provides profit opportunities. Frankly, as borrowing costs rise, some of this speculative inventory may be reduced.
While I remain skeptical about significant reductions
in oil prices well into next year, I can see some improvement on the
horizon. Two years from now we
may again be at $30 oil and $3 natural gas (which currently is more than $6
per thousand cubic feet).
In the meantime, $300 million per day is being diverted
from consumers to pay the higher prices for imported oil and domestic
supplies than a year ago. The
average wage earner has experienced a 1.5 percent decline in real earnings
during the past year.
Is this income diversion enough to push the economy back into recession? I don’t think so. But it is enough to create a slower growing economy than needed to lower unemployment rates from their current levels. Until we get some relief in the oil patch, do not look for much additional vigorous economic growth, or much improvement in related equity values.