Is this time different?
Because Israel is involved in a war with Hezbollah in Lebanon there was a natural tendency to attempt to draw a parallel to the Yom Kippur (Oct. 6-26, 1973) war and the 1973 Oil Embargo. However, this is not a good example. That war involved an invasion of Israel by two Arab states, Egypt and Syria, with the general support of most Arab nations. The clearest evidence of that support came on October 17, 1973 when the Organization of Arab Petroleum Exporting Countries announced an embargo on nations which had assisted Israel. The United States and some European allies were the primary target of the embargo. The current situation is not a war between Israel and a nation state but rather with the Hezbollah faction within Lebanon. Hezbollah is supported by Arab Syria and Persian Iran. In the current conflict many Arab nations, with the Saudis at the forefront, have condemned Hezbollah's actions for starting the conflict. For this reason the current conflict does not portend an Arab oil embargo.
The dramatic price increase of the last 2-3 years is more akin the the 79-81 price run up. In a 24 month period from January 1979 to January 1981 oil prices increased 160% in international markets and domestic prices gained almost 200% because of the combination of the higher international prices and the lifting of price controls on oil produced in the U.S. In the recent price cycle we would have to start in May 2003 to show a 160% increase in price and that is a period of 34 months or almost 3 years. While it may not be comforting to an American filling his SUV this increase has been more gradual than it was in 1979 and 1980.
Production
The 79-81 and 03-06 increases and today have in common and many of the same players are involved. The in the late 70s the Iranian Revolution caused production in that country to drop from 6.1 million barrels per day in September 1978 to under a million barrels per day in early 1979. This took 5 million barrels of the market and started the spike in prices. By late 1979 Iranian production was nearing nearing 4 million barrels per day.
In September 1980 Iraq invaded Iran and production of both countries plummeted. By October production in both countries was near zero and over 8 million barrels less than in 1978. Neither Iraq nor Iran ever fully recovered their oil production. Today, Iran's production is only two thirds its pre-revolution peak.
The current run of prices has some parallels on the production side. First, a civil disruption with the PDVSA strike in Venezuela dropped Venezuelan production 2.3 million barrels per day. Most production was recovered following the strike but it is it is still 700,000 barrels per day below its pre-strike capacity of 3.5 million barrels per day. Iraq's production suffered from the invasion by coalition troops and is near a million b/d below its previous capacity. Indonesia has been in steady decline and is down 200,000 b/d from 2002. While there has been lost production associated with this round of price increases they were not of the magnitude of the 79-81 period.
In the 79-81 period there were there were other production related factors as well. As prices were peaking Alaskan production was coming on line and North Sea production was in its infancy. were coming on line making up for some of the losses in Iraq and Iran. The post Embargo period was one of rapid growth in non-OPEC production. Because of the long term nature of the exploration and production investment cycle non-OPEC production continued to increase long after prices began to decline.
The long term impact of the 03-06 price increase on production remains to be seen.
Consumption (Recession and Conservation)
The 1979-81 price increase was accompanied by a drop in US consumption. By 1982 U.S. total petroleum consumption was down 18 percent from 1978 but gasoline consumption only declined 12 percent. The response was far greater for distillates and heavy fuel oils which were lower because conservation and efficiency were augmented with fuel switching to natural gas, coal and nuclear power.
The last 34 months in which there was a comparable price increase to the 1979-1981 period but instead of causing a drop in consumption there has been a 3.6 percent increase in total petroleum consumption with gasoline consumption up 3.2 per cent.
Why is there such a dramatic difference in the U.S. consumption response of between then and now? There are three easily identifiable reasons.
First, in the 1970s there was a concerted effort by government to lower consumption. This was accomplished by fuel conservation through the implementation of the CAFE standards for automobiles, lower temperatures in commercial buildings, tax credits for improved efficiency and higher standards for insulating new homes and buildings. In 1978 the average automobile got 14.3 miles per gallon. By 1982 it was 16.9 mpg. In contrast in the last three years the average mileage of the fleet barely moved from 22.0 to 22.4 mile per gallon. In the last year the fleet mileage remains unchanged.
Second, there were two back-to-back recessions. The first was from January - July, 1979 and the second from July 1980 to November 1982. In in contrast in the last three the U.S. has not had a single quarter of negative growth. As we have noted in the past while it is historically evident that high oil prices often lead to recessions it could also be said that recessions cause lower oil prices.
Third, the U.S. is less energy intensive than in 1979 when we used 70 percent more energy per dollar of GDP than we did before. Some of the apparent improvement in consumed energy per dollar of GDP is because the U.S. is manufactures fewer of its consumer goods than it did in the late 1970s. Many of those goods have a high energy content. That means some of U.S. energy consumption is actually occurring in China when the plastic toy is made for shipment to WalMart. The lack of a floating currency in China has insulated the U.S. consumer from some of the oil related price increases that would normally be passed through to the retail level.
Another obvious difference in consumption patterns comes outside of the U.S. with the rapid growth of consumption in Asia. Over the last few years higher consumption and contributed as much to the decline in spare production capacity as have production problems in Venezuela, Iraq, Nigeria and Indonesia.
Stocks
In the 24 month period from early 1979 to early 1981 when prices increased 160% and the last 34 months when prices are up by the same percent U.S. crude oil inventories increased 25 and 20 percent respectively. In both times of perceived shortage, crude oil inventories grew substantially indicating that supply exceeded consumption.
It is easy to see why refiners would want to build inventories in a time of concern about supply interruption and rising prices. A higher inventory provides a greater buffer when there are problems and if the refiner expects prices the additional stock is expected to be worth more when you use it than when you bought it.
NYMEX
Crude oil futures trading did not begin on NYMEX until 1983. In the 1979-1981 period the prices were generally determined by participants in the physical market. The current situation is a market heavily influenced by futures trading which in turn has an impact on physical spot prices. In the 79-81 period spot prices would often remain unchanged for a week or more. It is now a rare event when crude oil or product prices are the same two days in a row. It is unlikely that in the absence of an active futures market that there would have been any price movement associated with the current conflict between Israel and Hezbollah.
Conclusion
The recent price spike is the result of a combination of supply interruptions and increases in consumption especially in Asia and less developed nations. Unlike previous periods of rapidly rising prices the government response has been minimal with little impact on consumption patterns. Thus far the impact of higher prices has not led to a U.S. recession.
International oil companies increasingly find their access to countries with significant reserves limited by the host countries. They find themselves replaced by state owned oil companies and where the are allowed to operate they often face higher lease bonuses, royalty rates and income taxes. All of these combine to slow the rate of increase in oil production capacity and in actual production. The slower production response and minimal effect of high prices on consumption combined with continued economic strength worldwide has extended the length of this price cycle.
Next week we address is some detail the factors with the greatest potential to cause a significant reduction in oil prices. The potential impact of a weaker world economy, increased production capacity and fuel switching will be addressed separately and in combination.
