OPEC’s Power to Prevent Price Spikes Ebbs and Vanishes: 2004–2008
For OPEC and the oil industry, the 1990s and early 2000s were relatively stable and orderly compared with the preceding periods. But once again, starting soon after the turn of the twenty-first century, tectonic shifts in global oil demand and supply began to reshape the oil market, subjecting oil producers, consumers, and governments to massive oil price volatility not seen since the 1920s and 1930s and shattering perceptions that OPEC could maintain oil price stability.
On the demand side, global GDP growth picked up strongly between 2003 and 2007, averaging a healthy 5 percent per year. Strong economic activity caused oil consumption to grow by 6.5 mb/d (8 percent) over the period.
1 Whereas consumption of oil had been rising by an average of 1.0 mb/d during 2000 through 2003, from 2004 to 2007 consumption rose by 1.6 mb/d, 60 percent faster.
2 In China, demand exploded stemming from faster economic growth and rapid industrialization and urbanization. Electricity shortages played a big role, too. To keep the lights on, China was forced to fall back on older power plants burning distillate and heavy fuel oil. Many businesses, facing periodic compulsory shutdowns to save energy, also invested in diesel power generators.
3 The confluence of these factors more than doubled China’s oil demand growth, from 0.4 mb/d in 2003 to 0.9 mb/d in 2004.
4Demand patterns also started to shift, and in doing so somewhat exaggerated the tightness in the market. European countries tightened regulations on distillate fuel by lowering the amount of sulfur it could contain, sending refiners scrambling to make the cleaner fuel. Doing so required “light” crude oils that came from producers like Nigeria—which was prone to unrest and disruptions—and were in relatively low supply.
5 Since benchmark oil prices are set on such lighter grades like Brent and WTI, the acute tightness of “light crude” registered heavily in the market.
On the supply side, production growth outside OPEC was unexpectedly weak while the costs of production soared due to increases in the cost of steel pipe, drilling rigs, oil field services, and cement. IEA forecasts continually overestimated the increase in supply from outside OPEC from 2004 through 2007 (see
figure 9.1).
Russia was largely responsible for the disappointments in non-OPEC supply. Between 2000 and 2004 Russia succeeded in reversing its decline of the 1990s, squeezing 500–700 kb/d out of old fields each year during that period. But this trend unexpectedly reversed in 2005 as President Putin became less friendly to the independent oil companies, foreign capital and technology that had generated the supply boom and that was needed to opening up new, difficult fields.
6 But Putin cared less about how much oil was produced and more about who benefited financially and politically from the production. He persecuted the oil barons and effectively nationalized oil production. Investment waned, and Russia’s production plateaued.
FIGURE 9.1
Annual non-OPEC production growth, 2003–2009, IEA projections.
Source: IEA oil market reports, January 2003–June 2009.
In addition to Russia’s big slowdown, giant workhorse fields like those in the North Sea and Mexico’s Cantarell, which made life so difficult for OPEC when they began large-scale production in the late 1970s and early 1980s, were in decline. Delays to the startup of new complex, mostly offshore projects in Brazil, Canada, U.S. Gulf of Mexico, North Sea, and elsewhere also plagued the industry and compounded the issue. The 1990s had featured mergers and acquisitions, but relatively little investment in new production.
Unexpectedly strong demand and weak supply resulted in steadily rising crude prices. But OPEC remained wary of increasing supply. Ministers were still haunted by the “Ghost of Jakarta” (pumping too much oil into the market while demand is unknowingly weakening, producing a price crash). By December 2003 oil prices had risen beyond OPEC’s $22–$28 price band and kept ascending. All eyes in the market turned to OPEC to see if it could fill the gap between roaring demand and tepid non-OPEC supply. The oil market was “calling on” Saudi Arabia and other OPEC producers to increase production—but there was not a lot of shut in or spare capacity for them to use.
At the end of 2003, OPEC only held around 1.7 mb/d or about 2 percent of total world demand in spare, less than half of the level a year earlier. As usual, most of that capacity was in Saudi Arabia, which had already increased production due to the Iraq invasion, Venezuela labor strikes, and disruption in Nigeria. Moreover, some OPEC producers were unable to increase production. Supply was falling in Indonesia, an early member of OPEC (it would leave the cartel in 2009 but reenter in 2015 as an importer) and Iraq’s production would not bounce back for five years.
To add to the challenge, Saudi Arabia was reluctant to use what little spare capacity it had. With fears of the 1997 Jakarta debacle still fresh, Saudi Arabia wanted to avoid oversupplying the market. After all, the oil market is notoriously uncertain and supply and demand could turn suddenly loose as fast as it could tighten. As a producer dependent on oil revenues, Saudi Arabia and other OPEC countries fretted about lower prices more than higher ones. After the 2003 invasion many hoped Iraq’s production would quickly resume, a concern producers had to take seriously. Saudi Arabia had even
cut production when the March 2003 military invasion phase of the Iraq conflict ended without a major disruption to Kuwaiti or Saudi facilities.
