World Oil Demand and the Effect on Oil Prices

CRS Report for Congress
World Oil Demand and
its Effect on Oil Prices
Updated June 9, 2005
Robert Pirog
Specialist in Energy Economics and Policy
Resources, Science, and Industry Division

Congressional Research Service ˜ The Library of Congress

World Oil Demand and the Effect on Oil Prices
Summary
The price of oil began rising in October 2003 and reached record levels in 2004
and again in 2005. As a result of these price increases, consumers’ budgets have
been under pressure, business costs have risen, and oil producers’ profits have^th
increased. The 109 Congress is considering broad energy legislation (H.R. 6), that
addresses conditions in the oil and petroleum products markets.
A long term explanatory factor for increasing oil prices could be the decline of
the world reserve base. The reserves to production ratio is the measure which
indicates the world’s ability to maintain current production, based on proved
reserves. Over the past decade there has been little change in the reserve to
production ratio, suggesting that, at least for now, long term forces are not driving up
the price of oil.
A wide variety of cyclic and short term factors have converged in such a way
that the growth of demand has been unexpectedly high causing upward pressure on
oil prices. Those factors which have been identified as contributing to the high price
of oil include the resumption of relatively rapid growth rates of gross domestic
product in many countries around the world, a declining value of the U.S. dollar,
gasoline prices, the changing structure of the oil industry, OPEC policies, and the
persistently low levels of U.S. crude oil and gasoline inventories.
Expectations concerning future market conditions are quickly embodied in oil
prices formed in futures markets like the New York Mercantile Exchange. The fear
of terrorism and war, uncertainty concerning the relationship between the Russian
government and the oil company Yukos, and other political factors are quickly
reflected in price along with real political unrest like that experienced by oil
producing Venezuela and Nigeria. Speculative buying and selling might also affect
prices as financial traders adjust their investment portfolios to reflect expected
market conditions.
Demand patterns for world oil and oil products show significant diversity by
country, region, and product groupings. As a result of this diversity it is not possible
to attach blame for the current level of price to any one nation, region, or product
segment. The view that the oil market is international in scope and tightly
interrelated is enhanced by the demand data.
As a result of the integrated nature of the world oil market it is unlikely that any
one nation acting on its own can implement policies that isolate its market from
broader price behavior. As new major oil importers, notably China, and potentially
India, expand their demand, the oil market likely will have to expand production
capacity. This promises to increase the world’s dependence on the Persian Gulf
members of the Organization of Petroleum Exporting Countries, especially Saudi
Arabia, and maintain upward pressure on price.
This report will be updated.

Contents
Background ......................................................1
Oil Prices........................................................2
Reserves and Production............................................5
Price and Markets.................................................7
Economic Growth.............................................8
Exchange Rates...............................................9
Gasoline Prices...............................................10
Industry Structure.............................................11
OPEC Policy................................................11
Inventories ..................................................12
Exceptional Events............................................14
Sectoral Demand Patterns..........................................15
Countries and Regions.........................................16
Petroleum Product Demand.....................................17
Future Projections................................................18
Conclusions .....................................................19
List of Figures
Figure 1. U.S. Spot Price of Oil, 2003-2005............................2
Figure 2. U.S. Spot Market Price for Reformulated Regular Gasoline,
New York Harbor, 2003-2005....................................4
Figure 3. U.S. Crude Oil Stocks Excluding Strategic Petroleum Reserve.....13
List of Tables
Table 1. Oil Reserve/Production Ratios, Selected Years...................6
Table 2. World Demand for Oil, 2003................................16

World Oil Demand and the Effect on Oil
Pric es
The world oil market was characterized by strong demand growth that began in
2003 and continued through 2004 and into 2005. As a result of this growth, and the
resulting high prices, consumers’ budgets were under pressure, the profits of energy
producers were up, and consuming nations again had to face the economic and
political costs of dependence on imported oil.
Appropriate policy responses to world oil market conditions may well depend
on whether the factors that pushed the market to its current level are likely to be
temporary or permanent. The lessons of past volatility in the oil market suggest that
even transitory forces and market adjustments can yield not only changing prices, but
changing patterns of consumption and production as well. Past performance also
suggests that the expectation, or actuality, of a period of high prices or reduced
availability of supply, can change economic incentives, as both consumers and
producers adjust to the new perceived conditions.
This report analyzes the factors that have driven both demand and supply in the
world oil market in the period 2003 through 2005. The report provides and analyzes
basic information to inform debate on broad energy legislation (H.R. 6).
Background
While the primary focus of this report is on conditions in the U. S. market,
analyses should be carried out in the context of the larger world market. Few actions
by consuming, or producing nations, can be properly evaluated independently of the
world market. Oil is a fungible, international commodity whose ownership and
ultimate destination is determined by market forces once it leaves the producing
country. No country can effectively isolate itself from changes elsewhere in the
market, nor is it likely that any nation can take actions that do not indirectly affect
other nations.
Oil prices are linked, like those of other commodities, to the levels of economic
activity in the industrial nations. Demand, both from consumers and industrial users,
tends to pick up when growth rates of gross domestic product increase and slow
down when those growth rates decline. As a result, oil prices tend to be volatile, at
least partly due to variations in the business cycle.
While oil markets may behave like other commodity markets much of the time,
the oil market does have unique features. First, few commodity markets have an
institution like the Organization of Petroleum Exporting Countries (OPEC). Since
its creation in 1960, OPEC has had a variable influence on the price of oil through

