Rising Cost of Fuel

¶ … Rising Cost of Fuel

The price of light, sweet crude oil on NYMEX has been above $40/barrel since late July 2004. By October the price of crude oil had temporarily surpassed $55/barrel. In the United States (U.S.), the Consumer Price Index rose by 0.6% compared to 0.2% for September. This was driven by a 4.2% increase in energy costs. In this paper, we will examine two arguments: the primary cause, or causes of the rise in the price of fuel and the impact on the U.S. economy.

The cause of the rise in fuel prices is the current demand for petroleum in relation to the supply. High demand is coming from increased industry in emerging third world nations including India and especially China which is developing a large car culture and whose manufacturing bases have grown very rapidly in recent years. Consumption in 2004 compared to 2003 according to DOE EIA estimates (International Petroleum Information):

World: 3.4% increase

China: 20% increase

UK: 8% increase

US: 6% increase

Asia outside Japan and China: 6% increase

Analysts have explained the low supply in the following ways: the war in Iraq that has destroyed some of Iraq's oil refineries, Hurricane Ivan's damage to offshore oil platforms in the Caribbean, YUKOS in Russia, civil unrest in oil producing West Africa especially Nigeria, worker's strikes and mechanical problems with oil production in Norway. World supply (specification) came in at 83 million barrels a day during 2004 in Department of Energy EIA calculations (International Petroleum Information). This rate of increase is faster than that of any other date in the past.

This spike was largely without the immediate causes of the fall of 2004. During this period the Bush Administration was expanding the Strategic Petroleum Reserve at a rate of 250,000 barrels per day. Analysts vary in their explanations of the price increases. One factor cited is that winter in the U.S. was colder than usual, though this became less relevant as spring approached. Another reason is the continued growth in world demand, helped by the stellar growth of India and China. Finally, the dollar continues to slump against the euro. Since oil is traded in dollars, the price must increase for OPEC to maintain buying power in Europe. Some analysts conclude from this that the increases are permanent and prices may go much higher. Goldman Sachs released a report predicting that prices could hit $100 at some unspecified date.

In April 2005 the price began to fall, reaching $53.32 on April 9. It then reversed course and headed to an all time high of $58.28, driven mainly by lingering concerns of a prolonged weak dollar.

In June 2005, the Bush administration announced that the Strategic Petroleum Reserve was full, and that the ending of federal oil stockpiling would increase supply and temporarily ameliorate fuel prices. However, crude oil prices surged to record highs eventually breaking the psychological barrier of $60.

While some see these increases in the price of oil leading to a recession comparable to those that followed the 1973 and 1979 energy crises, most economists see this as unlikely. All developed countries have high fuel taxes that decrease as oil prices increase and can be eliminated in the event of a dramatic price spike. The American Strategic Petroleum Reserve could serve a similar role in overcoming price increases in an emergency.

The western economies aren't as reliant on oil as they were thirty years ago, despite substantial growths in productivity. In the United States, for instance, each $1,000 dollars in GDP required 2.4 barrels of oil in 1973 when adjusted for inflation this number had fallen to 1.15 by 2001.

The price of light, sweet crude oil on NYMEX has been above $50 a barrel since March 5, 2005. After prices retreated for several months during the winter of 2004/2005 they rose to new highs in March and closed at a then new peak of $57.27 a barrel at the beginning of April 2005. On March 16, 2005, the price surpassed the October 2004 high of $55.17, closing at $56.46. On March 18th, the price rose to $57.60. This made the price 50% higher than its year-ago level. Later in April, prices began to fall, reaching $53.32 on April 9th. It then reversed course and headed to an all time high of $58.28, driven mainly by lingering concerns of a prolonged weak dollar. Prices retreated again and reached just above $47 a barrel on May 22nd. Oil prices jumped to almost $52 a barrel May 27th on expectations of high U.S. gasoline demand over the Memorial Day holiday and amid reports Saudi Arabia's King Fahd had fallen ill. "Any uncertainty in the Kingdom might cause prices to move higher,' said Mike Fitzpatrick, vice president for energy risk management at Fimat USA. 'We'll have to see how much movement there is if and when the King actually dies'" (Reuters). U.S. crude futures settled up 84 cents at $51.85 a barrel, building gains during the week of May 23rd to almost 11%. Brent crude gained 54 cents to $50.70 a barrel. It should be noted that the $50 to $60 range is still well below the all-time inflation-adjusted high seen in 1980 of $90.