But with soaring Chinese demand, weak supply growth outside OPEC, and Iraq’s failure to bounce back (its monthly output would not exceed pre-war highs until July 2008),
7 Saudi Arabia became more willing to increase production. Its output rose from 8.5 mb/d in the fourth quarter of 2003 to new highs of 9.5 mb/d by the middle of 2004. At 9.5 mb/d, Saudi production was approaching its maximum capacity, which EIA estimated to be between 10.0 and 10.5 mb/d. Thus, the world’s spare capacity cushion had fallen to between 0.5 mb/d and 1.0 mb/d—less than 1 percent of global oil production.
8 Compared with about 4 percent to 5 percent of production in the 1990s or almost 35 percent in the 1950s, the oil market was running on a thin cushion of spare capacity.
But even with this higher Saudi supply, annual average crude oil prices rose by 35 percent from 2003 to 2004 (from $31 to $42 per barrel),
9 and then by another 36 percent in 2005 (to $57). In February of that year, OPEC suspended its $22–$28 target band since the OPEC basket price had remained above the range ceiling for a year and had become superfluous (see
figure 9.2).
10FIGURE 9.2
OPEC basket price.
Source: Bloomberg, OPEC Secretariat Crude Oil Basket Daily Price.
Market participants and analysts began to notice the unusually low spare production capacity, and to regard it as a factor that contributed to higher oil prices.
11 “Surging global demand caught out most forecasters and pushed prices higher as the market responded to the thin availability of spare capacity,” noted
Middle East Economic Survey reporter Bill Farren-Price in January 2005. “The narrowing buffer of spare production capacity for OPEC oil producers in 2004 refocused interest on oil capacity expansion plans for 2005.”
12 This was a complete change from the depressed 1998 to 1999 period, when leading analysts said chronic
excess OPEC production capacity would cap oil prices around $20 into the future.
13By early 2005, structurally tightening markets dispelled fears of another Jakarta and convinced Saudi Arabia to increase oil production capacity. But spending billions to boost production capacity was not a decision Saudi Arabia took lightly. And like a city’s investment in a fire department, the new equipment was going to spend a lot of time sitting idle. Despite the costs and reservations, in January 2005 Saudi Arabia Oil Minister Naimi told the press that the kingdom planned to increase its maximum production capacity to 12.5 mb/d from the then prevailing level of around 11 mb/d. Saudi Arabia’s goal, Minister Naimi said, was to maintain at least 1.5 mb/d of spare production capacity. Saudi Arabia began taking some older fields, including a 500 kb/d producer named Khursaniyah, out of mothballs and expanding export facilities.
14 And in 2006, the kingdom announced a mammoth $10 billion program to develop three new fields—Khurais, Abu Jifan, and Mazalij.
15 Collectively named the Khurais Megaproject, it would be the kingdom’s most complex oil development, spanning half the size of Connecticut and requiring enormous infrastructure investments, including a sprawling network of pipes, water injection systems, and deep wells. These new “upstream” investments in crude oil production capacity intended to raise total Saudi production capacity from 11.3 to 12.5 mb/d,
16 but would not be available until 2009.
Meanwhile, super tight supply and demand propelled oil prices up to historic highs. Without ample surplus capacity, oil experts noted at the time, OPEC’s ability to stabilize oil prices declined, resulting in higher oil price volatility.
17 Combined with logistical bottlenecks in the oil industry’s “downstream” transportation and refining segments, low spare reduced the oil market’s ability to respond to shocks such as geopolitical disruptions, natural disasters, refinery accidents, or waves of speculative buying.
18 Low spare capacity also put the onus on the price of crude to balance the market. And because the inelasticity of oil supply and demand means that only big price increases stimulate lower demand and higher supply, big price increases were exactly what happened.
In the 1970s, oil prices spiked partly due to the
perception of tighter oil markets if not looming exhaustion of supplies. This was especially true earlier in the decade, when actual disruptions were small. Even when the Iran Revolution and Iran-Iraq war disrupted supply, it is questionable whether physical oil tightness adequately explained the price spikes, given substantial unused OPEC production capacity and ample if not brimming, inventories.
19 But after 2005, it was much clearer that the oil market was structurally tightening. The implication was faster price increases, more volatile price generally, and spikes when disruptions or disruption risks occurred.
Compounding tightening demand and supply trends, supply disruptions returned after the relatively placid 1990s. Between December 2002 and March 2003, a labor strike at Petroleos de Venezuela disrupted an average of 1.6 mb/d.
20 Just as Venezuela was coming back on the market, unrest in the Niger Delta and the war in Iraq further disrupted global supplies. In the run-up to Nigerian elections, militant groups attacked oil facilities, forcing oil companies to evacuate all nonessential personnel and disrupting an average of 0.25 mb/d between March and August of 2003. Nigerian militant groups funded themselves through “bunkering”—stealing fuel from pipelines and siphoning it off to barges, an increasingly profitable business at a time of rising oil prices. These armed factions became the basis of a new group that emerged in 2006, the Movement for the Emancipation of the Niger Delta, and significantly disrupted Nigerian production between 2006 and 2009 by an average of 0.6 mb/d. In Iraq, the invasion by the “coalition of the willing” on March 20 brought the country’s oil production to a halt, disrupting 2.4 mb/d at its peak and 1.4 mb/d on average in 2003. Three wars and decades of neglect took a heavy toll on the Iraqi oil industry, leaving significant amounts of disrupted supplies until early 2008.
