World Oil Demand and its Effect on Oil Prices
Released: 2005-06-09T00:00:00

Background

While the primary focus of this report is on conditions in the U. S. market, analyses shouldbe carried out in the context of the larger world market. Few actions by consuming, or producingnations, can be properly evaluated independently of the world market. Oil is a fungible, internationalcommodity whose ownership and ultimate destination is determined by market forces once it leavesthe producing country. No country can effectively isolate itself from changes elsewhere in themarket, nor is it likely that any nation can take actions that do not indirectly affect other nations.

Oil prices are linked, like those of other commodities, to the levels of economic activity inthe industrial nations. Demand, both from consumers and industrial users, tends to pick up whengrowth rates of gross domestic product increase and slow down when those growth rates decline. As a result, oil prices tend to be volatile, at least partly due to variations in the business cycle.

While oil markets may behave like other commodity markets much of the time, the oil marketdoes have unique features. First, few commodity markets have an institution like the Organizationof Petroleum Exporting Countries (OPEC). Since its creation in 1960, OPEC has had a variableinfluence on the price of oil through its member nation quota system. Second, oil has been subjectto supply disruption due to political instability as well as technical factors. Third, psychological orexpectations effects, tied to real or perceived probabilities of market disruption, may lead to pricevolatility. Finally, world oil transactions are settled in U.S. dollars, which affects the value of thedollar in world currency markets, as well as the magnitude of international reserves held bypetroleum importing and exporting nations around the world.

Oil Prices

Spot market price data for West Texas Intermediate (WTI) at Cushing, Oklahoma, is shownin Figure 1 . (1) During thetime period covered in Figure 1 , the OPEC price band for crude oil was at $22 to $28 per barrel. Accounting for quality and location differences between the OPEC reference crude (Saudi ArabianLight) and WTI, prices in the U.S. spot market during 2003 remained close to, or were above, theupper end of the OPEC price band. However, prices moderated for several months after thebeginning of the Iraq War in March 2003.

Figure 1. U.S. Spot Price of Oil, 2003-2005

Price increases began in the late fall of 2003, and continued into 2004, reaching a yearlypeak of over $53 per barrel in October 2004. Although prices fell by $10 per barrel by December2004, they began to rise again in January 2005, and peaked again at nearly $53 per barrel in April2005. (2) Some insight intofuture spot market prices might be gained by examining NYMEX futures market prices. (3) For example, in the five daysbefore it terminated trading on July 20, 2004, the August 2004 contract on WTI at Cushing,Oklahoma was trading at over $40 per barrel. As of July 23, 2004 the September and October WTIfutures contracts continued to trade at over $41 per barrel on the NYMEX. (4) On August 10, 2004 theNYMEX futures price for crude oil traded above $45, a first in the history of the exchange. On thesame day, the spot market price for WTI was at $44.48. (5) These data accurately suggested that high crude oil prices werelikely to continue for the remainder of 2004. By the end of May 2005, futures prices for the August2005 contract were trading at nearly $50 per barrel and the September 2005 contract was trading at$50.41 per barrel. These prices suggest that, while the crude oil price might remain volatile, reactingto current market conditions, it is unlikely that prices will return to pre-2003 price increase levelsfor the remainder of 2005.

Figure 2 shows the behavior of spot market prices for reformulated regular gasoline at NewYork Harbor. The price of gasoline has shown a pattern of movement somewhat similar to that ofoil prices.

Figure 2. U.S. Spot Market Price for Reformulated Regular Gasoline, New York Harbor, 2003-2005

Gasoline prices peaked in February and August of 2003. They then lagged oil prices, notshowing price increases in the fall of 2003. However, they did follow oil price increases throughoutthe spring of 2004, also peaking in May of 2004. Gasoline prices were volatile for the remainder of2004. After the May peak, the price remained approximately 12 cents per gallon lower for the nextfour months. Although the price went above $1.37 per gallon in October 2004, it finished the yearat $1.07, about 24% off the May peak. Gasoline spot prices increased in 2005. By April 2005, theprice peaked at over $1.52 per gallon. On June 3, 2005 the NYMEX future prices for gasoline inJuly, August, and September were above $1.50 per gallon. (6) As in the oil market, these futures prices suggest that there is likelyto be only modest, if any, moderation in gasoline prices for the rest of the year.

Conclusions concerning projected spot prices based on the trading value of current futurescontracts may or may not be accurate. Futures prices process new information and market conditionsquickly and prices can change direction on a daily basis. The futures price on the NYMEX and othermarkets is conditional on information available today. As more information becomes available,futures prices will adjust. However, futures markets are providing little indication that either oil orgasoline prices might decline in the near term.

