Alan Greenspan: Energy
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the National Petrochemical and Refiners Association Conference, San Antonio, Texas,
(via satellite), 5 April 2005.
* * *
Markets for oil and natural gas have been subject to a degree of strain over the past year not
experienced for a generation. Increased demand and lagging additions to productive capacity have
combined to absorb a significant amount of the slack in energy markets that was essential in
containing energy prices between 1985 and 2000.
This tendency has been especially pronounced for oil. Although the recent price of light sweet crude
oil is only a bit above the highs of last October, overall market prices of recent weeks, in fact, have
been much more elevated.
The prices of heavier, sour grades, which make up a significant part of the world production mix, are
notably higher than in October. Dubai crude for instance, at yesterday's close, sold for more than
$12 per barrel above its October price level. Moreover, although the price of six-year futures for light
sweet crude did not match the overall run-up of oil prices last fall, in recent weeks it has largely kept
pace with spot prices, leading to record levels for contracts maturing in 2011.
Reflecting a low short-term elasticity of demand, higher prices in recent months have slowed the
growth of oil demand, but only modestly. The slowdown in the growth of demand coupled with
expanded production, which the price firmness has induced, has required markets to absorb an
increased pace of inventory investment. The markets' response has been a shift in the spread
between spot prices and near-term futures that has facilitated inventory hedging. Futures prices for
delivery of both West Texas Intermediate and Brent crudes for the summer exceed spot prices. That
will likely support increased inventories of crude oil. If sustained, these market technicals could
encourage enough of an inventory buffer to damp the current price frenzy.
Natural gas prices, seasonally adjusted, have not returned to their peak of last October, but remain
significantly above the levels at year-end 2004. Working levels of gas inventories are seasonally
moderate, but domestic dry gas production plus net imports has not expanded sufficiently over the
past few years to prevent a marked rise in price. The inexorable rise in residential and utility use has
priced the more marginal industrial gas users partially out of the market and has induced significant
gains in gas efficiency among a number of gas users such as petroleum refineries, steel mills, and
paper and board mills. Industrial gas use overall in the United States has declined 12 percent since
1998.
***
The longer-term outlook for oil and gas is, if anything, more conjectural. Much will depend on the
response of demand to price over the longer run. Prices of spot crude oil and natural gas have risen
sharply over the past year in the face of constrained supply and the firming of overall demand. But if
history is any guide, should higher prices persist, energy use will over time continue to decline, relative
to GDP.1 Long-term demand elasticities have proved noticeably higher than those that are evident
short term.
Altering the magnitude and manner of U.S. energy consumption will significantly affect the path of the
U.S. economy over the long term. For years, long-term prospects for oil and gas prices appeared
benign. When choosing capital projects, businesses in the past could mostly look through short-run
fluctuations in oil and natural gas prices to moderate prices over the longer haul. The recent shift in
expectations, however, has been substantial enough and persistent enough to bias
business investment decisions in favor of energy-cost reduction.
Of critical importance will be the extent to which the more than 200 million light vehicles on U.S.
highways, which consume 11 percent of total world oil production, become more fuel efficient as
vehicle buyers choose the lower fuel costs of lighter or hybrid vehicles.
***
Aside from uncertain demand, the resolution of current major geopolitical uncertainties will materially
affect oil prices in the years ahead. That, in turn, will significantly influence the levels of investments
over the next decade in raising crude oil productive capacity and, only slightly less importantly,
investment in refining facilities.
Because of the geographic concentration of proved reserves, much of the investments in crude oil
productive capacity will need to be made in countries where foreign investment is prohibited or
restricted. Unless those policies are changed, a greater proportion of the cash flow of producing
countries will be needed for oil reinvestment if capacity is to keep up with projected world demand.
Concerns about potential shortfalls in investment certainly have contributed to current record-high
long-term futures prices.
To be sure, world oil supplies and productive capacity continue to expand. Major advances in recovery
rates from existing reservoirs have enhanced proved reserves despite ever-fewer new discoveries of
major oil fields. But investment to convert reserves to productive capacity has fallen short of the levels
required to match unexpected recent gains in demand, especially gains in China.
Besides feared shortfalls in crude oil capacity, the status of world refining capacity has become
worrisome as well. Of special concern is the need to add adequate coking and desulphurization
capacity to convert the average gravity and sulphur content of the world's crude oil to the lighter and
sweeter needs of product markets, which are increasingly dominated by transportation fuels that must
meet ever-more stringent environmental requirements.
***
U.S. natural gas prices have historically displayed greater volatility than prices of crude oil, doubtless
reflecting, in part, the less-advanced development of price-damping global trade in natural gas.
Over the past few years, notwithstanding markedly higher drilling activity, the U.S. natural gas industry
has been unable to noticeably expand production, or to increase imports from Canada. Significant
pressure on prices ensued. North America's limited capacity to import liquefied natural gas (LNG) has
effectively restricted our access to the world's abundant gas supplies.
Because international trade in natural gas has been insufficient to equalize prices across markets,
U.S. natural gas prices since late 2002 have been notably higher, on average, than prices abroad,
thereby putting significant segments of the North American gas-using industry in a weakened
competitive position. Indeed, ammonia and fertilizer plants in the United States have been particularly
hard hit as the costs of domestic feedstocks have risen relative to those abroad.
The difficulties associated with inadequate domestic supplies will eventually be resolved as consumers
and producers react to the signals provided by market prices. Indeed, the process is already under
way. As a result of substantial cost reductions for liquefaction and transportation of LNG, significant
global trade in natural gas is developing. This activity has accelerated sharply over the past few years
as profitable arbitrage has emerged in natural gas prices across international markets.
