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ECONOMICS OF THE PACIFIC STATES
HUMBLE PIE & OIL PRICES
This article differs considerably from others submitted in this space. Previous columns have dealt primarily with water issues, which are critical to farming. Not wanting to wear out his welcome on that topic, the author this month looks at another resource that is important to agriculture and virtually everyone else - oil.
Humble Pie ala mode
It is oft remarked that one mark of good forecasting economists is that they check the accuracy of their forecasts. In the late 1970s and early 1980s, common thinking among many (including the author, who was working for an oil company at the time) was that crude oil prices would increase for decades at a REAL rate of perhaps three percent per year after climbing from $3.18 per barrel in 1970 to $7.67 per barrel in 1975 and $31.77 per barrel in 1981. Based on that trend, expected worldwide oil demand, and available supplies, it was projected that nominal prices would be close to $100 per barrel by 1990.
Fortunately, that forecast proved well shy of the mark, as crude oil prices averaged a little over $20 per barrel in 1990. Many who had projected $50 or $100 oil likely ended up reducing the proportion of their portfolios in oil stocks (or had the adjustment done for them by the market). Several factors caused prices to actually drop rather than increase by 1990 and subsequently. First, deregulation of oil prices in 1981 caused an immediate pickup in drilling activity, and oil supplies increased. Second, the economy suffered through a severe recession as an aftermath of strict monetary discipline in the late 1970s. Third, businesses and individuals conserved with a vengeance, paralleling the behavior evident after the oil embargo in 1973. As a result, total energy consumed per dollar of Gross Domestic Product fell from $18.96 in 1970 to $16.00 in 1980, $12.55 in 1990, and $10.92 in 1999 - a 42 percent decline in 30 years.
More recently, of course, oil prices have increased sharply to their highest levels in ten years. No one is (publicly) forecasting prices to increase to $50 or $100 per barrel any time in the foreseeable future. Nonetheless, several structural factors suggest that the price hikes of the last 18 months for crude and refined petroleum products are not just a temporary blip. One is an increased reliance on imports, similar to the early and late 1970s. In 1970, petroleum imports accounted for 23 percent of U.S. petroleum consumption. By 1973, that ratio stood at 36 percent and by 1979 it was 46 percent. After oil prices were deregulated in 1981, the ratio fell, reaching 32 percent in 1985. By 1990, it had climbed back to 47 percent and last year stood at 54 percent. Clearly, the U.S. has increased its reliance on foreign oil sources to the point that imports now account for a greater proportion of total domestic petroleum consumption than at any time in more than 50 years.
A second factor suggesting the persistence of higher prices is what happened after prices were deregulated in 1981 and the resultant effects on demand. In contrast to the forecasts of three percent annual increases from 1981 through 1990, real prices fell 55 percent over that period - a compounded decline of 7.6 percent per year (lots of humble pie to spread around for that “reality check”). From 1990 through 1999, real prices fell a further 36 percent, or 4.3 percent per year. These declines, together with, and supporting, the unprecedented domestic economic expansion, have boosted petroleum consumption in the United States by 14 percent since 1990.
A third factor, not independent of the others, is the declining level of U.S. oil production. Production last year was 31.3 percent below 1980 levels and 35.6 percent below 1973. The number of petroleum rotary rigs in operation in 1999 averaged 128, down from a peak of 554 in 1988. Production for the first eight months of 2000 was level with the same period a year before because of a 33 percent increase in drilling activity and well completions. However, domestic oil production will not increase dramatically in the future, and imports will remain a key element of overall petroleum supplies.
A fourth factor which points to persistently-high petroleum product prices is the state of the U.S. refining industry. In 1973, U.S. refineries had a collective capacity of 13.6 million barrels per day (mbpd). Capacity utilization averaged 93.9 percent that year, and imports of distillate fuel, jet fuel, and gasoline averaged 0.738 mbpd. By 1980, capacity had increased to 18 mbpd, capacity utilization had fallen to 68.6 percent, and imports of the three finished products had fallen to 0.361 mbpd. Since then, however, many (typically smaller) refineries have shut down because of high crude oil prices, environmental regulations, and other factors. In California, half of the refineries have shut down since 1996 alone.