Reserves and Production

The long term ability of the oil market to meet demand depends on the magnitude ofavailable reserves. An important category of reserves are proved reserves. Proved reserves are thosequantities that geological and engineering analysis suggest can be recovered with high probabilityunder existing technological and economic conditions. Proved reserves can be augmented throughexploration and development of new discoveries, through technological improvements, as well asthrough the existence of more favorable economic conditions. In the past, all of these factors havecontributed to augmenting the proved reserve base.

Whether the proved reserve base grows over time or not depends in part on the level ofproduction. As production proceeds, the level of proved reserves declines. As new oil discoveriesare made, recovery technologies improve, or as the price of oil rises, the stock of proved reservesincreases. A standard measure of the potential availability of oil over time is the reserve toproduction ratio (R/P). The R/P can be interpreted as the number of years that the existing reservebase can sustain the current level of production. Since both proved reserves and production canchange year-to-year, the value of the R/P is more descriptive as a measure of potential marketviability when considered over time. Table 1 shows the R/P over the past 20 years for the world aswell as various regions.

Table 1 shows that on the world level there appears to be little cause for concern that oil isphysically running out. While the R/P is lower in 2003 than in 1993 it is actually higher than it wasin 1983. (7) A reasonableestimate, given the political changes since 1983 might be that the ratio has remained roughlyconstant over the past 2 decades, leading to the inference that 2003 levels of consumption seem tobe about as sustainable as 1983 and 1993 levels of consumption were at those times, even though2003 world consumption levels were 17% greater than those of 1993.

Table 1. Oil Reserve/Production Ratios, SelectedYears

Source: For 2003 and 1993, BP Statistical Review of World Energy, June 2004. pp. 4, 6; and for1983, U.S. Energy Information Administration. International Energy Annual 1983 . Tables 14, 30. pp. 30, 84.

* Europe and Eurasian data incomplete because of lack of USSR data for 1983.

The reserve portion of the ratio shows that the world had access to more reserves in 2003than in 1993 or 1983. Reserves in 2003 totaled 1.147 trillion barrels. Reserves in 1993 were 1.023trillion barrels, and in 1983 were 723 billion barrels. These data represent over a 12% increase inreserves for the decade since 1993, and a 36% increase compared to 1983. Similarly, worldproduction is greater in 2003, at 76.7 million barrels per day (b/d), than in 1993 when production was66 million b/d, or 1983 when production was 57.9 million b/d. This represents an increase inproduction of over 32% compared to 1983. (8)

On a regional level, the most important change between 1993 and 2003 is the weakeningreserve position of North America, and the reserve position of the United States. On one level, thedata suggest that the U.S. position is improving. The U.S. R/P has increased from 7.7 years in 1993to 11.3 years in 2003 and total U.S. reserves have also increased to 30.7 billion barrels from 30.2billion barrels in 1993. However, the U.S. R/P has increased because U.S. production has declined,from 8.6 million b/d in 1993 to 7.4 million b/d 2003. As U.S. total consumption has increased overthe period, the result has been that U.S. imports of oil have increased along with our dependence onother nations and the world oil market. The declining reserve position of North America in generalmeans that, absent new major discoveries, the United States will continue to depend on the worldmarket, and the OPEC, Persian Gulf nations for a large part of its supply. (9)

The Middle East, and especially Saudi Arabia, continue to be the largest holders of reservesin the world. Some of the other regional changes in the data reflect changing national and politicalborders as well as oil positions. European reserves are now dominated by members of the formerSoviet bloc, including Azerbaijan, Kazakhstan, Romania, and others. Overall, the data suggest thecontinuation of an integrated world oil market. Any region, or nation, might well experiencedifficulty in trying to implement a singular oil policy, independent of the world market.

Another conclusion that might be drawn from the R/P data is that it provides little supportfor the escalated prices of the first quarter of 2004. Since little has changed in the long term balancebetween reserves and production, it is unlikely that the R/P has been the source of upward pricepressures. Long term oil prices might be affected by reserve and production positions in the future,but R/P ratios do not appear to be a major cause of recent oil price increases.

