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10/22/2004

Greenspan on Oil

It continues to be all about energy these days. Following are
the comments of Federal Reserve Chairman Alan Greenspan in a
speech in Washington, D.C., on October 15, 2004. The chairman
has been way too sanguine on the topic of oil’s impact on the
global economy, in my book, though he adopts a more cautious
tone here. And of course his is an important voice and an opinion
well worth listening to, regardless of whether you agree with him
or not.

---

Owing to the current turmoil in oil markets, a number of analysts
have raised the specter of the world soon running out of oil. This
concern emerges periodically in large measure because of the
inherent uncertainty of estimates of worldwide reserves. Such
episodes of heightened anxiety about pending depletion date
back a century and more. But, unlike past concerns, the current
situation reflects an increasing fear that existing reserves and
productive crude oil capacity have become subject to potential
geopolitical adversity. These anxieties patently are not frivolous
given the stark realities evident in many areas of the world.

While there are concerns of seeming inadequate levels of
investment to meet expected rising world demand for oil over
coming decades, technology, given a more supportive
environment, is likely to ensure the needed supplies, at least for a
very long while.

Notwithstanding the recent paucity of discoveries of new major
oil fields, innovation has proved adequate to meet ever-rising
demands for oil. Increasingly sophisticated techniques have
facilitated far deeper drilling of promising fields, especially
offshore, and have significantly increased the average proportion
of oil reserves eventually brought to the surface. During the past
decade, despite more than 250 billion barrels of oil extracted
worldwide, net proved reserves rose in excess of 100 billion
barrels. That is, gross additions to reserves have significantly
exceeded the extraction of oil the reserves replaced. Indeed, in
fields where, two decades ago, roughly one-third of the oil in
place ultimately could be extracted, almost half appears to be
recoverable today. I exclude from these calculations the reported
vast reserves of so-called unconventional oils such as Canadian
tar sands and Venezuelan heavy oil.

[Editor note: The Canadian tar sands have huge potential.]

Gains in proved reserves have been concentrated among OPEC
members, though proved reserves in the United States, for the
most part offshore, apparently have risen slightly during the past
five years. The uptrend in world proved reserves is likely to
continue at least for awhile. Oil service firms still report
significant involvement in reservoir extension and enhancement.
Nonetheless, growing uncertainties about the long-term security
of world oil production, especially in the Middle East, have been
pressing oil prices sharply higher.

These heightened worries about the reliability of supply have led
to a pronounced increase in the demand to hold larger
precautionary inventories of oil. In addition to the ongoing
endeavors of the oil industry to build inventories, demand from
investors who have accumulated large net long positions in
distant oil futures and options is expanding once again. Such
speculative positions are claims against future oil holdings of oil
firms. Currently, strained capacity has limited the ability of oil
producers to quickly satisfy this markedly increased demand for
inventory.

Adding to the difficulties is the rising consumption of oil,
especially in China and India, both of which are expanding
economically in ways that are relatively energy intensive. Even
the recent notable pickup in OPEC output, by exhausting most of
its remaining excess capacity, has only modestly satisfied overall
demand. Output from producers outside OPEC has also
increased materially, but investment in new producing wells has
lagged, limiting growth of production in the near term.

Crude oil prices are also being distorted by shortages of capacity
to upgrade the higher sulphur content and heavier grades of
crude oil. Over the years, increasing demand for the
environmentally desirable lighter grades of oil products has
pressed refiners to upgrade the heavier crude oils, which
compose more than two-thirds of total world output. But refiners
have been only partly successful in that effort, judging from the
recent extraordinarily large increase in price spreads between the
lighter and heavier crudes. For example, the spread between the
price of West Texas intermediate (WTI), a light, low-sulphur
crude, and Dubai, a benchmark heavier grade, has risen about
$10 per barrel since late August, to an exceptionally high $17 a
barrel. While spot prices for WTI soared in recent weeks to meet
the rising demand for light products, prices of heavier crudes
lagged.