Demand stickiness meant that consumption did not fall swiftly in response to higher prices. China needed to keep the lights on and would pay any price to keep importing oil. In the United States, drivers had adjusted their behavior by buying more efficient cars after the huge price increases in the 1970s—but after the big price drop in 1986 and with relatively low and stable gasoline prices in the 1990s, drivers reverted to bigger, less fuel efficient cars and got in the habit of driving more. The Census data indicates commutes lasting more than an hour rose by 50 percent during the 1990s. “I drive 55 miles each way to work every day,” one sport utility vehicle owner told an Associated Press reporter in May 2007. “So I really don’t have a choice, unfortunately.”
21Stubbornly strong demand and weak supply growth sent crude price hurtling above $70 in 2006.
22 Moreover, prices of oil for future delivery were beginning to rise to new, unprecedented levels. The advent of crude oil futures trading in the 1980s enabled analysts and industry to monitor a transparent indicator of longer term expected oil prices.
23 In the 1990s, longer term crude oil prices tended to be uncorrelated with shorter term ones, implying traders and investors “looked through” near term influences on oil and assumed longer term prices would be relatively stable in a range between $18 and $26 per barrel. But after 2000, longer dated futures prices rose along with spot ones, implying market participants believed tightening in supply and demand conditions were not just a short-term but longer term, structural phenomenon.
24These sustained and large oil price increases took most completely by surprise. Market participants were familiar with price spikes due to wars and upheaval, but not to spikes caused by the normal workings of supply and demand. Oil industry and traders had grown accustomed to the notion that OPEC held spare production capacity precisely to prevent such extreme price moves from taking place.
25 Understanding these supply and demand dynamics were complicated by the problem of poor data on oil consumption, production, and inventories. The industry has always prized data. In the first days of oil in the 1860s, producer associations in western Pennsylvania prioritized collection of data on the market as a whole, and data collection and analysis were also central to the Standard Oil operations, state quotas, and Seven Sisters’ administration of their joint production and marketing operations. But OPEC was trying to manage a global market, which was especially challenging because data are notoriously incomplete and patchy, especially in the emerging markets.
As they had in the past, shock and uncertainty caused by unexpected price increases after 2003 rekindled perennial fears of an imminent limit in global oil production growth.
26 “Peak oil” fears resurfaced. Despite their checkered history at predicting past peaks, peak oil disciples emerged from the woodwork as oil prices soared.
27 In 2005, the late veteran energy investment banker Matt Simmons published
Twilight in the Desert, warning that Saudi Arabia was overstating its production potential and was closer to tapped out than widely believed. “Eighty-five million barrels of oil a day is all the world can produce, and the demand is 87 million,” prominent oil investor and hedge fund trader T. Boone Pickens said in May 2008. “It is just that simple.”
28 On the other side of the debate, prominent oil historian Daniel Yergin, among others,
29 argued that current peak oil fears would prove just as unfounded as others had been given technology’s tendency to surprise by unlocking new oil resources.
30The peak oil theory stems from an older debate about whether limits to the amount of finite resources like land or energy may jeopardize society’s ability to grow, and how peak production of a given resource affects the economy. Peak production occurs when half of the underground endowment is extracted, after which production can continue but will necessarily slow. Peak production should not be confused with “running out.” Peak refers to maximum production rates, after which production continues but at a slower and terminally declining rate than the peak. Technological progress combined with consumer responses to price signals (when prices go up, consumers use less of something or substitute for it) make it difficult to predict when production of a commodity like oil will peak. And with the discovery of new technologies and resources, the peak production of an older commodity does not spell an end to economic growth.
Peak production debates typically center on commodities that are critical for human survival: food, water, and energy. In the case of peak oil, the timing and pace of peak production is not just an academic matter. While economists believe people could adjust to steadily rising prices, and abrupt spike caused by unexpected peaking would be catastrophic, economically and politically. Modern transportation, agriculture, defense, and other core systems depend on oil, and there is no near term alternative to oil in these vital sectors. Peak oil adherents warn against assuming that past, smooth energy transition such as from wood to coal in the 1800s or coal to oil in the 1900s are a model for peak oil, which will be “abrupt and revolutionary.” In 2005 a report by three researches sponsored by the U.S. Department of Energy (though not reflecting government views) titled “Peaking of World Oil Production: Impacts, Mitigation, & Risk Management” concluded:
The peaking of world oil production presents the U.S. and the world with an unprecedented risk management problem. As peaking is approached, liquid fuel prices and price volatility will increase dramatically, and, without timely mitigation, the economic, social, and political costs will be unprecedented. Viable mitigation options exist on both the supply and demand sides, but to have substantial impact, they must be initiated more than a decade in advance of peaking.