At the liquefaction end of the process, new investments are in the works across the globe. In Qatar
alone, five large-scale projects have begun construction or are at advanced stages of development. In
January, Egypt exported its first LNG cargo. Enormous tankers to transport LNG are being
constructed, even without being dedicated to specific long-term delivery contracts. The increasing
availability of LNG around the world should lead to much greater flexibility and efficiency in the
allocation of energy resources. According to tabulations of BP, worldwide imports of natural gas in
2003 were only 24 percent of world consumption, compared with 59 percent for oil. Clearly, the gas
trade has significant margin to exercise its price-damping opportunities.
In the United States, import terminals in Georgia and in Maryland have reopened after having been
mothballed for more than two decades. The added capacity led to a noticeable increase in LNG
imports last year, but LNG imports still accounted for less than 3 percent of U.S. consumption.2
Additional import facilities, both onshore and offshore, are being developed. According to the Federal
Energy Regulatory Commission, the number of approved and proposed new or expanded LNG import
terminals in the United States stood at thirty-two as of last month with a capacity to import 15 trillion
cubic feet annually, far in excess of any pending needs. Clearly, not all of these projects will come to
fruition. Some will be abandoned for economic and business considerations, and others will fail
because of local opposition, motivated by environmental, safety, and other concerns.
The larger question, of course, is what will increased world trade in LNG and expanded U.S. import
capacity do to currently uncompetitive natural gas prices in the United States? During the past couple
of years, when U.S. prices of natural gas hovered around $6 million Btu, import prices of LNG in
Europe have ranged between $2 and $4 per million Btu, and those in Japan and Korea have generally
been between $3 and $5 per million Btu. Estimates of production and delivery costs of LNG to North
America appear to hover around $3 per million Btu. In the short run, exporters to the United States are
likely to receive our domestic price, currently above $7 per million Btu. But unless world gas markets
tighten aggressively, competitive pressures will arbitrage the U.S. natural gas price down, possibly
significantly, through increased imports.
In addition to increased supplies from abroad, North America still has numerous unexploited sources
of gas production. Significant quantities of recoverable gas reserves are located in Alaska and the
northern territories of Canada. Negotiations over the construction of pipelines connecting these
northern supplies to existing delivery infrastructure are currently under way.
***
To be sure, the dramatic changes in technology in recent years have made existing oil and natural gas
reserves stretch further while keeping energy costs lower than they otherwise would have been.
Seismic imaging and advanced drilling techniques are facilitating the discovery of promising new
reservoirs and are enabling the continued development of mature fields. But because of inexorably
rising demand, these improved technologies have been unable to prevent the underlying long-term
prices of oil and natural gas in the United States from rising.
Conversion of the vast Athabasca oil sands reserves in Alberta to productive capacity has been slow.
But at current market prices they have become competitive. Moreover, new technologies are
facilitating U.S. production of so-called unconventional gas reserves, such as tight sands gas, shale
gas, and coalbed methane. Production from unconventional sources has more than doubled since
1990 and currently accounts for roughly one-third of U.S. dry gas production. According to projections
from the Energy Information Administration, the majority of the growth in the domestic supply of
natural gas over the next twenty years will come from unconventional sources. In many respects, the
unconventional is increasingly becoming the conventional.
In the more distant future, perhaps a generation or more, lies the potential to develop productive
capacity from natural gas hydrates. Located in marine sediments and the Arctic, these ice-like
structures store immense quantities of methane. Although the size of these potential resources is not
well measured, mean estimates from the U.S. Geological Survey indicate that the United States alone
may possess 200 quadrillion cubic feet of natural gas in the form of hydrates. To put this figure in
perspective, the world's proved reserves of natural gas are on the order of 6 quadrillion cubic feet.
***
In the decades ahead, natural gas and oil will compete in the United States with coal, nuclear power,
and renewable sources of energy. As the manner in which energy is produced and consumed evolves,
it is not unreasonable to expect that, in the long run, the prices per unit of energy from various sources
would tend to converge. At present, long-term futures prices for natural gas are, on a Btu-equivalent
basis, notably less expensive than those for crude oil.
Clearly, limited substitution possibilities across fuels have resulted in persistent cost differentials, but
those very differentials inspire the technologies that, over time, reduce such limitations. A clear
example is gas-to-liquids (GTL) technology, which converts natural gas to high-quality naphtha and to
diesel fuel. Given the large-scale production facilities that are currently being contemplated (and some
that have already begun construction), GTL is poised to become an increasingly important component
of the world's energy supply. Current projections of production however remain modest. GTL promises
to add a good measure of flexibility in the way natural gas resources are utilized. In addition, given the
concerns over the long-term adequacy of liquid production capacity from conventional oil reserves,
GTL may provide an attractive, competitively priced, option for making use of stranded gas, which, for
lack of access to transportation infrastructure, cannot be brought to market.
***
We are unable to judge with certainty how technological possibilities will play out in the future, but we
can say with some assurance that developments in energy markets will remain central in determining
the longer-run health of our nation's economy. The experience of the past fifty years--and indeed
much longer than that--affirms that market forces play the key role in conserving scarce energy
resources, directing those resources to their most highly valued uses. Adequate productive capacity,
of course, is driven also by nonmarket and policy considerations.
To be sure, energy issues present policymakers and citizens with difficult decisions and tradeoffs to
make outside the market process. But those concerns, one hopes, will be addressed in a manner that,
to the greatest extent possible, does not distort or stifle the meaningful functioning of our markets. We
must remember that the same price signals that are so critical for balancing energy supply and
demand in the short run also signal profit opportunities for long-term supply expansion. Moreover, they
stimulate the research and development that will unlock new approaches to energy production and
use that we can now only scarcely envision.