This temporary partial fragmentation of the crude oil market has
clearly pushed gasoline prices higher than would have been the
case were all crudes available to supply the demand for lighter
grades of oil products. Moreover, gasoline prices are no longer
buffered against increasing crude oil costs as they were during
the summer surge in crude oil prices. Earlier refinery capacity
shortages had augmented gasoline refinery-marketing margins by
20 to 30 cents per gallon. But those elevated margins were
quickly eroded by competition, thus allowing gasoline prices to
actually fall during the summer months even as crude oil prices
remained firm. That cushion no longer exists. Refinery-
marketing margins are back to normal and, hence, future gasoline
and home heating oil prices will likely mirror changes in costs of
light crude oil.

With increasing investment in upgrading capacity at refineries,
the short-term refinery problem will be resolved. More
worrisome are the longer-term uncertainties that in recent years
have been boosting prices in distant futures markets for oil.

Between 1990 and 2000, although spot crude oil prices ranged
between $11 and $40 per barrel for WTI crude, distant futures
exhibited little variation around $20 per barrel. The presumption
was that temporary increases in demand or shortfalls of supply
would lead producers, with sufficient time to seek, discover,
drill, and lift oil, or expand reservoir recovery from existing
fields, to raise output by enough to eventually cause prices to fall
back to the presumed long-term marginal cost of extracting oil.
Even an increasingly inhospitable and costly exploratory
environment – an environment that reflects more than a century
of draining the more immediately accessible sources of crude oil
– did not seem to weigh significantly on distant price prospects.

Such long-term price tranquility has faded dramatically over the
past four years. Prices for delivery in 2010 of light, low-sulphur
crude rose to more than $35 per barrel when spot prices touched
near $49 per barrel in late August. Rising geopolitical concerns
about insecure reserves and the lack of investment to exploit
them appear to be the key sources of upward pressure on distant
future prices. However, the most recent runup in spot prices to
nearly $55 per barrel, attributed largely to the destructive effects
of Hurricane Ivan, left the price for delivery in 2010 barely
above its August high. This suggests that part of the recent rise
in spot prices is expected to wash out over the longer run.

Should future balances between supply and demand remain
precarious, incentives for oil consumers in developed countries
to decrease the oil intensity of their economies will doubtless
continue. Presumably, similar developments will emerge in the
large oil-consuming developing economies.

Elevated long-term oil futures prices, if sustained at current
levels or higher, would no doubt alter the extent of, and manner
in which, the world consumes oil. Much of the capital
infrastructure of the United States and elsewhere was built in
anticipation of lower real oil prices than currently prevail or are
anticipated for the future. Unless oil prices fall back, some of the
more oil-intensive parts of our capital stock would lose part of
their competitive edge and presumably be displaced, as was the
case following the price increases of the late 1970s. Those prices
reduced the subsequent oil intensity of the U.S. economy by
almost half. Much of the oil displacement occurred by 1985,
within a few years of the peak in the real price of oil. Progress in
reducing oil intensity has continued since then, but at a lessened
pace.

***

The extraordinary uncertainties about oil prices of late are
reminiscent of the early years of oil development. Over the past
few decades, crude oil prices have been determined largely by
international market participants, especially OPEC. But that was
not always the case.

In the early twentieth century, pricing power was firmly in the
hands of Americans, predominately John D. Rockefeller and
Standard Oil. Reportedly appalled by the volatility of crude oil
prices in the early years of the petroleum industry, Rockefeller
endeavored with some success to control those prices. After the
breakup of Standard Oil in 1911, pricing power remained with
the United States – first with the U.S. oil companies and later
with the Texas Railroad Commission, which raised allowable
output to suppress price spikes and cut output to prevent sharp
price declines. Indeed, as late as 1952, U.S. crude oil production
(44 percent of which was in Texas) still accounted for more than
half of the world total. However, that historical role came to an
end in 1971, when excess crude oil capacity in the United States
was finally absorbed by rising demand.

