Update: The Price of Oil

Impact on the Economy

The U.S. economy remained “solid” through the second quarter of 2005. Consumer and business spending remained strong, while requests for jobless benefits continued to drop, and gross domestic product grew at an annual rate of 3.3 percent.[1]

However, during the third quarter, high oil prices began to take a toll, particularly in some sectors of the economy. In August 2005, Wal-Mart warned that rising oil and gasoline prices were hurting sales and trimmed full-year earnings forecasts.[2] In September, two airlines-Northwest and Delta-filed for bankruptcy protection, citing oil prices as a major factor. In October, American Airlines announced it was suspending 15 domestic routes due to soaring fuel costs.[3]

Increasing costs have also begun to impact European economies. In the UK, transport costs have increased the annual rate of consumer price inflation to 2.3 percent-substantially above market expectations and the highest level since the measurement began in 1997.[4] France faced a record trade deficit during the first six months of 2005, as imports-led by oil-rose 3.5 percent over the previous six-month period.[5] Furthermore, inflation rates in Eurozone countries ranged between 2.5 and 2.7 percent during the third quarter, and are expected to remain above the Central Bank’s definition of price stability (2 percent or below) for the rest of the year.

Asian economies have not been exempt from oil price pressures. Governments in Thailand and Indonesia have faced political protests sparked by high oil prices. Japan and the Philippines initiated energy conservation programs to blunt the effect of increasing costs. Politicians fear that India could face political instability from expected oil price hikes. In addition, Chinese officials sent additional police to Guangzhou to control protests after service stations ran short of gas, and motorists faced lengthy waits and rationing.[6]

Supply Issues

Members of the Organization of Petroleum Exporting Countries (OPEC) continue to pump at or near capacity, with Saudi Arabia (the world’s largest oil producer) agreeing to increase output for the foreseeable future.[7] New supply continues to come on-line, including seven wells drilled in the Sea of Okhotsk off the coast of Siberia-which some experts are calling the “Alaska North Slope” of this decade.[8] Nevertheless, prices remain hypersensitive to any news or event that might disrupt production, including a showdown between the West and Iran over its nuclear activities, labor disputes in Nigeria and other oil-producing countries, terrorist attacks in Iraq and Saudi Arabia, and hurricanes in the Gulf of Mexico.

Rigs and platforms in the Gulf of Mexico supply approximately 28 percent of U.S. crude oil and 19 percent of its natural gas. Hurricane Katrina swept through the Gulf of Mexico in late August of 2005 before battering the Louisiana, Mississippi, and Alabama coasts. Hurricane Rita followed a similar path in September 2005 before plowing into the Texas-Louisiana border. Katrina sank more than 50 oil rigs and natural gas production platforms. Initial damage estimates from Rita revealed one production platform pulled from its moorings, two drilling platforms with visible damage, and 38 mobile drilling units adrift. Though damage was less than feared, 100 percent of Gulf of Mexico crude oil production and 80 percent of natural gas production were shut down in anticipation of Rita. All these facilities required inspection before they were returned to service.[9]

While the human toll-particularly with Katrina-was high, the impact on oil supply and prices was short-lived. Katrina and Rita did, however, highlight the vulnerability of supply from an area deemed safe-or safer-from the usual worries of political unrest, labor disputes, and terrorist attacks.

Demand: Some Relief?

Global demand for energy remains high in 2006 with little change in U.S. demand and increasing demand from developing countries, particularly China and India. However, there are some signs that high prices are beginning to impact consumption.

One visible sign of change in consumer habits, or at least potential change, can be seen in U.S. automobile sales. Demand for gas guzzling SUVs dropped dramatically in September with sales of the GMC Envoy and Chevrolet Tahoe down more than 50 percent. Sales of other SUVs fell 18 percent or more. In contrast, Asian automobile manufacturers, with their lines of energy efficient models, enjoyed double-digit sales increases.[10] The trend continued in November led by the Ford Explorer, with sales down 52 percent, the Cadillac Escalade, down 48 percent, and the Chevrolet Suburban, down 46 percent from November 2004. Toyota’s U.S. sales, however, were up 13 percent year-to-year.[11]

China continues to aggressively search for energy sources to meet its growing demand. China National Offshore Oil Corporation (CNOOC), after losing its bid to buy Unocal, stated that it would continue to work with foreign governments and companies to expand its overseas oil and gas reserves.[12] Additionally, the Chinese government is considering plans to invest $24 billion in plants that turn coal (which is abundant in China) into gas and oil (which are not). A number of pilot plants are already under construction in coal-rich Inner Mongolia.[13] The Chinese government also recognizes that growing demand will cause energy prices to increase, and price increases could cause a slowdown in China’s economic growth. To combat such a potential slowdown, the government’s latest announced five-year plan focuses on energy efficiency and environmental protection.[14]

Speculators: Maximize Returns

The financial markets have been particularly rewarding to energy investors. Energy outperformed every other type of domestic investment in 2005. Calendar year 2005 economic sector performance, represented by Standard & Poor’s Depositary Receipts (SPDRs) Sector Exchange Traded Funds (ETFs), is outlined below in Chart 1. An ETF is a basket of securities that trade as a portfolio. SPDR Sector ETFs are designed to duplicate the returns earned in the underlying economic sector of the S&P 500’s broad market index. Chart 1[15] illustrates that the energy sector earned more than three times any other sector.

