OCR Document

4/1/04

REVIEW &: OUTLOOK What's Up With Oil

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No doubt about it: High oil and gasoline prices make a great Presidential campaign issue for Democrats. And, right on cue, Senators are popping up to blame the White House and ask the Bush Administration to "do something:"

New York's Charles Schumer and Barbara Boxer of California are attacking the decision to fill the Strategic Petroleum Reserve and demanding that the White House .release some oil. Just how releasing only 0.15% to 0.2% of the world's oil market will push down gasoline prices by 25 cents a gallon, the Senators don't reveal.

But current prices do raise an interesting question: What has happened over the past 10 months to ruin forecasts of oil at $22 per barrel? The short answer is plenty.

Most important, demand has skyrocketed. Not only in the U.S., where economic

growth has been gang-

busters, but also in China, which has leapt ahead of Japan to become the second largest oil market in the world. While there is some debate about whether China is consuming oil or using it to build a strategic stockpile, the result is the same strong demand. China's growth has also sparked an economic recovery and higher oil demand in the rest of Asia. Count India, too, as an increasingly oil-thirsty economy.

This roaring demand has not been met with increasing production. Blame that mostly on OPEC. The oil cartel has been smarting over the fall of the dollar against the euro. That, of course, reduces dollar-denominated oil revenues and increases the incentive to keep supplies tight. With prices at or above $28 per barrel- the upper-bound of OPEC's target range the Saudis, for example, ran a budget surplus for the first time in decades.

Inventories are also low. The U.S. has not yet recovered from the disruption in crude and refined products from Venezuela last year. And tight inventories exaggerate any changes in supply at the margin.

As the market got tighter, several events have injected uncertainty. Russian President

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Putin created some political risk by clamping down on the oil industry and arresting the former head of Russia's largest oil company, Yukos, and accusing a second company of tax fraud. There has been continued instability in Venezuela, Nigeria and Indonesia. It also hasn't helped that Royal Dutch Shell announced it was lowering, by 20%, its estimate of reserves. And there have been questions raised about the size of Saudi reserves and the possibility that Saudi production might be peaking.

Now throw in a big bunch of uncertainty

ahead of tomorrow's OPEC meeting. Although OPEC only has a 33% market share, history shows it is able to generate more than its share of speculation. Several weeks ago, OPEC announced it would cut production, then two members balked, and now OPEC is hemming and hawing. Speculators have been going nuts. And that brings us

back to the U.S. Strategic Petroleum Reserve, which was created after the Arab oil embargo in the early 1970s. The idea was to stockpile oil to cope with any future emergency shortfall in supply-not to mitigate short-term price spikes. As part of the run-up to the Iraq war, the Bush Administration decided to add to the reserves-now about 650 million barrels.

But hundreds of millions of barrels of oil is a seductive target for political manipulation, as Bill Clinton proved when he released reserves to tame gasoline prices before the 1996 election. We hope President Bush resists that temptation, because in the long term such a response would be dangerous.

If every President turned to the oil reserve when prices shoot up, companies would reduce the amount of inventory they are willing to carry and exacerbate the supply problem. In the short term, there is also no economic need to draw on the reserve. The economy is humming along and panicking would only create other dislocations. The oil reserve was not designed, nor should it be used, to relieve consumers at the pump for a few weeks.

The Price of OPEC

Crude-oil futures in dollars per barrel