At that point, the marginal pricing of oil, which for so long had
been resident on the Gulf coast of Texas, moved to the Persian
Gulf. To capitalize on their newly acquired pricing power, many
producing nations in the Middle East nationalized their oil
companies. But the full magnitude of their pricing power
became evident only in the aftermath of the oil embargo of 1973.
During that period, posted crude oil prices at Ras Tanura, Saudi
Arabia, rose to more than $11 per barrel, significantly above the
$1.80 per barrel that had been unchanged from 1961 to 1970. A
further surge in oil prices accompanied the Iranian Revolution in
1979.

The higher prices of the 1970s brought to an abrupt end the
extraordinary period of growth in U.S. oil consumption and the
increased intensity of its use that was so evident in the decades
immediately following World War II. Between 1945 and 1973,
consumption of petroleum products rose at a startling 4
percent average annual rate, well in excess of growth of real
gross domestic product. However, between 1973 and 2003, oil
consumption grew, on average, only percent per year, far short
of the rise in real GDP.

Although OPEC production quotas have been a significant factor
in price determination for a third of a century, the story since
1973 has been as much about the power of markets as it has been
about power over markets. The signals provided by market
prices have eventually resolved even the most seemingly
insurmountable difficulties of inadequate domestic supply in the
United States. The gap projected between supply and demand in
the immediate post-1973 period was feared by many to be so
large that rationing would be the only practical solution.

But the resolution did not occur quite that way. To be sure,
mandated fuel-efficiency standards for cars and light trucks
induced slower growth of gasoline demand. Some observers
argue, however, that, even without government-enforced
standards, market forces would have produced increased fuel
efficiency. Indeed, the number of small, fuel-efficient Japanese
cars that were imported into the United States markets rose
throughout the 1970s as the price of oil moved higher.

Moreover, at that time, prices were expected to go still higher.
Our Department of Energy, for example, had baseline projections
showing prices reaching $60 per barrel – the equivalent of about
twice that in today’s prices.

The failure of oil prices to rise as projected in the late 1970s is a
testament to the power of markets and the technologies they
foster. Today, despite its recent surge, the average price of crude
oil in real terms is still only three-fifths of the price peak of
February 1981. Moreover, the impact of the current surge in oil
prices, though noticeable, is likely to prove less consequential to
economic growth and inflation than in the 1970s. So far this
year, the rise in the value of imported oil – essentially a tax on
U.S. residents – has amounted to about percent of GDP. The
effects were far larger in the crises of the 1970s. But, obviously,
the risk of more serious negative consequences would intensify if
oil prices were to move materially higher.

***

In summary, much of world oil supplies reside in potentially
volatile areas of the world. Improving technology is reducing the
energy intensity of industrial countries, and presumably recent
oil price increases will accelerate the pace of displacement of
energy-intensive production facilities. If history is any guide, oil
will eventually be overtaken by less-costly alternatives well
before conventional oil reserves run out. Indeed, oil displaced
coal despite still vast untapped reserves of coal, and coal
displaced wood without denuding our forest lands.

Innovation is already altering the power source of motor
vehicles, and much research is directed at reducing gasoline
requirements. At present, gasoline consumption in the United
States alone accounts for 11 percent of world oil production.
Moreover, new technologies to preserve existing conventional oil
reserves and to stabilize oil prices will emerge in the years ahead.
We will begin the transition to the next major sources of energy
perhaps before mid-century as production from conventional oil
reservoirs, according to central tendency scenarios of the Energy
Information Administration, is projected to peak. In fact, the
development and application of new sources of energy,
especially nonconventional oil, is already in train. Nonetheless,
it will take time. We, and the rest of the world, doubtless will
have to live with the uncertainties of the oil markets for some
time to come.

Source: Federalreserve.gov

Wall Street History will return Oct. 29.