Chart 1. Economic Sector Returns-Calendar Year 2005

* Does not include income

The high returns earned by the energy sector-higher than all major indices and asset classes-attracted more and more investors seeking speculative profits. A popular strategy called “price momentum” seeks to identify rapidly advancing assets, thereby enabling an investor to purchase similar assets and “ride along.” The graph below shows the cumulative daily returns from energy futures versus daily volume. The contract under examination is a near-term expiration, continuously rolled into the next contract as it expires. The graph displays how as returns increased (i.e. building momentum), volume increased as well, implying that the higher returns attracted speculators seeking price momentum.

Chart 2. Energy Futures Returns and Volume

Data provided by Reuters[16]

Refineries: Still a Problem

Refinery capacity, or lack thereof, remains a problem. In the U.S., there has been no large investment in refineries in over 25 years. To meet demand, refineries were running at 95 percent capacity in 2005, up from 75 percent two decades ago. Additionally, many plants are deferring scheduled maintenance to limit downtime, thereby raising concerns about long-term risks.[17] Furthermore, these conditions existed before hurricanes Katrina and Rita.

The paths of Katrina and Rita took the two hurricanes into the heart of U.S. refineries. Katrina knocked out four refineries in the New Orleans area, and the lack of electricity kept them closed more than a month after the hurricane. Katrina and Rita each knocked out about 5 percent of U.S. refining capacity. However, damage was less than feared. As one oil analyst said, “… we dodged one of those rocket propelled grenades, but we took a couple of bullets.”[18]

The hurricanes highlighted the need for more refinery capacity. On October 7, the U.S. House of Representatives passed (by two votes!) the Gasoline for America’s Security Act. The bill directs the president to designate sites-including former military bases-for new refineries, streamlines the permit process, limits the different gasoline blends produced to meet clean air rules, allowing easier movement of fuel from one area to another (it is why limiting blends is important), and requires the Federal Trade Commission to investigate alleged energy price gouging. The Senate is drafting its own bill, which includes tax breaks to encourage refinery construction and expansion. The fate of both bills is uncertain as environmentalists accuse Congress of using the hurricanes as an excuse to approve long-term requests from the energy industry.[19]

What Does It All Mean?

To repeat the question asked one year ago, what does it all mean? The U.S. economy grew at a healthy 3.8 percent annualized rate during the third quarter despite the devastating hurricanes. Price inflation, excluding energy and food, rose at a low 1.3 percent annual rate.[20] However, the U.S. trade deficit, driven by increasing energy prices, grew to a record $66.10 billion in September 2005. The University of Michigan consumer sentiment report for November 2005 hit 79.9, down from 96.5 in July due to high gasoline prices and the fear of high heating oil prices this winter.[21] Thus the economic picture is mixed and the future uncertain.

On the supply side, new drilling areas may provide some relief. Royal Dutch Shell has been granted the right to explore for oil and gas off the western coast of Ireland. However, environmental groups continue to fight plans for an on-shore gas refinery and pipeline.[22] In the U.S., proposals are before Congress to relax bans on new drilling off California and the Atlantic Seaboard and to encourage exploration in the Rocky Mountains. However, critics from Governor Schwarzenegger to environmentalist groups have already come out against the plan, pointing to the 191,000 barrels of oil that polluted the Gulf of Mexico after Katrina and Rita ruptured pipelines and battered oil facilities.[23]

On the demand side, Americans are still driving their automobiles, but gasoline at $3.00 a gallon increased use of public transportation in Los Angeles and has increased the demand for fuel efficient automobiles. The mild start to the winter in the U.S. also lowered energy prices and increased inventories. However, many forecasters are predicting a colder than normal winter, which could send heating oil and natural gas prices up sharply.[24] The cold snap in early December 2005 emphasized the vulnerability of oil prices to weather by briefly sending the price of oil again above $60 a barrel-up 8 percent in one week.[25]

Conservation is becoming the byword, not only in Asian countries that have announced government enforced conservation policies, but also in the U.S. as well. After hurricanes Katrina and Rita, President George Bush appealed to the public to conserve energy by limiting discretionary driving.[26] Joseph Desmond, chairman of the California Energy Commission, called on residents, businesses, institutions, and government to immediately cut energy consumption and increase energy efficiency-especially of natural gas.[27]

Regarding speculation, as long as the returns in the energy sector far exceed the returns in other sectors, investors will probably continue to participate actively in this market, thereby impacting the price of oil.