The world R/P has stayed roughly constant over the past 2 decades because investments havebeen made in exploration, development, and production. The International Energy Agency estimatesthat over $3 trillion, or $103 billion per year will need to be invested in the oil sector through 2030if its projections for increased demand materialize. It estimates that 70% of this total will be spenton exploration and development, with the remainder in refining, transportation and the developmentof non-conventional oil sources. (10)

Oil industry investment is only partly required to meet new demand. Only 16% of totalinvestment is projected to meet new demand growth. The remaining 84% is required to compensatefor declining production from the reserve base. The reason so much investment is needed tocompensate for declining fields lies in the decline rates observed in producing fields. Decline ratesdepend on a wide variety of factors, including geology, extraction technology, field age, andproduction policies. Decline rates range from 4% to over 11% per year. If production levels are tobe maintained, new reserves and production must continually be developed to compensate, financedby investment in exploration and development. (11)

Price and Markets

After averaging about $23 per barrel for the five year period 1998 to 2002, the average priceof oil increased to $31 in 2003. For 2004, price remained high, reaching a peak of $53.28 per barrelin October. (12) As ofApril 2005, the price of oil continued to remain over $50 per barrel, and peaked at $54 per barrel inMarch 2004. (13) R/Panalysis showed that there has been little change in the underlying long term balance in the oilmarket that might be used to justify high prices. However, a number of short term economicfundamentals as well as the coincidence of a set of singular events affecting the market may haveinteracted in such a way that prices were pushed up.

Economic Growth

Economic growth in oil consuming nations increases the demand for oil and pushes up oilprices. The world economy continued its recovery in 2003 and 2004 with gross domestic product(GDP) growth rates increasing in many regions. The strongest growth performances were in oilimporting United States and China, but better performance was also observed in Japan and Russia,as well as the emerging growth nations of Asia. U.S. growth was 3.1% in 2003, and forecast to reach4.6% during 2004. Chinese economic growth was 7.4% in 2003 and projected to be 6.8% in 2004,moderating only slightly for 2005. (14) In the United States, economic growth has been linked to highlevels of oil consumption, of which increasing gasoline demand is an important component. InChina, expanding exports have increased the industrial demand for oil, and rising consumer incomehas increased consumers' demand for gasoline. U.S. oil demand increased by 1.9% in 2003 to over20 million b/d. Chinese oil demand increased by 11.5% in 2003 to almost 6 million b/d. (15)

In both the United States and China the increase in GDP growth, and economic activity ingeneral, has led to increases in energy demand. However, a feedback relationship exists which canmitigate this effect. To the extent that oil prices rise, reflecting increased oil demand, GDP growthrates might decline for two reasons. (16) If the monetary authorities interpret increasing oil costs asgeneralized price inflation, they may adopt restrictive monetary policies which could slow theeconomy's growth. Also, if oil product prices rise, and consumers are unable or unwilling to reduceoil product consumption, consumers may reduce expenditures on other goods and services, againpotentially slowing the rate of GDP growth. (17)

While the United States and China increased their demands for crude oil and petroleumproducts as a result of their GDP growth, Russia, an oil exporter, improved its GDP growth rate asa result of the expansion of the petroleum industry. For Russia, it is likely that expansion of the oilsector led the growth in Russian GDP. This behavior is typical of nations whose oil exporting sectoris a major component of their GDP. For nations in this category, high oil prices, based on rising oildemand, create an inflow of oil derived revenue, increasing GDP growth. The danger for thesenations is that if prices go too high, and stay high, GDP growth in the consuming nations mightdecline, reducing the demand and price of oil. An additional factor is that high prices lead toincreases in exploration and development budgets around the world. As new oil is found andbrought to market, supply increases and prices might be reduced, damaging the oil exporting nation'sgrowth or high oil prices can make alternative fuels more competitive potentially reducing thedemand for oil.

Exchange Rates

Changes in the exchange rate of the U.S. dollar can affect the level and distribution of worldoil demand. The U.S. dollar achieved a recent peak value in February of 2002. Since that time, theindex measuring the value of the dollar has declined by over 20%. (18) The decline in the dollar'svalue has not been uniform against all currencies. Most of the change has been against nations inthe Euro area. The Japanese and some of our other Asian trading partners have intervened in thecurrency markets in an attempt to prevent the dollar from declining in value relative to theircurrencies. China maintains a fixed exchange rate against the dollar; as a result, the yuan hasexperienced no appreciation against the dollar.

Exchange rate variations in the U.S. dollar can affect the world price of oil because oil ispriced in dollars and generally paid for in dollars. Several results may follow from this relationship. First, if the value of the dollar declines against other currencies the dollars received by oil exportingnations are worth less in terms of world purchasing power. If oil exporters are able to exert marketpower in setting prices, or if market conditions permit oil exporters to dictate higher prices, they haveincentives to increase the money price of oil in an attempt to preserve the purchasing power they earnthrough selling a barrel of oil.

