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2005’s Lessons From The Oil Market

By A. F. Alhajji

All predictions made at end-2003 and early-2004 regarding oil prices, world oil demand, and world oil production were wrong by a large margin. For example, at end-2003, the IEA projected world demand in 2004 to be 79.6mn b/d. The actual demand in 2004 was 2.85mn b/d higher than projected at 82.45mn b/d. In early-2004, the EIA projected end-2004 oil prices to average $24.25/B in the base case and $32/B in the high-growth case. The actual average at the end of 2004 was $43.48/B.

In 2005, nominal oil prices increased by about 40% and reached new records. World oil production, world oil demand, world oil trade, and US oil imports also hit new records. The oil producing countries generated record revenues, experienced budget surpluses, and enjoyed higher rates of economic growth. Many oil companies generated record quarterly profits. The economies of various countries, especially the US, India, and China, continued to grow at high rates, unfazed by higher energy prices.

Why have oil prices exceeded expectations? Why have they not started the process of oil demand destruction? Here are nine lessons from the high price experiences in 2005 that will affect the 2006 outlook.

OPEC has abandoned the price band in favor of signals to the market; if traders fail to understand these signals or fail to act on them as OPEC expects, then OPEC will surprise the market with unanticipated changes in production. In the last two years, OPEC has been very innovative in its surprises.

OPEC is powerless and cannot influence oil prices when it produces at full marketable capacity. OPEC has market power only when it has marketable excess capacity.

High oil prices do not reduce demand if the increase in oil prices is gradual and expected. Despite the fivefold increase in oil prices between early 1999 and spring 2005, high oil prices did not lead to oil demand destruction. Demand destruction started in early September, when oil prices increased suddenly by about $10/B after Hurricane Katrina ravaged the Gulf of Mexico region.

High oil prices do not reduce demand in the consuming countries when government expenditures increase. Rises in government expenditures increase economic growth and counter the negative effect of increasing oil prices. The increase in government expenditures in OECD countries in the last three years was unprecedented, especially in the US.

High oil prices do not affect oil demand when interest rates are low or declining. Low interest rates stimulate consumption and investment, which in turn counter the negative effect of oil prices on the economy.

Oil producers and refiners end up with severe technical problems when they operate at full or near full capacity. Subsequently, production of crude and products declines.

Hedge funds and other speculators have become significant players in the oil markets and might have a relative effect on prices. Blaming speculators for the increase in oil prices will not solve the problem of high prices, especially since the effect of speculators on oil prices is unknown at this time. Causality tests indicate that higher prices lead to more speculation and that speculation does not cause prices to increase. The counter argument is that the published data does not reflect the true level of speculation.

Dollar devaluation reduces supply and increases demand. For example, it increases the cost of producing oil in the North Sea region. It also makes oil cheaper from the European and Japanese point of view.

Free markets work, especially, if governments limit their policies to correcting market failures. A combination of government action and inaction mitigated the impact of hurricanes on oil and products prices. The IEA’s release of the 60mn barrels from the SPR from its members, including the US, and the suspension of specific environmental regulations in the US contributed to increased supplies. These actions also increased US gasoline imports and put downward pressure on crude and products prices. At the same time, federal and state governments rejected calls for price controls and direct intervention in pricing. This “inaction” allowed market forces to work.

To conclude, the experience of 2005 teaches us several lessons. The most important is that markets work. Governments should limit their policies to correcting market failures. The second important lesson is that researchers and modelers should focus their attention on the impact of exchange rates on the oil industry. The first lesson explains why oil prices declined in the aftermath of last year’s hurricanes, despite the fact that large portions of production in the Gulf of Mexico was still shut-in. The second lesson explains why world oil demand continued to grow despite the continued increase in oil prices.

A. F. Alhajji is a widely published oil analyst, and Professor of Business at the College of Business Administration, Ohio Northern University. Petroleumworld not necessarily share these views.

Editor's Note: This article was written by Dr Alhajji for “Gulf in the Media”, an affiliate of the Gulf Research Center (GRC) in Dubai, UAE and it is reprinted in Middle East Economic Survey-MEES with permission from the GRC, on July 3, 2006, Issue.

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Petroleumworld News 08/06/06

Copyright©2006 A. F. Alhajji . All rights reserved

 

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