31Modern-day peak oil adherents such as Colin Campbell and Jean Leherrère trace their lineage to Marion King Hubbert, a U.S. geologist who in 1956 correctly predicted U.S. oil production would peak and start falling in the late 1960s to early 1970s. But Hubbert erroneously predicted U.S. production would keep on falling and approach exhaustion by 2018.
32 Instead, as we shall see later, since 2010 the shale oil boom caused U.S. production to rebound and rise to nearly 1970s peak (see
figure 9.3).
One of the challenges involved in trying to predict when oil production will peak and start to decline is measuring the amount of “proved reserves” (oil that can be drilled profitably given prevailing prices and technology) in the earth’s crust. Estimates of proved reserves depend on current and future price and prices and technological innovation, both of which are constantly changing and unpredictable.
In the 1950s Hubbert was able to correctly predict the U.S. peak partly because he had good data on proved reserves from the well-drilled and analyzed U.S. fields. And yet Hubbert was very off on his prediction of where production would go from there because he did not foresee the U.S. shale revolution, which led to a 90 percent increase in proved reserves between 2008 and 2014. At 36.4 billion barrels, proved reserves are less than 4 billion barrels shy of the 1970 high (see
figure 9.4).
33 Oil industry ingenuity has repeatedly wrong-footed those who have tried to predict the timing of peak oil production.
FIGURE 9.3
U.S. crude production, 1920–2015.
Source: EIA, U.S. Field Production of Crude Oil (Thousand Barrels per Day).
At the global level, our knowledge of subsurface oil resources globally remains especially foggy. Poor data about global reserves made Hubbert’s prediction of a 34 mb/d peak in world supply around the year 2000 miss by a wide margin. Oil production in 2014 was over twice that amount.
34FIGURE 9.4
U.S. proved crude reserves, 1899–2014.
Source: EIA, Crude Oil Proved Reserves, Reserves Changes, and Production.
There is an old industry shibboleth that one only knows how much oil a reservoir contains when it stops producing. That said, the oil industry has been able to defy frequent peak predictions in the past and increase reserves while also increasing production. In 1980 world reserves equaled 28 years of production. Existing proved reserves are currently estimated to be around 1.7 trillion barrels, equal to 58 years of production. Reserves amounted to 58 years of production in 2014, although this measure fails to account for the role technology and new discoveries can play in increasing reserves and therefore should be taken with a grain of salt.
35 The IEA estimates another 6 trillion barrels of technically recoverable resources (that is, not necessarily economical to produce today but still present) remain buried in the earth’s crust.
36 While those technically recoverable resources are by definition not producible at present given prevailing prices but could be produced with existing technology, the history of the oil market shows that price and technology changes and the acumen of oil explorers and producers should not be underestimated. The consensus among geologists and oil supply experts is that between reserves in the ground and likely new reserves that will be discovered and developed there is enough oil to last until the middle of the century.
37BURN THE SPECULATORS!
Sharply rising oil prices also rekindled suspicion about and anger toward speculators. Speculator is a loaded term, and often misunderstood—in the case of oil, it refers simply to a person who buys or sells oil for some purpose other than immediate use (usually, in anticipation of a future price change).
38 Speculators have been around as long as markets have existed and often been blamed for causing shortages and price spikes for critical commodities, especially food. Also called profiteers and hoarders, speculators are seen as making shortages worse—with a supply shortfall coming, they hoard supplies and hold them off the market, only charging exorbitant prices to desperate consumers when the shortage hits.
39 In the sixth century
BCE, Athens established complex laws in the attempt to prohibit speculation in grains such as corn such as restrictions on storage, and the penalty for violation was death.
40Oil exchanges flourished in the industry’s early decades but largely died out during most of the twentieth century as the TRC and Seven Sisters managed supply and stabilized process. Exchanges made a return in the 1980s. In today’s oil industry, speculation is accomplished by buying and selling oil futures and derivatives contracts on organized exchanges such as the Chicago Mercantile Exchange and the Intercontinental Exchange in London. Exchanges and trading exist because oil market participants want to hedge or insure against adverse oil price moves. A fuel purchaser for an airline company goes to an exchange to lock in forward prices for jet fuel. A refinery wants to lock in prices for gasoline it will sell in four months. A shale oil producer may seek protection on the price of output from the company’s wells in the next year—and its lending bank may insist on it.
The oil industry also values exchanges because they provide transparent, publicly available, and unbiased price information. It is logistically impractical to record and publish the prices and quantities of every individual physical oil transaction. So to aid in “price discovery,” exchanges standardized contracts that dictate both the size (1,000 42-gallon barrels) and grade (of which there are many to choose from) of each transaction. For prices to reflect broad market conditions, the more buyers and sellers in the exchange the better.
Speculators are necessary for well-functioning exchanges because they provide “liquidity”—a deep pool of ready buyers or sellers. Excluding speculators would have drastically limited the number of sellers and buyers and, therefore, the number of transactions, reducing the value of the exchanges and providing a transparent price signal to everyone. Speculators are needed to take the price risk that hedgers want to shed. Speculators are happy to take a bet on where prices are going, whereas many oil market participants prefer to focus on what they do best: fly planes, produce gasoline, drill for oil.
