Oil Markets: Principles, Perceptions, and Prices
Speech at a meeting at the Peterson Institute
These are challenging times for the US economy. The economy is slowing in the wake of a significant downturn in the housing sector, tenuous financial markets, and unprecedented commodity prices. Chief among the concerns on the minds of most American consumers is the dramatic rise in the price of oil. High oil prices are an enormous burden on American families and the US economy, as well as families and economies around the world. Further, the growing financial imbalances created by the flow of oil and money between consumers and producers are both concerning and unsustainable.
The economics are clear: With strong growth in demand and sluggish increases in production, the price must go up to allocate the limited oil available.
In January 2002, a barrel of oil cost about $20. By January 2005, the price had more than doubled, and by January of this year, the price had doubled again. Earlier this month, the price approached $150 per barrel. More recently, as concerns about the slowdown of the global economy increased and as fears of hurricane-related disruptions of oil production in the Gulf of Mexico dissipated, the price of oil dropped to its current level of about $125 per barrel.
Today I'd like to discuss why this dramatic increase in price has happened and what we should do about it. Simply put, the world economy-and with it global demand for oil-has been growing rapidly, and the supply of oil has not kept pace. In response, prices must rise to allocate limited supply. These long term trends are indisputable, and they are the primary drivers of the increase in oil prices.
Our challenge is complicated, however, by the fact that the difficulties we face in achieving a secure, stable, and cost-effective worldwide supply of energy are the flip side of the pressing need to address global climate change. There are no simple solutions to these deeply interconnected problems. But there are steps that policymakers can pursue now to put us on a path to a more stable supply of lower cost energy while also reducing the emissions of greenhouse gases. While my remarks today focus on high oil prices, the actions we take on this front-and in achieving energy security more broadly-can and must be consistent with our efforts to protect the planet.
A Fundamentals Story
On the demand side of the fundamentals story, we start with a positive development. Global economic growth from 2002 through the end of last year was remarkably strong, averaging about 4.25 percent in real terms, led by emerging market economies, like China and India. This has not only benefited millions of people within these countries, but also strengthened industrial economies through access to dynamic, high-potential export markets.
Most of the world's largest energy consumers are industrialized economies. But the growth in emerging markets has been accompanied by an increasing thirst for electricity and automobiles and the consequent extraordinary growth in demand for oil. According to the US Energy Information Administration (EIA), global oil consumption jumped about 9 million barrels per day since 2001, with the lion's share of this increase concentrated in economies where per capita consumption of oil is relatively low.
On the other side of the equation, global oil supply has not kept pace with the remarkable growth in the global economy and oil demand. Between 2002 and the present, the quantity of oil produced has risen at an average annual rate of about 2 percent, less than half the rate of expansion of the global economy. The economics are clear: With strong growth in demand and sluggish increases in production, the price must go up to allocate the limited oil available. This is what we have seen over the past several years.
Why has oil supply growth been slow? First, real investment in new capacity to produce oil has been weak around the world. Oil prices troughed after the Asian crisis in 1997, at one point going below $10 per barrel, as hard as that is to believe right now. At that price, there was minimal investment, capacity and workforces were cut, and spending on exploration fell sharply. In addition, the wave of nationalization of oil production and the increasing concentration of oil resources in global hot spots has resulted in reduced investment.
Most oil fields take years to develop, and in some cases a decade or longer. Because investment has been curtailed over the last decade, we now barely have the oil needed to offset declining production in older fields, let alone increase production to meet new demand. And looking ahead, it is increasingly the case that oil reserves are located where it is geologically difficult to develop them, and even greater investment will be needed to tap these resources.
Second, oil fields go through a natural progression. They start up, peak, and slow down. Over the past few years, a number of major fields are producing significantly less, and that loss has to be made up simply to keep global production flat.
This rising demand and stagnant supply has steadily chipped away at global spare capacity. In the 1990s, spare capacity averaged over 4 million barrels per day. Over the last five years, however, spare capacity has averaged less than half that amount and has dropped even more dramatically as a share of global consumption. Into this mix, we throw the third key factor that has affected the supply of oil-disruptions, or the perception of growing potential for disruption, resulting from events such as wars, civil turmoil, or hurricanes in the Gulf of Mexico. With little spare capacity to buffer against these events, these disruptions, and the fear of possible future disruptions, feed directly into higher prices.
Turning to this year, expectations of supply and demand have changed significantly and account for most of the rapid run up in price over the past six months. This development is explained by the fact that perceptions about future supply and demand can and do affect prices today.