The effect of a declining dollar on oil importing consumer nations varies with respect to howtheir currency has adjusted to the changing value of the dollar. For the United States, of course, anyincrease in the dollar price of oil is immediately felt as an increased price burden, possibly leadingto decreases in demand. For the Euro area consumers, the situation is different. Since the value ofthe euro has increased in terms of dollars, the effect of any increase in dollar denominated oil pricesis offset by the amount of euro appreciation. For example, if the euro appreciates by the samepercent that the price of oil in dollars increases the two effects cancel each other. The result is thatthe demand for oil in the euro area is less likely to be affected by high oil prices as long as the euroappreciates. (19)

Nations that intervene in world currency markets to prevent the dollar from falling relativeto their currencies, for example, Japan, Korea and Taiwan, are implicitly choosing to forego theassociated real reduction in oil prices an appreciating currency would bring, to preserve the exportadvantage for their goods that a lower exchange rate brings. Since these nations are both large oilimporters as well as major exporters on world markets, the choice can have important implicationsfor their economies. China, which maintains a fixed exchange rate against the U.S. dollar, alsoforegoes any exchange rate based benefit with respect to oil purchases in favor of supporting exportindustries.

Gasoline Prices

Crude oil is the major physical input in the production of gasoline and accounts for over 40%of its cost. (20) As aresult, changes in the cost of crude oil will be reflected in gasoline prices. Recently, it might be thatthe relationship has been reversed: the high price of gasoline may have become a factor in keepingthe price of oil at elevated levels, especially on the New York Mercantile Exchange (NYMEX).

Gasoline prices have achieved record levels since they began increasing in the first quarterof 2004. Although the rising price of crude oil is one factor, other factors exist which areindependent of the oil market in general. The high utilization rates of refinery capacity in the UnitedStates, the lack of investments in new refining capacity, the extra costs associated with producingthe variety of different gasoline mixes to satisfy environmental requirements in various regions ofthe country, low inventories as the summer driving season 2004 approached, and the high cost ofrefinery investment to meet both product and site environmental requirements all contribute to therecord levels of gasoline prices. Additionally, on the NYMEX a condition known as"backwardation" was common during the first half of 2004. In this situation the near-month futurescontract, in this case regular grade gasoline delivered to New York harbor, is persistently pricedhigher than the price level of the same gasoline, scheduled for delivery months further in the future. The effect of this pricing condition is to make the acquisition of inventories in the present monthmore expensive than acquiring them further in the future. Backwardation provides an incentive tokeep current inventories low. The low current inventory position then acts as a factor keeping priceshigh, because low inventories are taken to be indicative of a tight supply situation in the market.

It is possible that the high price of gasoline, a price that is highly visible in the U.S. market,might contribute to keeping the price of oil high through an expectations based effect. Traders could hypothesize that since the price of gasoline is high, this might be the result of tight oil markets. Ifnot, there would be more oil refined, and gasoline produced, driving down the price. Theseexpectations could be acted upon through the NYMEX futures markets. This position ignores theimportance of the independent factors, cited in this report, that suggest that gasoline prices in theUnited States would likely have risen even if the price of crude oil moderated.

Industry Structure

A recent study by the Government Accountability Office (GAO) asserted that a total of over2,600 merger transactions took place in the oil industry from 1991 through 2000. These mergers fellinto two main classes: asset mergers and corporate mergers. Asset mergers accounted forapproximately 80% of the total, and the remaining 20% were corporate mergers. Asset mergers aredefined by the GAO as one company purchasing a part, or a specific asset from another company. For example, Tosco Petroleum's acquisition of Unocal's refining and marketing assets on the WestCoast in 1997 was an asset merger. Corporate mergers are defined as those in which one companyacquires the other company's total assets, resulting in one company. Examples include Exxon-Mobiland Chevron-Texaco, which produced two of the super major oil companies. (21)

A possible outcome of mergers and acquisitions is that the resulting companies, larger andmore capable of exerting market power, raise prices to the detriment of consumers. GAO carriedout econometric analysis on a set of these mergers and found that mergers and the resulting higherconcentration ratios observed in the oil industry resulted in wholesale price increases of about 2 centsper gallon in six of the eight specific cases it examined. (22) The Federal Trade Commission and its staff have challengedthe GAO finding on methodological grounds and question the validity of their conclusions. (23)

If the mergers that took place in the U.S. oil industry did raise wholesale gasoline prices, itis possible that retail gasoline prices also increased as a result. If that was so in a period when oilmarkets were perceived to be tight, those price increases might have fed back through the futuresmarket process described in a previous section of this report to help support high oil prices.