While not punishable by death as in ancient Athens, oil speculation has remained unpopular in the modern oil industry. Refiners like Rockefeller and western Pennsylvania drillers disdained speculators for having no real attachment to the oil business and instead trafficking only in oil and later pipeline certificates (often frantically and based on rumors and sentiment). Manic buying and selling by uninformed speculators, those in the oil industry believed (and many still do), just adds volatility to a market already all too prone to it. Today, the line between speculating and hedging gets blurred. For example, some oil producers may decide to “hedge” or lock in prices by buying futures contracts when they believe prices are going to fall. But a producer who decides not to lock in prices when they are expected to rise is in effect speculating on rising prices.
41Since the widespread return of exchange traded oil futures in the 1980s, OPEC as well as many Western politicians and oil executives have frequently denounced speculators for causing oil price volatility. They argue that speculators distort oil prices because they are ignorant about the oil industry and market, often exhibiting a herd behavior seen in equity markets and causing oil prices to become unhinged from supply realities.
The price run-up during 2004–2008 spawned accusations against speculators once again, especially against a new type of speculator: the “massive passives.”
42 Unlike old-style speculators perfectly happy to either buy or sell oil contracts depending on which way they saw prices heading in the future, new “passive” or “long-only” investors only bought. Retail investors, pension funds, and sovereign wealth funds became interested in “long-only” holdings in oil and other commodities during the post-2000 commodity price boom. They sought oil and other commodity exposure because of weak returns on other asset classes like equities or bonds. In addition, commodities offered diversity and returns that were uncorrelated to the usual equities and bonds holdings. Banks and brokers met demand from these new financial investors by creating investment vehicles or so-called commodity index funds that gave their clients “long” exposure to the commodity markets without their having to actually own any physical commodities.
43Some commentators and market participants concluded that massive passive buying itself was causing the mammoth oil price spike, insisting that rising price could not be explained by underlying supply and demand factors in the global oil market.
44 The most prominent proponent of this view was investor Michael Masters, who gave that idea considerable traction when he was featured in testimony before the Senate Homeland Security Committee in May 2008.
45Those who disagree with the view that speculators, whether traditional buy-or-sell or passive buy-only, distort oil prices make several counterpoints. First, they assert, oil market participants are not better informed than anyone else about the “true” supply and demand—partly because of enormous gaps in data. As the wildly inaccurate forecasts by OPEC and oil companies from the late 1960s through early 1980s show, oil companies have hardly demonstrated superior clairvoyance about future oil prices. Academic studies on the subject have shown that speculators contribute to stability and reduce volatility by providing liquidity and information to the market.
46 And although speculative buying and selling of futures contracts can have impacts on the price of oil, that is not necessarily a bad thing from society’s perspective, academics and officials (including then-Federal Reserve Governor Ben Bernanke) noted in 2004. To the degree that speculators are informed and their buying or selling brings new information to the market, their actions can enhance social welfare by making oil available when it is needed. They can also signal a tightening market, and the resulting price increase stimulates more production and less consumption, thus making more oil available in the future.
47Second, to “distort” or “manipulate” prices, speculators would have to hoard physical supply and take advantage of weak or broken convergence between paper and physical markets. That is because under exchange trading rules, anyone who holds a “long” futures contract when it expires in a given month must take physical delivery, and whoever is “short” must deliver the oil. Futures and physical prices converge primarily because any discrepancy creates a profitable arbitrage opportunity. Traders would jump on the price discrepancy, finding a way to take delivery in the futures market and then offset the position in the spot market until the discrepancy was no longer profitable. This mandatory convergence between paper and physical barrels at monthly settlements keeps oil futures linked to physical reality in the oil market.
48 There is no evidence that this convergence, which is closely watched by market participants, is broken. Furthermore, the size of the futures market when combined with its strict regulatory environment, makes it near impossible for one or more individuals to corner the oil market by accumulating and removing enough oil supply to manipulate prices. In fact, oil inventories had fallen significantly below normal in 2007 and 2008, suggesting that as high and fast as oil price had risen, they were still not rising enough to bring demand down to available supply.
49Third, critics of Masters’ thesis that long-only investors were behind the increase in prices point out that the price of commodities not actively traded on futures exchanges (thus, out of reach of speculators, including massive passives) were rising as much or even more (in the case of rice and iron ore) than those traded on exchanges like oil.
50 This suggests the cause of co-movement among commodities, including oil, was economic, not rooted in financial flows.
51 In October 2008 the IMF noted the broad commodity boom was similar in magnitude to the commodity price boom of the early 1970s,
52 when there were no major futures trading in oil, much less “massive passives.”
While massive-passive purchasing of oil futures correlated with moves in crude oil prices, correlation is not causality. Because a rooster’s crow correlates with the sunrise does not mean that the rooster causes the sun to rise. Writing in June 2009, the IEA noted the correlation of financial flows with rising oil prices, but concluded that tight OPEC spare capacity provided a “plausible account of how the fundamentals have changed and provide a clue as to why oil was priced so high in the first half of 2008, fell some 75 percent in the following six months, and is now hovering around $70 per barrel.”
