Bubble, Bubble, Oil and Trouble Econoday Focal Point 3/15/00 By Anne D. Picker, International Economist

Oil’s slippery slope
World oil prices have been increasing since February 1999 when the Organization of Petroleum Exporting Countries (OPEC) reduced the permitted production output for its members by about four million barrels a day. Since then, inventories have dwindled and prices have tripled. The price increases have begun to filter through to countries' price indexes and are worrying central bank policy makers including those at the Federal Reserve. OPEC members have not, as they have in the past, succumbed to the temptation to increase production and cash in on higher prices — especially at prices above $22. The compliance level remains at about 74 percent.

 

OPEC's rocky history The Organization of the Petroleum Exporting Countries (OPEC) is a permanent, intergovernmental Organization located in Vienna. Founded in 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, 11-member OPEC was joined later by Libya, Qatar, United Arab Emirates, Algeria, Nigeria and Indonesia. OPEC's objective is to coordinate and unify petroleum policies among member countries. The OPEC Conference of Ministers meets in ordinary session twice a year, and is responsible for the formulation of the organization's general policies including production allocations. The upcoming meeting on March 27th will decide future production limits. OPEC currently supplies more than 40 per cent of the world's oil and owns about 78 per cent of the world's total proven crude oil reserves. Throughout its history, compliance to its guidelines has been fractious. Even now, on the eve of their important March 27th meeting, agreement on increased amount of production is by no means assured at this writing. Production has to give producing countries the money they need to function, while providing the world the crude it needs at a reasonable price.

Supply and demand still apply
World economies are always sensitive to the supply and price of commodities, especially oil. Oil prices are rising for two reasons — demand is increasing while OPEC producers are limiting supply. As world growth recovers, more oil is demanded for factories and businesses, and this bids up the price of energy. At the same time, production quotas are now being honored instead of ignored, reducing available supply. The net result has been higher prices

With OPEC's March 27^th meeting finally approaching, the rhetoric of political maneuvering builds here and abroad. But oil experts think that OPEC's apparent reluctance to open the taps as wide as users would like could backfire. Major OPEC members do not want to see exceptionally high prices, which would trigger another boom and bust cycle. Rather, the producing countries will put more oil on the market to prevent that from happening whether OPEC approves or not.

There is a growing consensus in the oil industry — after a period of skepticism in mid-summer — that higher oil prices are here to stay. Saudi Arabia, Venezuela and Mexico have agreed that increased output is necessary. But the ministers’ statements emphasize the crucial role that strict compliance is playing in oil’s recovery along with the importance of ensuring that global inventories stay under control. And diplomatic rapprochement between Saudi Arabia and Iran is being tested with Iran promising adequate and timely supplies. Analysts interpreted this as support for raising output when the agreement expires on March 31^st. As demand rose and inventories fell below the comfort level, oil prices have tripled, much to the surprise of the biggest oil companies and their shareholders.

However, a rerun of the seventies' grim story when supplies shrank, oil prices skyrocketed and inflation soared is unlikely. Inflationary pressures remain extremely subdued despite the recent rise in oil and other non-food commodity prices. A large part of the world economy is just emerging from the threat of a deflationary recession. The unexpectedly strong signs of recovery in southeast Asia and a better outlook for Europe have helped to raise the demand for oil, reversing the buildup of excess stocks.

The west has become far less dependent on oil thanks to energy conservation and also a decline in heavy industries. This decline reflects not only deliberate policy — such as the encouragement of smaller car engines and improvements in industrial efficiency — but also the evolution in the advanced economies to information, not oil.

Since the early 1970s the amount of oil consumed per real dollar of output has fallen by half in the developed countries. In the United States, for example, energy now represents three percent of gross domestic product verses nine percent in the 1970s. Similarly, the link between oil and commodity prices and inflation has broken down during the past decade. The old rule of thumb that a 10 percent increase in commodity prices would trigger a one percent increase in inflation has not worked well since 1990.

In the period after 1985, when OPEC collapsed and oil prices fluctuated between about $15 and $20, the big oil companies made spectacular gains in efficiency. The cost of finding, developing and operating a new source of oil has fallen to only about $6 per barrel, less than half the figures in the mid-1980s.

Oil suddenly re-emerged as an economic and political threat mainly because of events abroad. Some of the factors that brought oil down to record lows in late 1998 have been reversed in recent months. The main factor is oil hungry Asia. The sharp recession in Asian economies beginning in 1997 foreshadowed a collapse of oil prices. Asia's speedy recovery recently has created hefty demand and contributed a great deal to the price surge.

At the same time, oil producing nations, their solidarity in tatters as recently as 1997, have engineered a period of strategic harmony unseen since the 1973 Arab oil embargo. Like the 1970s, experts these days analyze closely every public statement by world oil ministers for hints that more oil will start flowing soon.

OPEC's cutbacks have been so effective that stocks in consuming countries are now approaching historically — and some say dangerously — low levels. Gasoline inventories in the U.S. are already at record lows. If refineries wait for prices to catch up with their rising crude costs, gasoline prices could go up more as the summer driving season heats up. Those refineries in Europe that meet U.S. product standards might not be able to help because they too will feel the pinch from increased driving demand. A rule of thumb is that it takes about two months for crude in the middle east to arrive at the gasoline pump in the United States.

Conventional wisdom says the new economy depends much less on energy, and oil seems to have no more power to sway the U.S. economy than cotton or copper. But it's taken only a few weeks of $2 per gallon heating oil, $40 airline ticket surcharges and $60 gasoline bills to fill up the sport utility vehicle to make people wonder if oil is really so irrelevant after all.