OPEC Policy

OPEC seeks to create favorable oil prices for its members by assigning production quotasto its member nations with the goal of limiting the supply of crude oil available on the world market. The ability of the quota system to control price has been questioned because of the well knownpropensity for OPEC members to produce beyond their assigned production levels. Even so, thevery existence of OPEC has influenced conditions in the petroleum market as buyers and sellersawait decisions taken at OPEC meetings, and monitor the institution's behavior. At certain times inits history OPEC has had relatively clear influence on oil prices, as in 1996, when a flood of Saudicrude oil came on the market and drove down prices

.

In response to recent price increases, OPEC has maintained that a shortage of crude oil onthe world market is not the reason. OPEC has asserted that the market is well supplied, and its actualproduction has exceeded quota levels. OPEC official production for June 2004 was announced as25.5 million b/d by the OPEC 10, to increase to 26 million b/d on August 1, 2004. (24) Actual OPEC productionfor June was thought to exceed 29 million b/d. (25)

Although gross volumes are consistent with a market that is not suffering from supplytightness, the effects of product segmentation must be considered. A fundamental breakdown in thecrude oil market exists between sweet, or low sulfur content, and sour, high sulfur content, oil. Itmay be that OPEC volumes of sour crude make the over-all market appear in balance while atightness in the sweet crude market underlies this over-all balance. Sweet crude oil is useful inefficiently producing the low sulfur transportation fuels, both gasoline and diesel, that environmentalregulations increasingly require, and is important to nations with relatively strict air qualitystandards.

The role of OPEC in the 2004 market price may be more traceable to actions taken in 2002. In 2002, OPEC production declined from an average of over 30 million b/d to approximately 28.5million b/d, a decline of some 5%. This production cutback changed the nature of the market in2003, as economic growth began to recover and enhance oil demand growth. Production in 2003not only had to satisfy the growing demand requirements of 2003, but also to compensate for thereduced availability in 2002 which reduced inventories. The result of these conditions is that as themarket evolved in late 2003 and into 2004 with economic growth strengthening, persistent shortfallsin inventory levels were observed.

Inventories

The United States holds petroleum stocks in three ways. The oil industry holds stocks ofcrude oil in inventory as well as stocks of petroleum products. These stocks are held to insure theefficient operation of refineries in the face of shifting seasonal product demand and potentialdisruptions in crude oil supply. Seasonal fluctuations in product demand are managed throughvarying the stocks of petroleum products, mainly gasoline. If inventories of either crude oil orgasoline are low relative to the past average, or in the perception of market traders, this is taken tobe an indication that the market is tight, implying that demand is nearly equal to, or might evenexceed, potential supply at current price levels. As a result, upward pressure on price occurs, evenif there is no physical shortage observable.

Figure 3 shows the behavior of crude oil stocks in the United States, excluding the StrategicPetroleum Reserve. The level of reserves in 2003 is relatively low compared to 2002. Stocks areincreasing in 2004 on a month to month comparative basis with 2003, but satisfying growing demandat the same time that stocks are growing contributes to the strong demand that has been a majorfactor in oil price increases. It has been reported that U.S. crude oil inventories during the last weekof July 2004 reached 298.6 million barrels, which on its own was judged to be consistent with a priceof oil of around $26 per barrel. (26)

Several factors have contributed to the decline in stocks held by the private sector. A longterm trend in the refining sector particularly, and the oil industry in general, is cost reduction. Inventory is expensive to hold, and one way to minimize costs is to reduce the size of inventory andexpand the use of efficient inventory

Figure 3. U.S. Crude Oil Stocks Excluding Strategic Petroleum Reserve

management techniques. While this strategy benefits theprofitability of the companies, it has the side effect of providing less of a buffer in times of surgingdemand. Second, when the futures market for commodities is in a "normal" price relationship, pricesfor future delivery tend to be somewhat higher than current prices, making inventory accumulationeconomically viable. Recently, oil future markets have reversed the more typical price structure, andthe future price has been lower than the current price, providing a disincentive to accumulateinventories at current prices. The third factor contributing to low inventories in the private sectoris the tight market. Refineries are near full capacity production, and supplies of light, low sulfurcrude oil are perceived to be tight on the world market. (27) Taken together, this is a difficult set of circumstances withinwhich to expand stocks of oil for inventory. However, since inventories remain low in the view ofsome market traders, they are one more factor contributing to the high price of oil.