53Energy economist James Hamilton concluded that although the oil price run-up from 2004 to 2008 was influenced by the inflow of investment dollars into commodity futures contracts, oil’s low price elasticity of demand and the failure of production to increase sufficiently prior to the peak explained the phenomenon. Supply and demand, instead of speculation per se, was the cause of oil’s dramatic price moves.
54Officials agree with Hamilton. An interagency task force led by the U.S. Commodity Futures Trading Commission and composed of several federal departments as well as the Federal Reserve, Federal Trade Commission, and the U.S. Securities and Exchange Commission conducted an in-depth study and concluded:
that current oil prices and the increase in oil prices between January 2003 and June 2008 are largely due to fundamental supply and demand factors. During this same period, activity on the crude oil futures market—as measured by the number of contracts outstanding, trading activity, and the number of traders—has increased significantly. While these increases broadly coincided with the run-up in crude oil prices, the task force’s preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices.
55THROW IN THE (STRATEGIC) RESERVES!
Political heat generated by soaring gasoline prices in and after 2000 led not just to scrutiny of speculators but also to demands to use strategic oil stockpiles to dampen oil price volatility. As a rule, when oil prices are rising, even in the absence of a disruption, calls to release strategic stocks go out. During the 1996 price run-up, many analysts called for SPR releases due to rising oil prices stemming from relatively low commercial stocks.
56 (When oil prices are falling, one rarely hears calls to stabilize prices filling the SPR. Decisions to refill the SPR usually proceed an emergency that rekindles energy security concerns, such as President George W. Bush’s decision to fill the SPR to capacity in the wake of the September 11 terrorist attacks.)
The IEA had coordinated IEA strategic stock releases twice before: the first at the outset of Operation Desert Storm during the Gulf War in January 1991, and the second in 2005 in conjunction with Hurricane Katrina in the Gulf of Mexico. The U.S. Congress or presidents have also ordered a number of other unilateral releases, including three instances in 1996 when Congress mandated releases to raise cash for the budget.
57But releasing oil from U.S. reserves in response to rising prices was controversial. In September 2000, President Bill Clinton ordered a release of 30 million barrels from the SPR amid rising oil prices. Vice President Al Gore, then two months away from a neck-and-neck race with George W. Bush for the presidency, had publicly called for a release, reversing his earlier opposition.
58 Clinton justified the release due to concerns about low commercial heating oil inventories and the associated risk of higher prices. But President Clinton’s claim and the timing of the release were widely criticized as a thin excuse for politically motivated intervention in the market. Even President Clinton’s Treasury Secretary, Lawrence Summers, perceived the release as interference in the market who warned of setting a “dangerous precedent.”
59 And indeed, the 2004–2008 price booms led policymakers to call on President Bush to release strategic stocks, even though there had been no disruption.
60 He refused on grounds the SPR should be reserved for severe supply interruptions.
Assuming strategic stock release and fill capabilities of several million barrels per day or more, it is theoretically conceivable that officials could direct SPR sales and purchases with an aim toward offsetting not only geopolitical disruptions but also supply-demand imbalances of equal amount. “For example,” the International Energy Agency (IEA) noted, “at a drawdown rate of 2 million barrels per day, public stocks could flow for 24 months.” At a rate of 4 million barrels per day, strategic stocks would cover one year.
61 And in theory policymakers could buy oil during periods of depressed prices with the aim of imposing a floor.
However, there are many problems with the notion of using strategic stocks to stabilize oil prices, even if policymakers were willing to buy and sell depending on tightness or surplus in the market.
62 The main problem is that buy and sell decisions would doubtless be influenced by political or budgetary considerations, not just for market stabilization. Moreover, to be effective, strategic stock releases would need to be coordinated among IEA members. Some IEA members could find themselves squabbling about burden sharing just like OPEC members do, as some would argue it makes no sense for one country to release stocks while others hold on to or increase theirs.
63Another problem with using strategic stocks to stabilize prices is operational. The SPR was designed for large-scale, infrequent withdrawals in anticipation of major supply emergencies, not frequent withdrawals and fills. Frequent, small uses of the SPR caused the underground salt caverns holding crude to deteriorate, because to release oil freshwater is injected into the salt caverns. Injecting freshwater in small volumes at low rates results in uneven salt leaching that misshapes the caverns, reducing their integrity. (One solution would be to invest in infrastructure to inject fully saturated brine instead of freshwater, although this would require expensive capital expenditures.
64)
Officials may not have sufficient information to inform decisions on when and how to add or subtract from the global market to keep prices stable, and could well run out of supplies before they managed to flatten prices. Moreover, even assuming political interference could be excluded, officials could try to defend price levels or ranges that are inconsistent with actual market fundamentals. If they tried to hold prices below levels justified by fundamentals, they would expend all of the reserves, giving them away at cheap prices to market participants. If SPR use failed to stabilize prices, it would reduce or eliminate whatever psychological impact having the untapped option conferred.
