Oblivious to Oil

August 20, 2004 • Commentary

Can the major industrial economies survive $45 oil? If so, it would be a first. Every time oil topped $35 in the past — in 1980–82, 1990 and late 2000 — industrial production soon began to fall in the largest industrial economies, including the United States.

A recent Wall Street Journal feature noted: “Factories worldwide cut production in June.… In the U.S., the drop was 0.3 percent, in Japan 1.3 percent, in the U.K. 0.3 percent, and in Germany 1.9 percent.… Industrial output fell 3.4 percent in Singapore, 2 percent in South Korea and 2.5 percent in Taiwan.… If the June decline in output marks the beginning of a slowdown, high oil prices will be the most likely culprit.… Higher energy costs are pressuring profit margins, and could limit potentially unprofitable output.”

The big risk is not from higher national gasoline prices but from lower international industrial output. Most petroleum is used to produce and transport industrial products. Less than a third is used by passenger vehicles, even in the U.S. If the global industrial slump continues, world demand for oil would fall and thus also its price. But that solution is worse than the problem.

The U.S. economy has been relatively strong, better able handle this oil shock than others. Between the first quarters of 2003 and 2004, economic growth was just 1.3 percent in the euro area, 4.8 percent for the United States. The six‐​month trend of the Organization of Economic Cooperation and Development’s (OECD) leading indicators for the seven largest economies (the Group of 7) was up 8 percent in January but only 3.6 percent in June. Italy and the United Kingdom were below that average and the United States a bit higher.

Since the oil price is a ratio of barrels to dollars, some blame much higher oil prices on a slightly lower dollar. That can’t explain much. Over the past year, the dollar slipped only 6 percent to 8 percent against the euro and yen.

Others blame the big spike in oil prices on a small increase in China’s oil imports. But China still accounts for less than 8 percent of the world oil market. China had fewer than 15 million cars, trucks and buses in 2001, compared with 207 million in the United States. A seemingly large percentage increase in Chinese vehicles doesn’t amount to much.

That mainly leaves actual and threatened supply shocks, aided and abetted by speculative betting on such shocks. Most recently, this included terrorist attacks on Iraq pipelines, Russian seizure of Yukos’ oil facilities, and a potentially troublesome political referendum in Venezuela. Such news can cause unsettling oil‐​price spikes that may not persist, but nonetheless do real damage to business and investors. And that is why U.S. taxpayers have spent $21 billion since 1977 to build and fill the Strategic Petroleum Reserve (SPR).

The Energy Department Web site notes that laws governing the SPR make a critical distinction between a “full drawdown” and a “limited drawdown.” A full drawdown means selling the entire reserve, now 666 million barrels. But members of Congress who propose utilizing the SPR contemplate a limited drawdown, normally less than 30 million barrels. That would amount to only 4½ percent of the SPR, so hyperbole about jeopardizing national security is unwarranted.

SPR sales smaller than 30 million barrels slashed the price of oil from $40 to $20 in January 1991 and from $37 to $28 in the last four months of 2000. Neither SPR sale was politically motivated, and both were tardy. The drawdown of 2000 was less effective because it was an exchange — oil traders knew SPR oil sales would soon be followed by repurchases.

The USS Cole also was attacked just as the drawdown period was ending. And sales on any given day were artificially constrained and too obvious to speculators.

The SPR can unload as much as 4.3 million barrels on any day the market is particularly unruly. That far exceeds the exports of Iraq and Yukos combined and is threefold normal U.S. imports from Saudi Arabia. Just leaving the possibility of a sizable SPR sale dangling would make it far riskier to speculate in futures and options markets on the overly comfortable bet big oil price moves are likelier to be up than down.

Energy Secretary Spencer Abraham recently said Congress should have labeled it “the National Security Petroleum Reserve.” That was his opinion, not the purpose of the law. The law permits even a full drawdown if “there is a significant reduction in supply which… [results in a] severe increase in the price of petroleum products… likely to cause a major adverse impact on the national economy.” Even in this extreme case — totally emptying the reserve — Congress clearly intended the SPR to be used in “significant” supply disturbances, defined as those causing a “severe” increase in oil prices.

Mr. Abraham uses the legislative language about “significant” and “severe,” but never in the accurate context of “a severe increase in the price.” In a July 7 interview in The Washington Times, he said: “We are absolutely prepared and capable of utilizing the Strategic Petroleum Reserve if these threats [such as those that have since become evident in Iraq, Russia and Venezuela] take place.”

In a recent issue of The Times, however, he appeared unprepared and incapable of utilizing the SPR even after these threats took place. “The reason we have a Strategic Petroleum Reserve,” he claimed, “is to protect us in the event that somebody… disrupts oil production significantly.” “Those reserves,” he added, “are not to manipulate prices.”

But what does “significantly” mean? And how could anyone tell whether a disruption is significant without looking at prices?

Did disruptions in Iraq and Russia qualify as “significant”? The oil market and stock market said yes. Mr. Abraham said no: “We clearly will use our oil reserves if there is a severe disruption,” he said in a CNBC television interview. “That hasn’t happened.”

“Significant” used to be adequate, but now it must be “severe.” When does “significant” graduate to “severe?” In reality, there is no way to determine whether a supply disruption is “significant” or “severe” except by what happens to the price.

The cost of crude oil to U.S. refiners averaged $20.80 from 1977 to 2003, yet Energy Department experts managed to spend $27.14 a barrel for oil reserves. U.S. taxpayers sank $21 billion into the SPR and are still paying too much to fill it even higher, so we all have a right to ask why this overpriced reserve is not used for the purpose it was created.

President Bush gets energy policy advice and economic policy advice from separate sources. But oil prices and the economy cannot be separated. The unmentioned elephant in the parlor is that oil prices higher than $35, much less $45, have always been followed by industrial cutbacks at home and abroad.

The United States is in a uniquely good position to do something useful to minimize this mammoth international economic danger, partly thanks to President Bush’s past efforts to refill the SPR. For the president to do the right thing now will require ignoring predictable political criticism of the sort wrongly aimed at President Clinton in 2000. It will also require ignoring treacherous advice from national and international energy bureaucrats.

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