America’s Oil Problem

Don’t look for oil prices to decline any time soon.

At last week’s meeting in Algiers, the OPEC cartel’s oil ministers claimed that warm weather in the next few months will curtail demand for oil, and bring down its price, which has risen about 15 percent this year. Never mind that with oil at $33 per barrel in the U.S. ($30 for Brent benchmark crude), OPEC’s revenue has risen from $199 billion in 2002 to $247 billion last year, a jump of 25 percent. The producers, upset that their shrinking dollars don’t go as far in Harrod’s as they once did, have raised their price target from its old range of $22-$28.

So they are calling for members to stop pumping the one-to-two million barrels per day they are producing in excess of their 24.5 million barrel daily quota. In April, the cartel plans to cut the quotas themselves by another one million barrels per day.

Phil Flynn, a senior market analyst at Chicago’s Alaron Trading, expects prices to hit $34 in the spring. And Philip Verleger, a long-time student of oil markets, now at the Institute for International Economics, thinks that is optimistic: he sees $40 oil in our future.

All of which has the White House worried that its prediction that the economy will create 2.6 million jobs this year might prove to be wishful thinking. And more than a few businessmen fear that the nascent economic recovery will be strangled at birth by $35 oil.

Since OPEC members are famous for cheating on quotas, it is unlikely that all of the agreed cuts will be realized. But with inventories near their lowest level in thirty years, even some cheating will leave supplies tight, and the world dependent on Saudi Arabia to moderate any price spikes.

Those looking to Russia, which now produces almost as much oil as does Saudi Arabia, to step up exports sufficiently to return prices to the $25 range are likely to be disappointed. Russian oil is relatively expensive to produce, and costly additions to infrastructure (ports, pipelines) are needed if exports are to be increased significantly. Also, the government’s fiscal health depends heavily on continued high oil prices, giving Russia little incentive to ease price pressures on Western consumers.

Nor can we count on Iraq for relief. Not only is it proving difficult to get Iraqi oil back onto world markets in significant quantities, but Iraq has made it clear that it plans to return to OPEC as the good cartelist it once was.

Other potential sources of more oil are even less likely to raise output. Venezuela’s president has decimated his country’s industry by meddling in the management of PDVSA, the state-owned oil company. Wood Mackenzie, the respected oil consultancy, says that the North Sea is no longer a profitable area in which to look for new oil. And analysts at the White House tell me that African sources can’t be counted as “reliable.”

At the same time, the best guess is that demand for crude will not fall sharply in the spring, as OPEC is forecasting. China’s appetite for more oil continues unabated: demand grew by 33 percent last year. And the U.S. recovery should keep demand here high.

Combine that picture of constrained supply and growing demand, and it is unlikely that the end of the U.S. cold snap will bring a collapse in oil prices, especially since the summer driving season is not far off.

Fortunately, prices in the $33-$35 range do not certainly mean a screeching halt to the recovery. Some analysts are guessing that $35 oil will cut about one-half of a percentage point off the GDP growth rate. Perhaps. But hardly a reason for gloom. And with forecasts for growth ranging from 3.5 percent to 5 percent, we will probably never know what might have been had prices stayed well below $30.

That doesn’t mean that we should be indifferent as between $25 and $35 oil—cheaper is obviously better, especially for the motorist-consumers who have been fueling the economic recovery and are now likely to face spikes in gasoline prices during the summer driving season.

But before pushing the panic button, we should keep in mind that the recovery has been gathering strength even though oil prices have remained high; that more fuel-using industries rely on natural gas, the price of which has been falling, than on oil; that consumers continue to snap up gas-guzzling SUVs, suggesting they feel they can afford higher prices for gasoline; and that there are powerful forces operating to keep the recovery rolling.

Fiscal policy is loose to the point of irresponsibility, as the president opts for guns, butter, tax cuts, prescription drugs, and Mars. Federal Reserve Board chairman Alan Greenspan appeared before Congress last week and repeated that the absence of inflationary pressures allows the Fed to be “patient” before raising interest rates, adding relaxed monetary policy to the more-than-relaxed fiscal policy. Businesses that have delayed investments are loosening their purse strings as profits continue to exceed expectations, and corporate demand for bank loans is rising for the first time in four years. Consumer confidence remains high and spending remains strong, driving retail sales in January to 5.8 percent above year-earlier levels. The service sector is growing at the fastest pace since we started keeping records in 1997, the manufacturing sector is also on the upswing, construction spending is at an all-time high, and the economy added at least 112,000 new jobs last month.

So America’s oil problem is not the price the cartel is currently able to extract. It is, instead, the threat to the continuity of Middle Eastern supplies from terrorists and fanatics who will be emboldened to create chaos if we fail to achieve our goals in Iraq.

This article appeared in London’s Sunday Times on February 15, 2004.