65 Conversely, if officials were really willing to gut against the grain and attempt to prop up prices above levels justified by market supply and demand, they would have to buy and fill until capacity was reached, at which point prices would collapse below the official target levels.
Two final risks are that private companies would reduce their inventories held to address price volatility—both from regular interaction of supply and demand and due to disruptions—or that OPEC producers could offset SPR releases intended to cap prices by withdrawing production.
66These risks, however, did not stop calls for the government to do something—anything it could—to arrest the upward climb of oil prices.
PEAK OF THE BOOM
Amid dire warnings about peak oil and demands to crackdown on speculators and release strategic stocks, oil prices kept rising into 2008. A series of sabotage attacks, strikes, and commercial disputes in Venezuela, Iraq, Nigeria, the North Sea hit the market and contributed to the rapid increase in crude prices.
67 For the first time ever, in February 2008, crude prices breached $100. As the summer of 2008 approached, they were hurtling over $140.
68The crude oil price shock between the fourth quarter of 2007 and second quarter of 2008—37 percent in real terms, 41 percent nominal, for U.S. imported crude oil prices—was “by any measure … one of the biggest oil shocks on record.”
69 In the United States pump prices tracked those of crude to astounding new highs. In real terms, average national pump prices for regular grade gasoline exceeded their prior high set in March 1981 ($3.80 per gallon) in April of 2008 ($3.84) and then jumped up to peak at $4.43 in June.
70 In nominal terms, pump prices peaked in July 2008 at $4.06 per gallon.
The shock walloped consumers. About 71 percent of Americans surveyed told Gallup gasoline prices were causing financial hardship.
71 The CEO of Northwest Airlines, Doug Steenland, testified to Congress in June 2008 that U.S. airlines were “on track to spend $61.2 billion on jet fuel [that] year, $20 billion more than in 2007, and [were] projected to incur losses totaling close to $10 billion.” Between December 2007 and June 2008, the soaring price of oil and jet fuel forced eight airlines out of business and two more into bankruptcy, while the surviving carriers trimmed capacity and reduced services.
72 Truckers and other fuel-intensive workers conducted strikes and protests in the United States and Europe. A Gallup poll in May 2008 found majorities favored releasing oil from the strategic petroleum reserve, opening U.S. coastal and wilderness areas to drilling, and even imposing price controls.
73Politicians and industry executives continued blaming spectators. Senator Susan Collins (R–ME) said “[c]onstituents get it … [t]hey don’t see the reason for it. They don’t see (supply) shortages. They don’t see [the Organization of Petroleum Exporting Countries] greatly reducing production or other reasons prices are going up so much.”
74 In his plea to Congress, the CEO of Northwest Airlines said: “I cannot overstate the importance to my company and the entire U.S. airline industry of immediate congressional action to halt excessive speculation in oil futures markets.”
75 Despite the academic consensus that speculation was not behind the price increase, deep and widespread anger and protest at stratospheric oil prices triggered a wave of official investigations, studies, and hearings. In June 2008 the House of Representatives directed the Commodity Futures Trading Commission to “curb immediately” what it perceived to be excessive speculation in energy futures markets.
76 Officials and regulators probed aggressively but sided nearly unanimously with the academics, finding little to no causality between commodity index inflows and rising commodity prices and saying instead that supply and demand fundamentals explained the dramatic moves.
77 Officials found neither evidence of such hoarding nor weak or broken convergence between futures and physical markets. The IEA did its own probe and found no evidence that speculation caused unusual inventory building while oil prices were ascending.
78The press was littered with forecasts for continued—apparently unstoppable—price increases. Goldman Sachs forecasted oil prices would exceed $140 in the summer of 2008 and could average $200 in 2009.
79 An OPEC minister predicted $200 oil; Gazprom’s CEO saw $250 in 2009.
80 Driving these dire predictions were warnings from the IEA that OPEC spare capacity would dwindle to “minimal levels by 2012” and that by 2015 the world oil supply could come up short by as much as 12.5 mb/d.
81 Warnings about low capacity from IEA hit hard, especially because most private experts believed IEA’s estimates of spare capacity were generous from the start.
82 By anyone’s standard, OPEC’s spare capacity was unusually low between the Second Gulf War and 2007. And in the first half of 2008 it was starting to shrink again.
In January, President Bush told reporters: “I hope OPEC nations put more supply on the market. It would be helpful.” But Saudi Oil Minister Naimi insisted oil inventories were normal and that Saudi Arabia would only add more supply if the market justified it.
83 When Bush visited Saudi Arabia to ask for more oil in person, he was reportedly rebuffed. He traveled again to Riyadh in May, and this time Saudi Arabia announced a 300,000 barrel per day supply boost.
84 But prices continued to rise, drawing new wails of complaint from U.N. Secretary-General Ban Ki-moon and other leaders.
No one was sure exactly how much spare capacity was left, but as crude prices lurched higher, pleas from the United States, and most of the other G8 (but Russia was a large exporter), and other oil-importing countries grew more insistent that it be used, and fast. WTI crude began May 2008 trading around $113; before the month was over it had almost reached $133 before falling back. June trading opened at $127 and ended the month just under $140 per barrel.