The third way the United States holds stocks, in this case crude oil, is in the StrategicPetroleum Reserve (SPR). This government-held reserve was established to provide a buffer againsta physical disruption in the delivery of imported crude oil. Recently, there have been calls to eithersuspend deliveries to the SPR, or to release oil from the SPR to the market with the intent ofincreasing market supply, reducing speculation, and moderating prices. (28)

Exceptional Events

This section briefly identifies and discusses a set of factors that may exert an influence onoil prices, but seem to be more in the nature of a "one time" event rather than a trend or cyclic factor. The effect of each of these factors tends to be made more important by the general tightness of themarket. In some cases, there is an interactive relationship between two or more of these factors,again possibly increasing the over-all effect on price.

The war in Iraq has contributed to high oil prices in different ways as events have progressed. The predominant effect of the conflict on oil prices has been an increase in uncertainty. During theearly stages of the conflict, concerns about a possible disruption of oil supply out of the Persian Gulfand disruption of Iraqi production due to military operations were prominent, until it became clearthat the military would quickly oust the government of Saddam Hussein. Later, market uncertaintyrevolved around the ability of Iraq to export oil in the midst of political transition in which pipelineand other oil facilities were attacked by hostile groups within the country. Uncertainty with respectto terrorist attacks, both in Iraq, and spilling over to other Gulf nations, including Saudi Arabia,continue to unsettle the oil market and contribute to a "fear factor" being built into the price of oil.

Recent terrorist attacks in Saudi Arabia, directed at the oil industry and its personnel, aremore than a psychological influence on the market. Recent reports have asserted that as of July2004, world spare production capacity was between one and two million b/d, almost all in SaudiArabia. (29) This levelof spare capacity is close to the minimum amount required to cover a supply disruption from oneexporting nation. A major disruption in Saudi oil production would cause that cushion to disappearand would likely cause upward volatility in world oil markets.

The concern the market has shown regarding supply disruption has been borne out by events. Political unrest and strikes have disrupted oil exports from both Nigeria and Venezuela. Indonesianoil production has been declining, leaving it unable to meet its OPEC quota. The legal conflictbetween Yukos, the major Russian oil company and the Russian government over back taxobligations threatens to bankrupt the company, or force the sale of producing assets. Markets areconcerned that bankruptcy, or significant asset sales, might lead to an oil supply cutoff, or reduction,of exports from Russia, the world's largest non-OPEC producer. (30)

Another factor that some feel might be influencing the price of oil is the influence of financialinvestors and financial instruments. At the time of the first oil shock in 1973/1974, the primarymarket for oil price formation was the Rotterdam spot market, where physical cargoes of oil for nearterm delivery were bought and sold, generally by traders who had a real commodity interest in themarket. (31) Today, theprimary market in price formation may be the NYMEX, supplemented by the InternationalPetroleum Exchange (IPE). In these markets, the focus is not on physical supply for current delivery,but on the open interest in a financial contract, generally a future or options contract, that will expirein the near month, generally the month after the current month. The goal of financial traders is tomake a profit on the contract, which may necessitate the price of the contract rising or fallingdepending on the trader's position in the market and current prices. The implication of this is thatfinancial traders may have an interest in the price moving either up or down, almost without regardto the underlying fundamentals of the market.

The rationale for this view is that financial traders have entered the NYMEX oil market inlarge numbers seeking profits that stock and bond markets have not produced since the boom yearsof the late 1990s. Profits can be earned on futures and options markets when prices of the underlyingcommodities go steadily up, or down, stay the same, or even when they exhibit more or less randomvolatility, depending on the strategic position the trader has created.

Sectoral Demand Patterns

Global oil demand was over 79 million b/d in 2003, an increase of about 1.8% over 2002levels. Demand for 2004 was over 82 million b/d, an increase of about 3% compared to 2003 levels. Demand projections for 2004 were increased for nine consecutive months by the IEA since itsestimate in November 2003. World oil demand is expected to exceed 84 million b/d in 2005. (32) Within this pattern ofworld growth, differences among regions, as well as individual countries, exist. In addition,increased demand is not evenly spread across the product mix that is produced at refineries.

Countries and Regions

As shown in Table 2 , North America was the largest oil consuming region in the world, withthe United States accounting for about 83% of the total. However, growth in the region was less thanworld growth, and the growth in Canada, at 4.5%, was more than double that of the United Statesat 1.9%. Asia Pacific was the second largest consumer of oil, with China moving ahead of Japanin total consumption, to be the second largest oil consuming country in the world. The Asia Pacificregional growth of 4% was the highest in the world, and China had the highest yearly growth indemand of any of the major consuming countries at 11.5%.

Table 2. World Demand for Oil, 2003

(millions of barrel per day)

Source: BP Statistical Review of World Energy, June 2004 . p. 9.