Is the economy as immune to an old-fashioned commodity as many had come to believe? If not, does oil pose a threat to the record American economic expansion? Washington is growing nervous about the intentions of oil producing countries for the first time since the Persian Gulf War, when oil last crested above $30 a barrel.

Oil can be a powerful drag on rich economies. The Organization of Economic Cooperation and Development (OECD) estimates that every $10 rise in the price of a barrel of oil lifts inflation by half a percentage point and reduces economic growth by a 0.25 percent. The OECD also estimates that inflation in developed countries has nearly doubled to 2 percent from 1.1 percent a year ago, with the price of oil accounting for the difference.

Impact of higher crude oil prices
Despite the economy's shift to technology, making it less dependent on oil, below are just some of the places where the impact is being felt.

On currencies — Crude oil is priced in U.S. dollars. This automatically creates demand for more dollars to pay for the crude. As countries other than the United States need to pay increasing amounts for energy, they are required to use their foreign exchange reserves or purchase dollars. This drives up the value of the U.S. dollar.

On current account surpluses — Assuming there is no reduction in the amount of crude imported, higher prices reduce the size of the surplus (or increase the deficit). For example, crude oil and oil products accounted for 10.5 percent of Japan's imports in value in 1999. Rising energy costs will likely depress Japan's trade balance, while adding to inflationary pressures. In the graph below, imports have declined as the price refiners pay for crude has risen.

On prices — The higher priced crude will raise costs to companies who use petrochemical-based inputs for their products. Higher fuel prices add to delivery charges. If the rising costs cannot be absorbed, increases in the form of higher prices will be passed along to consumers. Fuel, for example, is a major cost component for airlines and truckers and is beginning to be passed on to consumers. Nevertheless, in today's highly competitive environment, it has been difficult to pass on rising costs.

On profits — If the additional costs cannot be passed on to consumers or offset by greater productivity, profits will decline. If demand softens because of the higher prices, this too will negatively impact profits through lower sales.

On exploration and use of reserves — Consistently higher prices would encourage increased exploration and development of otherwise inefficient resources. Higher prices provide the incentive and profits to tap these reserves. Producers would also look to alternative energy sources to substitute for oil.

Soaring world crude prices are likely to lead to higher consumer prices across Asia and Europe and may trim some projected current account surpluses. Because most Asian countries hold limited stockpiles, few have the option that local producers or the United States have of dipping into hefty strategic petroleum reserves to offset the increases. Most others are dependent on oil imports and higher prices are expected to be passed on to consumers, bringing about varying degrees of imported inflation, which potentially could threaten demand.

On the road
In the United States, where cheap gasoline has always fuelled a national romance with the open road, the surge in oil prices during the past year is seen as a personal affront. Pump prices have soared to $1.50 per gallon and higher and that outrages American motorists. But it is not just U.S. consumers who are thinking about the politics of gasoline prices. Big oil producers know the sheer size of the U.S. oil market makes it very important to them. The United States last year consumed nearly 20 million barrels of the 75 million barrels of oil burned in the world every day. Imports last year accounted for 51 percent of United States oil demand, and the trend is for imports to rise steadily in coming years as U.S. reserves become depleted.

 

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Item	Amount	Cost	Cost per Gallon
Diet Snapple	16oz	$1.29	$10.32
Lipton Ice Tea	16oz	$1.19	$ 9.52
Gatorade	20oz	$1.59	$10.17
Ocean Spray	16oz	$1.25	$10.00
Pint of milk	16oz	$1.59	$12.72
STP Brake Fluid	12oz	$3.15	$33.60
Vick's Nyquil	6oz	$8.35	$178.13
Pepto Bismol	4oz	$3.85	$123.20
Whiteout	7oz	$1.39	$25.42
Scope 1	5oz	$0.99	$84.48
and
Evian water	9oz	$1.49	$21.19

The International Energy Agency (IEA), which monitors world oil supply and demand, reported that fourth quarter oil inventories fell by the largest amount in a decade and are now likely draining even faster.

Non-OPEC supply has done little to moderate the declines. Oil companies have been occupied with integrating their mergers from the past two years and have remained too skeptical about the high prices lasting to boost refinery output. With Asian economies recovering, world oil demand is projected to increase 2.4 percent this year to 77 million barrels a day. OPEC and non-OPEC producers would have to add about 2.4 million barrels daily just to keep pace with rising demand, according to IEA estimates.

Some analysts say the lesson of the latest price spike is that oil is not yet just another commodity. Every American depends on oil products every day, to keep warm, move around, wrap food and ship packages.

BOTTOM LINE
Economists and OPEC watchers are split on whether the oil problem will persist. Many believe that prices have peaked, with oil ministers already sending signals that they intend to increase output. If that proves true, then today's high oil prices will probably be seen as nothing more than a temporary disturbance. The conventional wisdom about oil will seem truer than ever.

Though U.S. officials seem optimistic that the March meetings will lead to some increased output, the question is how much. With oil inventories at record lows relative to demand, the International Energy Agency estimates that OPEC would need to increase output by nearly 10 percent just to keep pace with world demand.

But there is also a much less rosy scenario that sees oil supplies remaining tight for a couple of years, until non-OPEC producers respond by drilling for new oil. Prices would hold at current levels or even jump higher. That would fuel inflation and repeated interest rate increases by the Fed. In the worst case, higher interest rates could push the U.S. economy into recession. In that scenario, oil, having helped prompt downturns in the early 1970s, the early 1980's and the early 1990s, would once again become the bête noire of the U.S. economy.

Stay tuned for more…