This current spike was due to other causes than those that occurred during the fall of 2004. During that period the Bush administration was expanding the Strategic Petroleum Reserve at a rate of 250,000 barrels per day. Reasons for the current price increases vary depending on the analyst. One cause may be due to the fact that winter in the U.S. was colder than usual, although this became less and less relevant as year progressed towards spring. Another reason may be that world demand also continues to increase, helped by the stellar growth of India and China. According to Nariman Behravesh, "probably the biggest economy right now or the one that's having the biggest impact on energy markets other than the U.S. is China. China is now the second largest importer of petroleum. And it's really China that in some sense is setting the pace here. So China and China's developments and China's industrialization are clearly one of the biggest drivers of this picture at this point in time" (Lehrer, Fueling Inflation?). Finally, the dollar continues to slump against the euro. Oil is traded in dollars, and so in order for OPEC to maintain buying power in Europe, oil prices must increase. Some analysts thus feel that the increases are permanent and prices may go much higher. In addition, Goldman Sachs recently released a report predicting that prices could hit $100 at some unspecified date.

The price of light, sweet crude oil on NYMEX has been above $40 a barrel since late July 2004. By October the price of crude oil had temporarily surpassed $55 a barrel. In the United States (U.S.), the Consumer Price Index (CPI) rose by 0.6% compared to 0.2% for September. This was driven by a 4.2% increase in energy costs. "In real economic terms, prices are still below the levels of the early 1980s, but they have crept and diesel fuel in California now costs $2.27 per gallon while gasoline averaged $2.11 per gallon across the Golden State" (Szczesny). The cause is the current and expected demand in relation to the supply of petroleum. High demand is coming from increased industry in emerging third world nations including India and especially China, which is developing a large car culture.

World supply was at 83 million barrels a day during 2004 according to Department of Energy EIA calculations. "The recent oil price surge underscores the economic importance of oil and the reality that oil supplies are starting to dwindle. This is an issue that no longer can be ignored. During the past 15 years, world oil consumption rose an average of 948,000 barrels a day. It rose more this year, and the International Energy Agency forecasts higher consumption next year" (Attarian). The media have explained the low supply in the following ways: the war in Iraq, hurricane Ivan's damage to offshore oil platforms in the Caribbean, YUKOS in Russia, OPEC's, most notably Saudi Arabia's, failure to bring prices down via dipping into spare capacity, if it has spare capacity, civil unrest in oil producing West Africa especially Nigeria, worker's strikes and mechanical problems with oil production in Norway. In a recent satellite address, Federal Reserve Chairman Alan Greenspan said, "In the decades ahead, natural gas and oil will compete in the United States with coal, nuclear power, and renewable sources of energy. As the manner in which energy is produced and consumed evolves, it is not unreasonable to expect that, in the long run, the prices per unit of energy from various sources would tend to converge" (Greenspan, Energy). It is an ever-growing list of explanations with new ones being added every month.

While some see these increases in the price of oil leading to a recession comparable to those that followed the 1973 and 1979 energy crises, most economists see this as unlikely. In 1973, the retail price of a gallon of gasoline rose from a national average of 38.5 cents in May 1973 to 55.1 cents in June 1974. Meanwhile, New York Stock Exchange shares lost $97 billion in value in six weeks. Underscoring the interdependence of the world societies and economies, oil-importing nations in the noncommunist industrial world saw sudden inflation and economic recession. In contrast today, all developed countries have high fuel taxes that decrease as oil prices increase and can be eliminated in the event of a dramatic price spike. The American Strategic Petroleum Reserve could serve a similar role in overcoming price increases in an emergency, and some say that western economies are about half as reliant on oil as they were thirty years ago, citing that in the United States, for instance, each $1,000 in GDP required 1.43 barrels of oil in 1970. In 2000 this number had fallen to 0.74, though these figures may not include adjustments for inflation.