European/Eurasian oil demand growth was roughly flat, with demand falling in Germany,Italy, and the United Kingdom, by -1.8%,-0.9%, and -1.8%, respectively. Within the region, mostof the large gains in demand are in nations with small initial consumption levels led by Azerbaiijan,Belarus, Austria, and Poland. These nations account for 1.2% of world demand. Although lowerthan average European oil demand growth may be tied to levels of economic activity, they may alsobe tied to changing consumption patterns and conservation, especially in Western Europe wheremotor vehicle transportation costs are very high.

Russian oil consumption grew by 23,000 b/d, to 2.5 million b/d in 2003, while productionrose by 845,000 b/d, to over 8.5 million b/d, enhancing the nation's role as a major exporter. However, the Russian economy has been in trouble for many years. If economic growth picks upand the economy restructures and stabilizes, consumption might return to levels similar to those in1993 when 3.8 million b/d were consumed. Russian consumption at that level might reduce theamount of oil available for export, pushing other consuming nations to become increasinglydependent on Middle Eastern supplies.

The Asia Pacific region includes some nations with the highest year-to-year growth rates inthe world, while other nations in the region experience declining demand. In 2003, Chinastrengthened its position as the second largest oil consuming nation in the world by increasing itsmargin over Japan from only 20,000 b/d in 2002, to 431,000 b/d in 2003. Given the disparity ofeconomic growth rates, geographic and population factors, as well as the comparative density oftransportation, it seems that the Chinese lead over Japan may widen. At current growth rates, a morerelevant question might be when China will overtake the United States as the world's largestconsumer. This is most likely not a competition either nation will directly benefit from winning. The United States imported about 63% of the oil it consumed in 2003, and production has fallenevery year since 1993. China imported about 45% of the oil it consumed, and production increasedby only 1.5% for 2003, less than the 11.5% increase in demand. The growing demands in both theUnited States and China make it likely that the world oil market will become increasingly dependenton Middle Eastern oil in the coming years and keep exerting upward pressure on price.

Petroleum Product Demand

Product demand analysis reveals that there are regional and country differences in the mixof oil based products consumed. Gasolines, middle distillates, fuel oil, and other products are themain groups. (33) At theworld level, gasolines comprise 31.6% of consumption, middle distillates 35.7%, fuel oil 12.2%, andother products 20.5%. (34) , (35)

The consumption pattern in the United States differs from the world averages. The U.S.demand is 46.2% gasoline, 29.3% middle distillates, 3.8% fuel oil, and 20.7% other products. (36) This mix reflects the U.S.use of oil as a transportation fuel, with car and light truck use responsible for the relatively highgasoline percentage. The U.S. refinery industry is unable to supply adequate gasoline to thedomestic market. As a result, imports of finished gasoline and gasoline blendstocks have increasedto almost one million barrels per day. U.S. refineries operate at near full capacity, but a lack of newcapacity expansion by the industry suggests further increases in imported gasoline, if available onthe world market. (37)

Europe has different preferences in transportation fuels than the United States. Middledistillates dominate the European product slate at 44%, with gasoline at 24.4%. These values reflectthe on-going shift to diesel engines in European passenger vehicles. As product demand shifts,refiners are following by investing in the technology needed to produce greater proportions of middledistillates and less gasoline. As this transformation proceeds, European refiners may find that theyhave less surplus gasoline available for export to the United States. This outcome could lead totightening U.S. gasoline markets, keeping an upward pressure on the price of gasoline, and indirectlysupporting high oil prices.

The Asian pattern of product demand, especially China's, includes a larger portion ofdemand, 13.8% in the case of China, dedicated to fuel oil. This percentage is approximately threetimes that of the United States. The use of fuel oil in industry accounts for the difference, as wellas the lower requirements for gasoline for private automobile use.

Future Projections

The International Energy Agency recently reduced its forecast for global oil demand in 2005. It estimated that world demand would be 84.3 million barrels per day in 2005. This value representsa growth of 1.77 million barrels per day, or 2.2% above 2004 levels. (38)

In a typical manufacturing or service market, demand growth of this magnitude might bewelcomed, and met with increased job creation and facility expansion, or more intensive use ofexisting facilities. Conditions in the oil and oil products industries might not be so accommodating. Excess capacity in the crude oil market is low, with most estimates averaging less than 1.5 millionbarrels per day. If we add the increased estimate of consumption in 2004 to the projected increasein 2005 it is clear that the crude oil industry is likely to be at full production capacity through 2005.

It has been reported that Aramco (Saudi Arabia) has a plan in place to expand production by1 million barrels per day within a year. Non-OPEC production is expected to increase by about 1.4million barrels per day in 2004, but only smaller increases are expected in 2005. (39) High prices, if they persist,can be expected to increase exploration and ultimately production in the longer term if the currentmarket follows past patterns.