For example, suppose it becomes clear that there will be a significant decline in the supply of oil six months from now. In that case, if you were a large consumer of oil, what would you do? You would likely buy as much oil as you could now, to avoid paying the future higher price. Yet, by buying the extra oil now, you would motivate the very price increase you anticipated. This also works in reverse. Expected future increases in supply, or future declines in demand, or some combination of the two, decrease the current price.
Over the past year, the market has gradually factored in the realization that supply is not keeping pace with demand. There was no one event that led to this realization. But a collection of small events-production delays for new oil fields, shortages in oil drilling equipment, the surprising resilience of emerging markets as the global economy has slowed, and growing geopolitical uncertainty in the Persian Gulf-changed market perceptions about current and future oil supply and demand.
We also see that even small changes in fundamentals can have large effects on prices, particularly in tight markets with a limited buffer between supply and demand. Again, back to basic economics: If supply falls by one percent, consumption must decline by an equal amount. That decline is brought about by an increase in price. Unfortunately, it is difficult to get people to reduce oil consumption, because it is so fundamental to everything we do and there are no close substitutes for it at present. Therefore, the price has to rise sharply to induce the necessary changes in consumption. We see this inelastic demand in current prices and feel its effects in our day-to-day lives.
So far, and despite their prominence in the news, I have not mentioned either speculation or currency depreciation. The reason is simple. The effects of these two factors are relatively minor in comparison to changes in the fundamentals that have been building up for a decade or longer. I am not dismissing them completely, but I want to put them in proper perspective. We must not let concerns over these second-order factors distract us from focusing our attention on the root cause of dramatic increases in price-a growing gap between the world's desire to consume oil and its capacity to produce it.
Other Contributing Factors
In oil futures markets, there are three types of participants: hedgers-these are market participants with commercial interests in oil, like oil companies or airlines, that need futures markets to offset the business risk created by volatile prices. Pension and index funds-these are typically funds that seek to diversify their assets with investments in commodities and who buy and hold for the long term. And, short-term investors often referred to as speculators-these are market participants with no commercial interest in oil who bet on future changes in the price.
Investors, whether focused on the long-term or short-term, play a crucial role by supporting a large and liquid oil market that makes it easier and cheaper for hedgers to minimize their business risks. Of course, there are well-documented examples of how small groups of investors have cornered markets in the past by hoarding physical commodities. This behavior is better known as "manipulation" and is rightly illegal. The Commodities Futures Trading Commission (CFTC) routinely polices markets and prosecutes such manipulation, and currently there is no evidence of hoarding. According to the EIA, inventories in the United States, and industrial countries more generally, are falling. Moreover, the CFTC's market monitoring shows that net positions of short-term investors have not grown relative to the overall market over the past two years, precisely the time at which they are being accused of causing the price of oil to soar.
Short-term investors can move prices-sometimes in a good way, like when they quickly move the market to incorporate the latest information, and sometimes in a bad way, like when they get caught having to "buy back" large bets on price swings that don't materialize. Clearly, they can contribute in this way to the volatility in prices that we have seen in recent months. However, by creating a large and liquid market, they also help reduce volatility, and over the longer haul, short-term investors do not systematically move prices away from the levels dictated by the fundamentals of supply and demand.
Some also assert that investors pouring money into oil futures contracts are driving up the price. Once again, however, there is little evidence to suggest that investment flows into futures are causing the rise in the price of oil. For example, the prices of other commodities, for which there are no futures markets and in which these funds are not investing, have risen as much or more than oil. As with oil, global demand for these commodities has increased dramatically, while supply has not kept pace. Fundamentals, not investment flows, are driving increases in these commodity prices and in oil.
Similarly, the effect of the depreciation of the dollar on oil prices is relatively small. The price of oil has soared regardless of the currency in which its price is quoted. For example, since early 2002, the euro-price of oil has shot up 250 percent, and the yen-price jumped 400 percent. Further, in the past 120 days, the dollar price of oil has risen more than 20 percent, while the real value of the dollar has changed very little.
It is true that a decline in the value of the dollar could result in higher demand for oil in countries whose currencies appreciate against the dollar. Everything else being equal, the price of oil in their local currency is cheaper and therefore could stimulate demand. However, over the last two years, consumption of oil in Europe has been flat, despite a strong appreciation of the euro against the dollar, suggesting that there are other factors more important than currency movements.
The Path Ahead
In many ways, I wish the problems we face were as straightforward as speculation or currency depreciation. Unfortunately, in addressing long-term trends in the supply and demand for oil, there are no easy solutions. We must take significant, credible, and comprehensive action today to change the dynamics of energy supply and demand in the longer term. Such steps will not only help over time to resolve the gap between supply and demand, but will also result in lower prices in the present.
