Recent Developments in U.S. Energy Markets: A Background Note - analysis of causes of high oil prices, International Monetary Fund - Statistical Data Included

New England Economic Review, Sept-Oct, 2000 by Jane Sneddon Little

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In its October 1999 World Economic Outlook, the IMF assumed that oil prices would be $18 per barrel in 2000. In reality, oil prices will probably average closer to $30 than to $20 a barrel this year. As oil prices have continued to rise above expectation, analysts have scrambled to find explanations. This note outlines some of the developments that have led to persistently high oil prices over the past two years. It compares the current situation with that prevailing at the time of previous oil shocks, and outlines some of the difficulties entailed in measuring the impact of sharp oil price increases on U.S. inflation and output.

I. The Current Situation

As Figure 1 shows, crude oil prices averaged close to $34 a barrel in September 2000. That was 200 percent above late 1998 prices (which, to be sure, were unusually low) and the highest nominal level since October 1990 during the Gulf War, when oil prices hit $35.90. Looking ahead, the (volatile) futures markets suggest that oil prices will remain above $30 per barrel at least through the first quarter of 2001, with prices falling to $28 per barrel by late in the year. That outcome would be a good deal higher than expected in January 1999. (1) According to Figure 2, the price of natural gas, our second most important energy source, has also increased almost 200 percent since late 1998 to reach $5 per million Btu, its highest level since 1985. Because dual capacity systems have spread and customers have an increased ability to switch between fuels, oil and gas prices may be more closely linked than in the past.

In part because oil prices have been "backwardized" for the past 18 months, with futures prices well below the contemporaneous spot, refiners and wholesalers have hesitated to buy petroleum stocks in advance.

Rather, anticipating lower oil prices, they have drawn down inventories instead. Accordingly, as Figure 3 indicates, U.S. crude and heating oil stocks are well below their normal range. Indeed, in August 2000 total stocks were near 24-year lows. In New England, the U.S. region most dependent on oil for heat, stocks of heating oil are about one-third of last year's level. The United States is not alone in this situation -- oil stocks are low in other OECD countries as well. As for natural gas, because gas is increasingly being being used for U.S. electric power generation, and a hot summer led to a surge in power use in Texas and California, U.S. natural gas stocks are also below normal -- by about 9 percent.

Further, both the oil and the gas industries are facing short-term capacity constraints through much of the supply chain. At the wellhead, for instance, among the major oil-producing nations, only Saudi Arabia has the ability to pump significant amounts of additional oil over the very near term, as Table 1 indicates. (2)

Moreover, as of the early autumn, tankers moving oil from the Middle East to Atlantic ports or heating oil from the Gulf Coast to New England were also fully booked. Further, as Figure 4 shows, oil refineries have been operating at an unusually high level for much of the past two years -- in part because U.S. refining capacity decreased markedly from the early 1980s to the mid 1990s. This summer, accordingly, when gasoline inventories were at historic lows, refiners were operating at peak capacity to meet the demand for gasoline for the summer driving season. With capacity stretched, refiners delayed the annual switchover from gasoline to distillates; as a result, stocks of heating oil were below normal at the start of the heating season. Looking ahead, over the coming winter, less than 1 percentage point of new refining capacity is expected to come on line. Gas pipelines are also expected to be operating near full capacity in the winter months. An important new conduit, the Alliance Pipeline from western Can ada to the Midwest, is being developed but is unlikely to be fully operational until the close of the heating season.

How did we arrive at the current juncture? Because oil is stored most cheaply in the ground, and arbitrage between ground and spot oil markets is slow (it takes six to eight weeks to move oil from the Middle East to the United States), oil prices tend to be quite volatile over the near term. This volatility has been aggravated by the unusually large imbalances between supply and demand (shown in Figure 5) associated with the onset of the Asian financial crisis, and by the unexpectedly strong and rapid recovery in global growth that followed. Over the medium term, moreover, the long lag times between decisions to drill new wells or build new refineries and increased supplies of petroleum products can amplify these instabilities.

To illustrate, in 1996, after three years in which world growth exceeded 4 percent, oil prices rose, briefly touching $25 per barrel late in the year. In response, OPEC increased production in early 1997, just before world growth (and demand for oil) stagnated with the start of the Asian financial crisis in the second half of that year. (3) As a result, nominal prices fell to $11 per barrel by late 1998; real prices fell to their lowest level since the early 1970s. In early 1999, thus, non-OPEC producers Mexico, Norway, Oman, and Russia joined OPEC in implementing a series of production cuts, culminating with a cut of over 4 million barrels a day -- about 6 percent of world output.