Brian Trumbore



AddThis Feed Button

 

-10/22/2004-      
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Wall Street History

10/22/2004

Greenspan on Oil

It continues to be all about energy these days. Following are
the comments of Federal Reserve Chairman Alan Greenspan in a
speech in Washington, D.C., on October 15, 2004. The chairman
has been way too sanguine on the topic of oil’s impact on the
global economy, in my book, though he adopts a more cautious
tone here. And of course his is an important voice and an opinion
well worth listening to, regardless of whether you agree with him
or not.

---

Owing to the current turmoil in oil markets, a number of analysts
have raised the specter of the world soon running out of oil. This
concern emerges periodically in large measure because of the
inherent uncertainty of estimates of worldwide reserves. Such
episodes of heightened anxiety about pending depletion date
back a century and more. But, unlike past concerns, the current
situation reflects an increasing fear that existing reserves and
productive crude oil capacity have become subject to potential
geopolitical adversity. These anxieties patently are not frivolous
given the stark realities evident in many areas of the world.

While there are concerns of seeming inadequate levels of
investment to meet expected rising world demand for oil over
coming decades, technology, given a more supportive
environment, is likely to ensure the needed supplies, at least for a
very long while.

Notwithstanding the recent paucity of discoveries of new major
oil fields, innovation has proved adequate to meet ever-rising
demands for oil. Increasingly sophisticated techniques have
facilitated far deeper drilling of promising fields, especially
offshore, and have significantly increased the average proportion
of oil reserves eventually brought to the surface. During the past
decade, despite more than 250 billion barrels of oil extracted
worldwide, net proved reserves rose in excess of 100 billion
barrels. That is, gross additions to reserves have significantly
exceeded the extraction of oil the reserves replaced. Indeed, in
fields where, two decades ago, roughly one-third of the oil in
place ultimately could be extracted, almost half appears to be
recoverable today. I exclude from these calculations the reported
vast reserves of so-called unconventional oils such as Canadian
tar sands and Venezuelan heavy oil.

[Editor note: The Canadian tar sands have huge potential.]

Gains in proved reserves have been concentrated among OPEC
members, though proved reserves in the United States, for the
most part offshore, apparently have risen slightly during the past
five years. The uptrend in world proved reserves is likely to
continue at least for awhile. Oil service firms still report
significant involvement in reservoir extension and enhancement.
Nonetheless, growing uncertainties about the long-term security
of world oil production, especially in the Middle East, have been
pressing oil prices sharply higher.

These heightened worries about the reliability of supply have led
to a pronounced increase in the demand to hold larger
precautionary inventories of oil. In addition to the ongoing
endeavors of the oil industry to build inventories, demand from
investors who have accumulated large net long positions in
distant oil futures and options is expanding once again. Such
speculative positions are claims against future oil holdings of oil
firms. Currently, strained capacity has limited the ability of oil
producers to quickly satisfy this markedly increased demand for
inventory.

Adding to the difficulties is the rising consumption of oil,
especially in China and India, both of which are expanding
economically in ways that are relatively energy intensive. Even
the recent notable pickup in OPEC output, by exhausting most of
its remaining excess capacity, has only modestly satisfied overall
demand. Output from producers outside OPEC has also
increased materially, but investment in new producing wells has
lagged, limiting growth of production in the near term.

Crude oil prices are also being distorted by shortages of capacity
to upgrade the higher sulphur content and heavier grades of
crude oil. Over the years, increasing demand for the
environmentally desirable lighter grades of oil products has
pressed refiners to upgrade the heavier crude oils, which
compose more than two-thirds of total world output. But refiners
have been only partly successful in that effort, judging from the
recent extraordinarily large increase in price spreads between the
lighter and heavier crudes. For example, the spread between the
price of West Texas intermediate (WTI), a light, low-sulphur
crude, and Dubai, a benchmark heavier grade, has risen about
$10 per barrel since late August, to an exceptionally high $17 a
barrel. While spot prices for WTI soared in recent weeks to meet
the rising demand for light products, prices of heavier crudes
lagged.