First, we must better understand this rapidly changing market. Efforts to study the dynamics of the oil market are already underway. The International Energy Agency and the IMF have been charged by the G-8 finance ministers to dig deeply into the root causes of this problem. Similarly, the interim CFTC report released last week and the final study to be released in September are an important contribution to this debate. There are also much needed efforts underway to improve the available data on financial flows in oil futures markets, oil inventories, and proven reserves. Better data and more transparency will greatly reduce the uncertainty that contributes to higher prices.
Greater investment in oil production and refining capacity, as well as in alternative sources of energy, is urgently required.
Second, in terms of supply, we must cultivate an open investment climate at home and abroad through bilateral investment treaties, free trade agreements, and pro-investment policies. Greater investment in oil production and refining capacity, as well as in alternative sources of energy, is urgently required. Production in key countries such as Mexico, Russia, and Venezuela is declining; the vast majority of the world's oil reserves are nationally-owned; and one third of reserves are in countries that allow no foreign investment. Policies that restrict market access deny these markets much needed capital, know-how, cutting-edge technology, and entrepreneurism.
We also need to invest more within our own borders, and we need to do so in an environmentally sustainable way. A few weeks ago, the President lifted the executive ban on exploration of the Outer Continental Shelf, and he has called for America to do its part to increase the global supply of oil by increasing domestic exploration, leasing oil shale on federal lands, and streamlining the refinery permitting process. These measures have the potential to increase domestic supply in the long run and to bring far greater credibility to our efforts to encourage increased production overseas.
We must also pursue energy diversification by increasing investment in alternative sources of energy in the United States and around the world. In this regard, the government can play an important role by supporting basic research on critical technologies and creating market incentives for the private sector to develop and rapidly deploy alternative energy sources. Under President Bush's leadership, the United States has made real progress in these areas. Since 2001, we have spent more than $12 billion to research, develop, and promote alternative energy sources. Similarly, as a result of the President's renewable fuels mandate, use of these types of fuels is projected to exceed 8 percent of the US gasoline supply by 2015, more than double the 4 percent that it is today.
Of course, with the price of oil at roughly $125 per barrel, the private sector has every incentive to invest in alternative energy, and here we see market forces already at work. For example, electric cars are actually being produced by several start-up companies, and established US automobile manufacturers plan to introduce their own electric vehicles as early as 2010. Given the magnitude of the challenge, we and other nations must accelerate our efforts to develop and deploy these and other game-changing technologies, such as modern, safe nuclear facilities, wind power, and carbon capture and sequestration that are on the cusp of widespread commercialization.
Third, we must take steps to stem global oil demand. To this end, President Bush has implemented the first significant increase in car fuel economy standards in more than two decades. We can also work to better educate consumers on how they can conserve as they make energy conservation a social and financial priority. For example, in response to high fuel prices, a recent Gallup poll indicated that more than 80 percent of Americans are taking steps to cut back on their daily driving, and we already see the effect in a 4 percent decline in US gasoline consumption this year.
Also on the demand side, we should ensure that critical price signals are not obscured by subsidies. Currently over 50 percent of the world's population has access to subsidized fuels (and 22 percent of all gasoline purchases are subsidized). We don't expect countries to remove all subsidies tomorrow, and we welcome the steps that some countries, like China and India, have already taken. But the countries that subsidize need to develop a plan to eliminate subsidies over time. Just formulating and beginning to implement a credible plan could impact current oil prices. Not only will such efforts result in greater market transparency that will allow price signals to lower global demand for oil, but they will remove a significant economic burden on governments that subsidize, allowing them to dedicate these resources to more productive purposes.
The list of potential policy options is long, and I have only highlighted a few of the many that should be pursued. Ultimately, a complete package of actions must be taken by energy producers and consumers alike to reduce oil consumption, increase the diversity of energy supply, and put prices on a lower and more stable trajectory.
We face a great challenge, but we are no strangers to adversity. Addressing it will require new investment, new innovation, and significant changes in how we consume and conserve energy, but in a way that maintains the vibrancy of America's economy.
Because the dramatic rise in the cost of oil is a global dilemma, it is one that we must tackle in concert with others. An affordable, environmentally-sound, and economically sustainable energy supply is in the interest of the entire global community-producers and consumers, developed countries, and those developing. Success will require us to take tangible, credible, and significant steps to address the fundamentals of supply and demand, and to do so in a way that substantially reduces global carbon emissions in the coming decades.
To overcome this enormous challenge, Americans must do what we have always done-adapt, innovate, persevere, and prevail. I am confident we are up to the task.