is difficult to judge. Opportunities to expand oil production elsewhere are
limited to a few regions, notably the former Soviet Union. But even there,
investment has slowed in the wake of the renewed consolidation of Russia's
oil industry under the control of the Kremlin.
Besides feared shortfalls in crude-oil production capacity, the adequacy
of world refining capacity has become worrisome as well. World refinery
capacity increased at an annual rate of only 0.9 percent between 1986 and
2006, in line with crude-oil capacity's inadequate growth of 0.8 percent.
Indeed, over the past decade, crude-oil production and refinery inputs have
increased faster than refining capacity. World refinery output has recently
risen almost to the limit of effective refining capacity. Should refining capacity
fall below crude-oil production capacity, lack of refining capacity
could become the binding constraint on growth in oil use—with minor exceptions,
petroleum must be refined before it can be consumed. This may
already be happening for certain grades of oil, given the growing mismatch
between the heavier and more sulfurous (or "sour") composition of world
crude-oil production and the rising world demand for lighter, "sweeter" petroleum
products. (Heavier oil now accounts for more than two-thirds of
world output.) We cannot change the quality of the oil that comes out of
the ground; there is thus a special need to add adequate coking and desulfurization
refinery capacity to convert the average gravity and sulfur content
of much of the world's indigenous crude oil to the lighter and sweeter
oil needed for product markets, particularly transportation fuels that must
meet ever more stringent environmental requirements.
Yet the expansion and modernization of refineries are lagging. For example,
no refinery has been built from scratch in the United States since
1976. While several are now on the drawing board, a major problem is the
uncertainty of potential future environmental standards—because a typical
new refinery represents a thirty-year financial commitment, such uncertainty
renders refinery investments particularly risky. To encourage adequate
refining capacity in the United States, we will probably need to either
grandfather existing environmental regulations for new refinery capacity
additions or lock in a schedule of future requirements. That would eliminate
a large unknown and help move construction forward.
The consequence of lagging refinery modernization has been reflected
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in a significant price spread between the higher-priced light sweet crudes
such as Brent; which are easier to refine, and the heavier crudes such as
Maya. Moreover, refining-capacity pressures have opened up refining-
market profit margins, which have added to the prices of gasoline and other
refined products.
H
H
ow did we arrive at a state of affairs in which the balance of supply
and demand is so fragile that weather, not to mention individual acts
of sabotage or local insurrection, could have a significant impact on world
energy supplies and hence on world economic expansion?
During the oil industry's first great wave of growth, in the closing years
of the nineteenth century, producers judged that price stability was going
to be essential to the continued expansion of the market. The necessary
pricing power was in the hands of the Americans, especially John D. Rock
efeller. He achieved some success in stabilizing prices around the turn of
the century by gaining control of nine-tenths of U.S. refining capacity. Even
after the U.S. Supreme Court broke up Rockefeller's Standard Oil trust in
1911, pricing power remained with the United States—first with the U.S.
oil companies and later with the Texas Railroad Commission. For decades,
the commissioners would raise limits on output to suppress price spikes
and cut permissible output to prevent sharp price declines.*
Indeed, as late as 1952, crude-oil production in the United States (44
percent of it in Texas) still accounted for more than half of the world total.
In 1951, excess Texas crude was supplied to the market to contain the impact
on oil prices of the aborted nationalization by Mohammed Mossadeq
of Iranian oil. Excess American oil was again released to the market to
counter the price pressures induced by the Suez crisis of 1956 and the Six-
Day War of 1967.
American oil's historical role, however, ended in 1971, when rising
*It is one of those peculiarities of history that a railroad commission would turn out to be the
arbiter of the balance of world oil supply and demand. Although originally empowered to regulate
Texas railroads, it later was used as a vehicle to prorate crude-oil liftings.
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THE LONG-TERM E N E RG Y S O U E E Z E
world demand finally absorbed the excess crude-oil capacity of the United
States. At that point, U.S. energy independence came to an end. The locus
of pricing power shifted abruptly at first to a few large Middle Eastern
producers and ultimately to globalized market forces broader than they or
anyone, can contain.
To capitalize on their newly acquired pricing power, many producing
nations in the early 1970s, especially in the Middle East, nationalized their
oil companies. The magnitude of that power, however, was not fully evident
until the oil embargo of 1973. During that period, posted crude-oil
prices at Ras Tanura, Saudi Arabia, rose to more than $11 per barrel, far
above the $1.80 that had been charged from 1961 to 1970. The further
surge in oil prices that accompanied the Iranian Revolution in 1979 eventually
pushed prices to $39 per barrel by February 1981—$77 per barrel in
2006 prices. The price peak of 2006 matched the previous record of 1981,
after adjusting for inflation.
The higher prices of the 1970s abruptly ended an extraordinary period
of growth of U.S. and world consumption of petroleum, which until then
far exceeded the growth of GDR That increased "intensity" of oil use was a
hallmark of the decades following World War II. In retrospect, it can be
seen that the surge in oil product prices between 1972 and 1981 nearly
halted the growth of world consumption. Indeed, by 1986 a global glut
drove crude prices down to $11 a barrel. Oil consumption, given time, has
turned out to be far more price sensitive than almost anyone had imagined.
Following the price escalation of the 1970s, world oil consumption per
real-dollar equivalent of global GDP declined by more than one-third. In
the United States, between 1945 and 1973, consumption of petroleum
products had risen at a startling average annual rate of 4.5 percent, well in
excess of the growth of our real GDR In contrast, between 1973 and 2006,
U.S. consumption grew, on average, by only 0.5 percent per year, far short
of the rise in real GDR In consequence, the ratio of U.S. oil consumption to
GDP fell by half.