The EIA's Annual Energy Outlook, 2004 (AEO) provides a projection of U.S. energy balanceout to 2025, and includes scenarios based on different market price assumptions. Price is taken tobe an assumption, rather than a predicted value, because it is assumed to be determined on the worldmarket. For the base case, the AEO assumes a crude oil price of $23.61 per barrel in 2010 and$26.71 per barrel in 2025. For the high price case, AEO assumes a price of $32.80 per barrel in 2010and $34.90 per barrel in 2025. (40) If the factors that are influencing the current market continue inthe future, it may be that even the high price case assumptions are too low.

Conclusions

The world oil market, as a result of the convergence of a number of factors, has experiencedsignificant tightness since the end of 2003, continuing through 2004 and the first half of 2005. Someof the factors influencing the market might be temporary, some may be cyclical, and others maypossibly be permanent. While the high prices that resulted from the tight balance between oildemand and supply caused increased energy expenditures for consumers, business, and industry, italso led to higher incomes for energy producers. It is possible that the economy as a whole mightexperience macroeconomic effects, not only from the high oil prices themselves, but as a result ofthe monetary and fiscal policy responses that might be taken if the high prices persist and aredetermined to constitute inflation.

Although it has been under pressure in 2003, 2004, and into 2005, the oil market has shownthat the market process is functioning. The factors discussed in this paper that affected oil andgasoline demand as well as the supply response of OPEC and other producers caused prices to rise,but there has been little, or no, evidence of physical shortage or supply disruption.

Effective policies to mitigate high oil prices are difficult to define at the national level. Theprice of oil is determined on a world market. It is unlikely that any consuming nation can insulateitself from the forces driving the world market. For example, if a nation decided to reduce oreliminate its direct dependence on the Persian Gulf, it might succeed in doing that by buying oil fromother nations. However, this would reduce the total amount of non-Persian Gulf oil available toother nations, increasing their dependence on the region and leaving the level of world dependenceunchanged. If political events in the Persian Gulf caused the price of oil to rise, that price increasewould be transmitted to all oil produced around the world. It is not possible to isolate oneself fromthe world market, except perhaps by cutting domestic consumption to the level of domesticproduction.

The market in 2004 was likely affected by a "fear factor" premium on the price of oil, raisingits price above that indicated by market fundamentals. Some estimates of the "fear factor" run ashigh as $15 per barrel, while others rate it at only a few dollars, or nothing at all. (41) The threat of supplydisruption due to potential terrorism or political instability appears to be the source of this pricefactor. An important question is, how long this factor will influence price? In the past, fears of political instability, especially in the Persian Gulf, tended to be quelled in relatively shorttime-frames. Today, with the war on terrorism perceived as a long term reality, it may be that oilprices will incorporate a "fear factor" for a significant time.

The nature of the exploration and production cycle in the oil industry encourages majorswings in the price of oil even in more politically stable times. This cycle makes it difficult forgovernments to time oil policies effectively. In the past, periods of high oil prices have led to a rapidexpansion of exploration, and given improving technology, have led to substantial oil finds in manyplaces in the world. As newly discovered extra oil comes on the market several years later, theincreased supply tends to overwhelm demand, causing price to drop. While demand tends toincrease incrementally, by a few percent per year, supply tends to increase discrete amounts inresponse to a period of high prices. This relationship leads to cyclic price volatility. Set against thisrecord is the opinion of some that world oil production is soon to peak as a result of geologicalfactors and the likelihood that the largest oil reserves have already been discovered. (42)

A major continuing factor in the market is the emergence of China as a major importer ofcrude oil. In addition, the possibility exists that India, and perhaps other Asian nations, might expandtheir imports of oil as industrial production expands in those nations. Although the 2005 projectionof Chinese import growth moderates to approximately 7% from the 2003 level of 11.2%, in thelonger term much depends on whether oil use for private automobiles in China expands very quicklyor is moderated by the government. However, either of these yearly growth rates imply stress forthe world oil market. Based on China's consumption of almost 6 million barrels per day in 2003, itmay generate increases of demand of 500 thousand b/d or more in the next few years. In a marketwith very limited excess capacity, and possibly facing the discovery of fewer giant fields, increasesin demand of these magnitudes promise to contribute to an upward pressure on price.

The 2004, and potentially for 2005, oil market reflects the influence of a number of factorsall of which have led to upward pressure on price. Although some of these factors might have beenjudged temporary in the past, there is a danger that in the current political environment they mayperpetuate themselves, keeping oil prices well above the OPEC price target.