The rise in oil prices has had a ripple effect throughout the economy.

Christie Baker, owner of Flowers on the Green, recently had to hike the cost of a delivery in Guilford, Conn., from $6 to $8 to make up for the higher cost of gas. In La Jolla, Calif., Domino's just increased the amount it pays delivery drivers by a nickel a trip: They now get 95 cents to transport a large pepperoni, but it's still not enough to cover the cost, says assistant manager Donald Cunningham. And at Meyers Moving & Storage in New York City, they're now charging $15 more an hour to move from an apartment on the East Side to the West. Owner Guy Drori says the rates may go up again come summer (Marks).

During the past year, the robust economy absorbed much of the increase in energy costs. Competition for consumers helped, and kept many businesses from passing along the spike in fuel costs. However, with gas prices hovering around new record highs, and the cost of diesel keeping pace, many businesses are finding they can no longer absorb the increased costs. "Rising oil and gasoline prices dampened consumer and business spending in the first quarter of this year, slowing the U.S. economy and kindling fears of a looming economic slowdown, or worse. The Commerce Department reported Thursday that the nation's gross domestic product, the broadest measure of U.S. goods and services produced, rose at a 3.1% annual rate in the January-March quarter. That's the slowest quarterly growth in two years" (Hall).

In his most recent report to Congress on February 16, 2005, Alan Greenspan, characterized the U.S. economy as steadily improving. Acknowledging that economic activity had increased in 2003, he said that the expansion appeared tentative as 2004 began, due primarily to reluctance by businesses to hire new employees. During the spring of 2004, however, the economy strengthened as businesses began adding to their payrolls, increased investment in equipment and software and increased inventory levels. The construction sector continued to be strong, but consumer spending was soft. Consumer price inflation increased primarily due to a rise in oil prices. In the second half of 2004, the economy continued to expand, although at mid-year there were signs of weakness, brought about as a result of high oil prices. By autumn this small slowdown was over, as consumer spending was up and businesses were again hiring and factory output increased. Business profits were healthy and capital spending increased throughout the remainder of 2004. According to Greenspan, "The fundamental factors underlying the continued strength of the economy last year should carry forward into 2005 and 2006, promoting both healthy expansion of activity and low inflation" (Board of Governors of the Federal Reserve System).

Since the first of the year, oil prices have surged more than 35%, but drilling for oil has declined by 3%. Over the same period, natural gas prices also have risen by nearly 30%, while drilling for natural gas has dropped nearly 15%. "According to research firm Value Line, domestic gas production has been slowly declining since 2001. Production continued to decrease in 2004, despite strong drilling activity. The time from drilling to market for natural gas can be as high as 18 months, so results from increased drilling in 2004 have yet to be felt" (Dolbeck). The reasons for the puzzling decline in drilling appear to be somewhat different for oil than natural gas. An overhang in the capacity to produce oil is restraining oil drilling, while a continued adjustment to previous declines in natural gas prices is driving down natural gas drilling.

Drilling for crude oil generally moves with oil prices. A closer relationship is more evident prior to 1998. As OPEC pushed prices upward by restricting production in 1999, however, the relationship weakened. The overhang of excess capacity in OPEC created the possibility that oil prices might fall. The result was a muted and delayed response in oil drilling. Oil drilling did not pick up until growing demand pushed OPEC closer to full capacity. The story is similar today. Political uncertainty and OPEC production restraint have pushed world oil prices upward, although excess capacity is nearly 10% of world oil consumption at 6 million barrels per day. The overhang of capacity creates the possibility of a sharp oil price decline and adds considerable risk to future oil prices, which discourages exploration and development activities.

Drilling for natural gas also moves with natural gas prices, but with a delay. Natural gas drilling still appears to be adjusting to the sharp decline in natural gas prices that occurred in 2001. Natural gas drilling was greatly stimulated by the strong rise in natural gas prices that occurred in 1999 and 2000, and the natural gas rig count remains relatively high despite recent gains in natural gas prices. In addition, relatively high inventory levels of natural gas in storage raise the possibility of slippage in natural gas prices.