Much of the decline in the ratio of oil consumption to GDP resulted
from growth in the proportion of U.S. GDP composed of service, high-
tech, and other less oil-intensive industries. The remainder of the decline
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THE AGE OF TURBULENCE
has been due to improved energy conservation: greater home insulation,
better gasoline mileage, and streamlined production processes. Much of
that displacement was achieved by 1985. Progress in reducing oil intensity
has continued since then, but more slowly. For example, after the initial
surge in the fuel efficiencies of our light motor vehicles during the 1980s,
reflecting the earlier run-up in oil prices, improvements slowed to a trickle.
The more modest rate of decline in oil intensity of the U.S. economy
after 1985 should not be surprising, given the generally lower level of real
oil prices that prevailed through much of that period. Longer-term U.S. demand
elasticities (that is, demand's sensitivity to price change) have proved
noticeably higher over the past three decades than those evident through
the 1960s.
The ratio of intensity of use since 1973 also fell by half in the euro area,
and by even more than half in Britain and Japan, where intensity is currently
below that of the United States. By comparison, oil use in the developing
world is too often wasteful by comparison; there the ratios of oil
consumption to GDP average well above those of the developed countries.
Intensity has not measurably decreased in recent years with the exception
of some declines in Mexico and Brazil and possibly China.
Although the production quotas of OPEC have been a significant factor
in price determination for the past 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 Arab oil embargo that followed the Arab-Israeli
war of 1973 led many observers, me included, to fear that the gap between
supply and demand could become so large that rationing would be the only
politically acceptable solution to petroleum shortages.* Yet the resolution
of the supply/demand imbalance did not occur that way. Instead, the pressure
of high prices prompted consumers to change their behavior, and the
intensity of oil use declined. (In the United States, of course, mandated
fuel-efficiency standards for cars and light trucks induced the slower growth
of gasoline demand. I, and a number of my colleagues at the Council of
*Having observed that rapid gains in U.S. consumption before 1973 seemed insensitive to price
change, I feared the oil price rise required to bring demand down to the levels of output implied
by a long embargo would not be politically acceptable. After all, President Nixon imposed
wage and price controls in 1971 to quell anxiety about inflation.
446
THE LONG-TERM E N E RG Y S O U E E Z E
Economic Advisors, believed, however, that even without government-
enforced standards, market forces would have led to increased fuel efficiency.
Indeed, the number of small, fuel-efficient Japanese cars that were
imported into U.S. markets rose throughout the 1970s as the price of oil
moved higher.)
This effect was quite dramatic. For example, based on then-recent
trends in petroleum use, the U.S. Department of Energy projected in 1979
that world oil prices would reach nearly $60 per barrel by 1995—the
equivalent of more than $ 150 in 2006 prices. The failure of oil prices to rise
as projected is a testament to the power of markets and the new technologies
they fostered.
Since oil use is less than two-thirds as important an input into world
GDP as it was three decades ago, the effect of the oil price surge on the
world economy during the first half of 2006, though noticeable, proved
significantly less consequential to economic growth and inflation than the
surges in the 1970s. Throughout 2006, it was difficult to find serious evidence
of any erosion in world economic activity as a consequence of sharply
higher oil prices. Indeed, we have just experienced one of the strongest
global economic expansions since the end of World War II. The United
States, especially, was able to absorb the implicit tax of rising oil prices
through 2006.
Nonetheless, holders of private inventories of oil, both industry and
investors, apparently foresee little likelihood of a change in petroleum
supply/demand fundamentals sufficient to alter long-term concerns. This
does not mean that oil prices will necessarily move higher. If the market
is efficient, then all knowledge affecting the prospective future supply/
demand balance ought already to be reflected in the spot prices of crude
oil.* Many analysts saw spot prices of early 2007 embodying a large "terror
*Spot prices in principle embody the market participants' knowledge not only of the forces
setting spot prices but also of those setting futures prices. In fact, when the market participants
perceive a forthcoming very large rise in price, long-term futures prices will rise and pull up the
spot price with them. If the spot price is below longer-term futures by more than the carrying
cost of inventories, speculators can buy spot oil, sell the distant futures, store the spot oil, pay
interest on the money borrowed to hold the oil, and, at the expiration of the contract, deliver
the oil and pocket the profit. This arbitrage will go on until the spot price is brought up to the
distant future price less carrying costs of inventory.
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THE AGE OF TURBULENCE
ist" risk premium. (Middle East peace would doubtless initiate a sharp drop
in oil prices.) To move crude-oil prices would require a change, or the threat
of a change, to the prospective supply/demand balance. History tells us
that will happen—that the balance will shift often and in either direction.
Technology cannot prevent that. But it can assuage the cost and price impacts
that such tight markets foster.
The hit-or-miss exploration and development of oil and gas during the
petroleum industry's early years have given way to a more systematic approach.
Dramatic changes in technology in recent years have made existing
oil reserves stretch further while keeping the costs of oil production lower
than they otherwise would be. Seismic imaging and advanced drilling techniques
are facilitating the discovery of promising deepwater reservoirs,
especially in the Gulf of Mexico, and making possible the continued development
of mature onshore fields. Accordingly, one might expect that the
cost of developing new fields would have declined. But development-cost
reductions have been overwhelmed by shortages and higher prices of drilling
rigs, as well as escalating wages of skilled oil workers.* Technology has
not been able fully to counter those factors.
Much of the innovation in oil development outside OPEC has been directed
at overcoming increasingly inhospitable and costly exploratory environments,
the consequence of more than a century of draining the more
immediately accessible sources of crude oil. Still, consistent with declining