Regarding refineries, everyone from Richard Branson of Virgin Atlantic Airways, et al. to oil sheiks in Kuwait is considering building new refineries. However, wanting and having are two different things. Arizona Clean Fuels has been trying for 12 years to get permission to build a new refinery in Arizona. They are still trying to get the necessary permits and approvals over the strong objections of community leaders. Even if plans were approved today, it would take at least five years to design and build a new plant. Therefore, refinery capacity will continue to be a problem, at least in the short term.[28]

Conclusion

Energy prices are a continuing concern to world economies. Most economies have weathered the high prices with only slight pauses and minimal disruptions. However, uncertainty is still high, and oil prices remain hypersensitive to decreases in supply and increases in demand.

So far the warnings of impending problems-reduction in spending (particularly consumer spending), increase in inflation, decrease in GDP growth rates, and decrease in corporate profits-have not appeared. Nevertheless, if oil prices begin to approach 1970s levels ($80 a barrel in today’s dollars), the economy could face a similar fate: sharp recession. The worst may be still to come.

[1] Bloomberg News. “Consumer, Business Spending Revised Up,” The Los Angles Times, 30 September 2005, C-3.

[2] Tassell, Tony. “Wal-Mart warning reflects impact of runaway world fuel prices,” The Financial Times, 17 August 2005, 22.

[3] Camerson, Doug. “American Airlines to suspend core routes as the price of jet fuel surges,” The Financial Times, 1-2 October 2005, 1.

[4] Swann, Christopher, Arnold, Martin and Tiesenhausen, Friederike. “Oil fuels world economy fears,” The Financial Times, 17 August 2005, 1.

[5] Thornhill, John and Atkins, Ralph. “Oil helps push France into record trade deficit,” The Financial Times, 18 August 2005, 4.

[6] Iritani, Evelyn. “Asian Economies Starting to Feel Effect of Oil Prices,” The Los Angeles Times, 29 August 2005, C-1.

[7] Douglass, Elizabeth. “Crude Oil Price Again Hits Record,” The Los Angeles Times, 9 August 2005, C-1.

[8] Brooke, James. “Texas Tea From a Russian Sea,” The New York Times, 28 September 2005, C-1.

[9] McNulty, Sheila and Hoyos, Carola. “Energy industry surveys Rita legacy,” The Financial Times, 27 September 2005, 4.

[10] Vincent, Roger. “Sales Downshift at Ford, GM,” The Los Angeles Times, 4 October 2005, C-1.

[11] Freeman, Sholnn, “SUV Sales Down Sharply,” washingonpost.com.

[12] Lague, David. “Aggressive Search by CNOOC For New Oil and Gas Seen,” The New York Times, 5 August 2005, C-4.

[13] McGregor, Richard. “China looks at $24bn coal-to-oil plan as Beijing bets on oil prices staying high,” The Financial Times, 27 September 2005, 6.

[14] Yang, Zhou, “China Hands Investors a Map,” The Wall Street Journal, 11 November 2005, C-14.

[15] Daily pricing on SPDRS from http://www.finance.yahoo.com, January 5, 2006.

[16] From Reuters through http://www.taosgroup.org (data from April 30, 2004 to October 21, 2005).

[17] McNulty, Sheila, “Refineries defer maintenance to keep oil flowing,” The Financial Times, 19 September 2005, 6.

[18] Douglass, Elizabeth. “Energy Prices Fall on Refinery Check,” The Los Angeles Times, 26 September 2005, C-1.

[19] Simon, Richard. “House Bill Calls for New Refineries,” The Los Angeles Times, 8 October 2005, A-14.

[20] Preciphs, Joi and Hilsenrath, Jon. “U.S. Economy Marks Solid Growth, Despite Storms,” The Wall Street Journal, 29-30 October 2005, A-2.

[21] Hitt, Greg and Preciphs, Joi. “U.S. Trade Deficit Swells to a Record,” The Wall Street Journal, 11 November 2005, A-2.

[22] Brown, John and Catan, Thomas. “Shell allowed to explore for oil off the Irish coast,” The Financial Times, 18 August 2005, 18.

[23] Simon, Richard and Weiss, Kenneth. “Plan for Coastal Drilling Emerges,” The Los Angeles Times, 3 October 2005, A-1.

[24] “Oil Prices Lowest Since July,” The Los Angles Times, 11 November 2005, C-4.

[25] Covel, Simona. “Crude Oil Rises as Cold Snap Hits,” The Wall Street Journal, 6 December 2005, C-5.

[26] McNulty, Sheila. “White House moves to prevent run on petrol,” The Financial Times, 29 September 2005, 6.

[27] Lifsher, Marc. “Conservation Urged to Cut Energy Bills,” The Los Angeles Times, 5 October 2005, C-1.

[28] Douglass, Elizabeth. “Hurricanes Aid Push for refineries,” The Los Angeles Times, 3 October 2005, C-1.