This temporary partial fragmentation of the crude oil market has
clearly pushed gasoline prices higher than would have been the
case were all crudes available to supply the demand for lighter
grades of oil products. Moreover, gasoline prices are no longer
buffered against increasing crude oil costs as they were during
the summer surge in crude oil prices. Earlier refinery capacity
shortages had augmented gasoline refinery-marketing margins by
20 to 30 cents per gallon. But those elevated margins were
quickly eroded by competition, thus allowing gasoline prices to
actually fall during the summer months even as crude oil prices
remained firm. That cushion no longer exists. Refinery-
marketing margins are back to normal and, hence, future gasoline
and home heating oil prices will likely mirror changes in costs of
light crude oil.

With increasing investment in upgrading capacity at refineries,
the short-term refinery problem will be resolved. More
worrisome are the longer-term uncertainties that in recent years
have been boosting prices in distant futures markets for oil.

Between 1990 and 2000, although spot crude oil prices ranged
between $11 and $40 per barrel for WTI crude, distant futures
exhibited little variation around $20 per barrel. The presumption
was that temporary increases in demand or shortfalls of supply
would lead producers, with sufficient time to seek, discover,
drill, and lift oil, or expand reservoir recovery from existing
fields, to raise output by enough to eventually cause prices to fall
back to the presumed long-term marginal cost of extracting oil.
Even an increasingly inhospitable and costly exploratory
environment – an environment that reflects more than a century
of draining the more immediately accessible sources of crude oil
– did not seem to weigh significantly on distant price prospects.

Such long-term price tranquility has faded dramatically over the
past four years. Prices for delivery in 2010 of light, low-sulphur
crude rose to more than $35 per barrel when spot prices touched
near $49 per barrel in late August. Rising geopolitical concerns
about insecure reserves and the lack of investment to exploit
them appear to be the key sources of upward pressure on distant
future prices. However, the most recent runup in spot prices to
nearly $55 per barrel, attributed largely to the destructive effects
of Hurricane Ivan, left the price for delivery in 2010 barely
above its August high. This suggests that part of the recent rise
in spot prices is expected to wash out over the longer run.

Should future balances between supply and demand remain
precarious, incentives for oil consumers in developed countries
to decrease the oil intensity of their economies will doubtless
continue. Presumably, similar developments will emerge in the
large oil-consuming developing economies.

Elevated long-term oil futures prices, if sustained at current
levels or higher, would no doubt alter the extent of, and manner
in which, the world consumes oil. Much of the capital
infrastructure of the United States and elsewhere was built in
anticipation of lower real oil prices than currently prevail or are
anticipated for the future. Unless oil prices fall back, some of the
more oil-intensive parts of our capital stock would lose part of
their competitive edge and presumably be displaced, as was the
case following the price increases of the late 1970s. Those prices
reduced the subsequent oil intensity of the U.S. economy by
almost half. Much of the oil displacement occurred by 1985,
within a few years of the peak in the real price of oil. Progress in
reducing oil intensity has continued since then, but at a lessened
pace.

***

The extraordinary uncertainties about oil prices of late are
reminiscent of the early years of oil development. Over the past
few decades, crude oil prices have been determined largely by
international market participants, especially OPEC. But that was
not always the case.

In the early twentieth century, pricing power was firmly in the
hands of Americans, predominately John D. Rockefeller and
Standard Oil. Reportedly appalled by the volatility of crude oil
prices in the early years of the petroleum industry, Rockefeller
endeavored with some success to control those prices. After the
breakup of Standard Oil in 1911, pricing power remained with
the United States – first with the U.S. oil companies and later
with the Texas Railroad Commission, which raised allowable
output to suppress price spikes and cut output to prevent sharp
price declines. Indeed, as late as 1952, U.S. crude oil production
(44 percent of which was in Texas) still accounted for more than
half of the world total. However, that historical role came to an
end in 1971, when excess crude oil capacity in the United States
was finally absorbed by rising demand.