As a result, 1999 refinery capacity averaged 16.26 mbpd -- the same level as in 1977. Capacity utilization averaged 92.7 percent, and imports of distillate fuel, jet fuel, and gasoline climbed to 0.689 mbpd. With consumption of petroleum products at 19.5 mbpd, there is little slack in the domestic refining industry. Production has exceeded rated capacity frequently, and any unexpected breakdowns or accidents translate into higher prices very quickly. Regional supply and demand balances are even more precarious. In California, periodic shortages because of scheduled maintenance or unscheduled shutdowns have caused dramatic spikes in prices.
Why It Matters
The data and experts suggest that the U.S. economy is not as vulnerable today to higher oil prices as it was 25 or 30 years ago. Certainly the dramatic trends in energy efficiency support this assertion. Hence, a tripling of oil prices from the 20 year lows in 1998 has not caused a recession as was the case following the 1973-74 tripling. The more recent hikes have likely caused some slowing of the economy, although higher interest rates since mid 1999 have likely been more important.
Nonetheless, there are forces in place which may have a greater influence going forward. One of the most important is that international oil prices are denominated in dollars. When the dollar is weak relative to other countriesâ€™ currencies, those other countries benefit from lower local prices (assuming no change in crude oil prices). But in the most recent situation of increases in both oil prices and the value of the dollar, oil-import dependent countries have been doubly impacted. Higher oil import bills reduce local funds available to purchase other imports, including those from the U.S. This applies, e.g., to many agricultural goods, for which export demand has stagnated. In addition, many foreign sources of agricultural products have begun to compete directly with U.S. farmers in export markets. As a consequence, the prices of many U.S. farm exports have fallen or stagnated. U.S. farmers, including those in states bordering the Pacific, are feeling the effects of low crop prices and higher production costs, particularly for fuels and lubricants and borrowed funds. Moreover, agricultural imports into the U.S. have increased. Hence, while the trade balance for farm products remains positive, the upward trend in that balance has reversed itself dramatically in just the last two years.
It is not only agricultural products that are affected by these shifts. Higher oil prices and lower local exchange rates translate into higher production costs for many goods and services in foreign economies. Profit margins and spending power both decline. Demands for imports also decline. For the U.S., if (as appears to be the case) the domestic economy also slows, the combined domestic and export demands for many goods and services will be adversely affected. Suppliers to the impacted industries are affected, as are their suppliers and employees. This cause-effect chain clearly affects a wide swath of industries.
More Humble Pie?
The purposes of this article were:
1) To implicitly seek absolution for previous forecasting sins; and
2) To broadly compare the oil and oil products environment today to those of the past 30 years.
The U.S. economy has successfully weathered previous sharp and persistent spikes in oil prices, and there is every reason to believe it will do so again. After such spikes, oil prices have retraced themselves, consumption has increased, imports have increased, and refinery utilization has increased. These and other factors lay the groundwork for the next round of price hikes, and this cycle continues for some time. This author is not vain enough to try to guess what OPEC and other foreign oil producers will do next week, month, or year. However, he does feel that trough of $8.59 per barrel for crude oil in December 1998 will not be seen again. Energy prices have pushed to a new level or plateau, and while fluctuations are unavoidable, the floor is much higher than it was as few as two years ago.
About the Author:
Duane Paul is a Charter Member of The Business Forum. He has 28 years of experience in financial analysis, agricultural economics, industry and resource analysis, benefit-cost analysis, land-use planning, and environmental analysis.
Duane joined NEA in 1991, and since that time he has directed or participated in more than 50 major studies for that organization. These varied projects have included critical issues of resource use and efficiency, environmental impacts, benefits and costs, economic and social impacts of resource shortages, and policy analysis. He also has directed studies to analyze the economic impacts of legislation at the federal and state levels.
Duane has directed or contributed to many benefit-cost studies in the Pacific States of America. He has, for example, helped to assess the regional economic impacts and benefits and costs of rules and regulations implementing legislation applying to federal water projects. He has also completed benefit-cost analyses of proposed flood control projects and of proposed irrigation systems on several Indian Reservations. His background in commercial banking complements his experience and education in economics. When Duane first became involved with The Business Forum in the mid-1980's he was employed as the Chief Economist, Southern California Region, with the Bank of America.
Previous articles from Duane Paul
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