85 Saudi and other OPEC officials continued to insist that supply was adequate and that speculators were driving up prices. U.S. Energy Secretary Samuel Bodman would hear none of that, tartly telling reporters on the eve of a June 22 emergency summit of oil-producing and oil-consuming countries in Jeddah, Saudi Arabia: “Market fundamentals show us that production has not kept pace with growing demand for oil, resulting in increasing prices and increasingly volatile prices. There is no evidence that we can find that speculators are driving futures prices” for oil.
86 And United Kingdom Prime Minister Gordon Brown joined U.S. officials in calling for Saudi Arabia to increase production so that “instead of uncertainty and unpredictability, there is greater certainty, and instead of instability, there is greater stability.”
87Under tremendous international pressure, Saudi Arabia announced another production hike at the June 22 emergency summit.
88 Saudi production was headed up to 9.7 mb/d, the highest level since 1981. Naimi told visiting officials that the kingdom was willing to boost its production capacity above the 9.7 mb/d level planned for July in 2009, but only if—in Saudi Arabia’s view—the market required it.
89 “After months of blaming the spike in oil prices on speculators,” the
Washington Post editorialized, “the Saudis have finally admitted, tacitly to be sure, that the root cause is insufficient supply.”
90 Crude oil prices peaked on July 11 at an intraday high of $147.27.
91BUST
Unbeknownst to oil market participants gawking at oil’s towering spike in the middle of 2008, a collapsing real estate bubble was about to drop the floor out from under crude oil prices, triggering a price bust as sudden and spectacular as the boom.
In 2006, a U.S. real estate bubble began deflating, spilling over into foreclosures, delinquencies, and financial institution failures. Credit tightened, transmitting distress to the real economy and slowing real estate investment and household spending. By the end of 2007, the U.S. economy was in a full recession. The collapse of the U.S. securities firm Bear Stearns in March 2008 intensified concerns about a financial crisis, and September brought more foreboding signs as Washington was forced to seize the government-sponsored housing lenders Fannie Mae and Freddie Mac.
92 On September 14, 2008, the U.S. subprime mortgage crisis erupted into a global financial emergency when Lehman Brothers—the fourth-largest investment bank in the country—declared bankruptcy. Like many other financial institutions, Lehman held enormous amounts of low quality household debt securities. Its failure prompted contagion risk and a widespread collapse in market confidence. In October some $10 trillion of global equity value vaporized, in the largest monthly loss ever recorded.
93 The world was quickly engulfed in a global credit crunch and economic growth screeched to a halt.
We know that consumers don’t quickly adjust their consumption of gasoline when oil
prices change—but they do when their
income changes. An employed worker has little choice but to pay whatever the pump price is to drive to work, but after losing his job, an unemployed person’s need to drive drops quickly. In 2008 incomes were collapsing and oil demand along with them, falling by 0.7 mb/d in 2008 and by 1.1 mb/d in 2009.
94As it became clear that the world was entering a massive recession, oil prices plummeted. In October of 2008, prices fell to almost $60 per barrel—half their level just two months earlier. By December prices had tumbled to $33, an astounding crash of 78 percent in just six months. Looking back on the year, the energy publication
MEES noted that “traders went from imagining crude oil prices reaching $200 per barrel to contemplating ‘demand destruction.’”
95The price volatility whipsawed oil consumers, from truck drivers to home heating oil merchants to automakers and airlines. In January 2009 The New York Times reported:
The volatility is showing up at the retail level. Drivers who only a few weeks ago were finding relief from the summer’s $4-a-gallon gasoline are now shaking their heads as the average national price for unleaded regular gasoline has surged to $1.79, from $1.62, since Dec. 30. Oil volatility has complicated the efforts of automobile companies to figure out future strategies. Toyota had to suspend production at one plant that builds the Tundra pickup truck for several months when gasoline prices soared last summer. Toyota then delayed completion of a second plant meant to build the Prius hybrid when falling gasoline prices led to weakening demand for that fuel-efficient model. The gyrations in prices affect shipping and other businesses around the world. Cathay Pacific, one of many airlines that use fuel hedging strategies, recently acknowledged that it had hedging losses of hundreds of millions of dollars as a result of the collapse in fuel prices.
96US Airways Group reported a third-quarter loss of $865 million, citing the recession and volatility of oil prices. At the time, several airline companies were hedging against the risk of high jet fuel prices using derivatives called swaps. Had oil prices continued to rise to $200 per barrel in 2008, an airline that had locked in a lower price through this kind of transaction would have been very happy because the earnings on their swaps contracts would have offset the higher costs of physical jet fuel. But these trades lost money when oil prices ripped through the lower end of the range they were designed work within.
While the credit crisis was the root of the Great Recession, soaring oil prices had helped weaken the economies of oil-importing industrialized countries by disrupting trade balances, putting upward pressure on inflation and interest rates, and hurting consumer and business income (in the United States, household spending on energy more than doubled from 2003 to 2008, to about 8 percent of income
97)—and ultimately making them more vulnerable to financial contagion.