At that point, the marginal pricing of oil, which for so long had
been resident on the Gulf coast of Texas, moved to the Persian
Gulf. To capitalize on their newly acquired pricing power, many
producing nations in the Middle East nationalized their oil
companies. But the full magnitude of their pricing power
became evident only in the aftermath of the oil embargo of 1973.
During that period, posted crude oil prices at Ras Tanura, Saudi
Arabia, rose to more than $11 per barrel, significantly above the
$1.80 per barrel that had been unchanged from 1961 to 1970. A
further surge in oil prices accompanied the Iranian Revolution in
1979.

The higher prices of the 1970s brought to an abrupt end the
extraordinary period of growth in U.S. oil consumption and the
increased intensity of its use that was so evident in the decades
immediately following World War II. Between 1945 and 1973,
consumption of petroleum products rose at a startling 4
percent average annual rate, well in excess of growth of real
gross domestic product. However, between 1973 and 2003, oil
consumption grew, on average, only percent per year, far short
of the rise in real GDP.

Although OPEC production quotas have been a significant factor
in price determination for a third of a century, the story since
1973 has been as much about the power of markets as it has been
about power over markets. The signals provided by market
prices have eventually resolved even the most seemingly
insurmountable difficulties of inadequate domestic supply in the
United States. The gap projected between supply and demand in
the immediate post-1973 period was feared by many to be so
large that rationing would be the only practical solution.

But the resolution did not occur quite that way. To be sure,
mandated fuel-efficiency standards for cars and light trucks
induced slower growth of gasoline demand. Some observers
argue, however, that, even without government-enforced
standards, market forces would have produced increased fuel
efficiency. Indeed, the number of small, fuel-efficient Japanese
cars that were imported into the United States markets rose
throughout the 1970s as the price of oil moved higher.

Moreover, at that time, prices were expected to go still higher.
Our Department of Energy, for example, had baseline projections
showing prices reaching $60 per barrel – the equivalent of about
twice that in today’s prices.

The failure of oil prices to rise as projected in the late 1970s is a
testament to the power of markets and the technologies they
foster. Today, despite its recent surge, the average price of crude
oil in real terms is still only three-fifths of the price peak of
February 1981. Moreover, the impact of the current surge in oil
prices, though noticeable, is likely to prove less consequential to
economic growth and inflation than in the 1970s. So far this
year, the rise in the value of imported oil – essentially a tax on
U.S. residents – has amounted to about percent of GDP. The
effects were far larger in the crises of the 1970s. But, obviously,
the risk of more serious negative consequences would intensify if
oil prices were to move materially higher.

***

In summary, much of world oil supplies reside in potentially
volatile areas of the world. Improving technology is reducing the
energy intensity of industrial countries, and presumably recent
oil price increases will accelerate the pace of displacement of
energy-intensive production facilities. If history is any guide, oil
will eventually be overtaken by less-costly alternatives well
before conventional oil reserves run out. Indeed, oil displaced
coal despite still vast untapped reserves of coal, and coal
displaced wood without denuding our forest lands.

Innovation is already altering the power source of motor
vehicles, and much research is directed at reducing gasoline
requirements. At present, gasoline consumption in the United
States alone accounts for 11 percent of world oil production.
Moreover, new technologies to preserve existing conventional oil
reserves and to stabilize oil prices will emerge in the years ahead.
We will begin the transition to the next major sources of energy
perhaps before mid-century as production from conventional oil
reservoirs, according to central tendency scenarios of the Energy
Information Administration, is projected to peak. In fact, the
development and application of new sources of energy,
especially nonconventional oil, is already in train. Nonetheless,
it will take time. We, and the rest of the world, doubtless will
have to live with the uncertainties of the oil markets for some
time to come.

Source: Federalreserve.gov

Wall Street History will return Oct. 29.

Brian Trumbore