its member nation quota system. Second, oil has been subject to supply disruption
due to political instability as well as technical factors. Third, psychological or
expectations effects, tied to real or perceived probabilities of market disruption, may
lead to price volatility. Finally, world oil transactions are settled in U.S. dollars,
which affects the value of the dollar in world currency markets, as well as the
magnitude of international reserves held by petroleum importing and exporting
nations around the world.
Oil Prices
Spot market price data for West Texas Intermediate (WTI) at Cushing,
Oklahoma, is shown in Figure 1.¹ During the time period covered in Figure 1, the
OPEC price band for crude oil was at $22 to $28 per barrel. Accounting for quality
and location differences between the OPEC reference crude (Saudi Arabian Light)
and WTI, prices in the U.S. spot market during 2003 remained close to, or were
above, the upper end of the OPEC price band. However, prices moderated for
several months after the beginning of the Iraq War in March 2003.
Figure 1. U.S. Spot Price of Oil, 2003-2005
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^J^a^{n 200}³^M^a^{y 2003}^S^e^p²⁰⁰³^J^a^{n 2}⁰⁰⁴^M^a^{y 20}⁰⁴^S^e^p²⁰⁰⁴^J^a^{n 20}⁰⁵
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Price increases began in the late fall of 2003, and continued into 2004, reaching
a yearly peak of over $53 per barrel in October 2004. Although prices fell by $10 per
barrel by December 2004, they began to rise again in January 2005, and peaked again

¹ Spot market prices are for current delivery of physical oil, in this case, WTI, at Cushing,
Oklahoma.

at nearly $53 per barrel in April 2005.² Some insight into future spot market prices
might be gained by examining NYMEX futures market prices.³ For example, in the
five days before it terminated trading on July 20, 2004, the August 2004 contract on
WTI at Cushing, Oklahoma was trading at over $40 per barrel. As of July 23, 2004
the September and October WTI futures contracts continued to trade at over $41 per
barrel on the NYMEX.⁴ On August 10, 2004 the NYMEX futures price for crude oil
traded above $45, a first in the history of the exchange. On the same day, the spot
market price for WTI was at $44.48.⁵ These data accurately suggested that high
crude oil prices were likely to continue for the remainder of 2004. By the end of May
2005, futures prices for the August 2005 contract were trading at nearly $50 per
barrel and the September 2005 contract was trading at $50.41 per barrel. These
prices suggest that, while the crude oil price might remain volatile, reacting to current
market conditions, it is unlikely that prices will return to pre-2003 price increase
levels for the remainder of 2005.
Figure 2 shows the behavior of spot market prices for reformulated regular
gasoline at New York Harbor. The price of gasoline has shown a pattern of
movement somewhat similar to that of oil prices.

² Oil Daily, Oil Nears $45/bbl on Iraqi Supply Concerns, Vol.54, No.152, August 10, 2004,
p.1.
³ The NYMEX trades futures contracts on crude oil. Futures contracts obligate buyers and
sellers to purchase or deliver crude oil one or more months in the future. However, delivery
of crude oil rarely occurs in conjunction with futures contracts. The difference between the
contracted future price and the actual cash price when the futures contract comes due, or
expires is usually settled in cash. During the trading life of the futures contract, its value
either increases or decreases on a daily basis depending on the current, spot value of crude
oil. Futures contracts are thought to aid in price formation in that they process current
information, and embody it in future price of oil. Trading in futures contracts terminates at^rd^th
the close of the 3 business day, prior to the 25 calendar day, of the month preceding the
delivery month of the contract. For example, the August 2004 contract terminated trading
on July 20, 2004.
⁴ Energy Information Administration, Weekly Petroleum Status Report, for the week ending
July 30, 2004, Table 16, p.30.
⁵ Oil Daily, Oil Futures Take a Breather After Breaching $45/bbl Mark, Vol.54, No.153,
August 11, 2004,. p.3.

Figure 2. U.S. Spot Market Price for Reformulated Regular
Gasoline, New York Harbor, 2003-2005

Gasoline prices peaked in February and August of 2003. They then lagged oil
prices, not showing price increases in the fall of 2003. However, they did follow oil
price increases throughout the spring of 2004, also peaking in May of 2004. Gasoline
prices were volatile for the remainder of 2004. After the May peak, the price
remained approximately 12 cents per gallon lower for the next four months.
Although the price went above $1.37 per gallon in October 2004, it finished the year
at $1.07, about 24% off the May peak. Gasoline spot prices increased in 2005. By
April 2005, the price peaked at over $1.52 per gallon. On June 3, 2005 the NYMEX
future prices for gasoline in July, August, and September were above $1.50 per
gallon.⁶ As in the oil market, these futures prices suggest that there is likely to be
only modest, if any, moderation in gasoline prices for the rest of the year.
Conclusions concerning projected spot prices based on the trading value of
current futures contracts may or may not be accurate. Futures prices process new
information and market conditions quickly and prices can change direction on a daily
basis. The futures price on the NYMEX and other markets is conditional on
information available today. As more information becomes available, futures prices
will adjust. However, futures markets are providing little indication that either oil
or gasoline prices might decline in the near term.
⁶ Energy Information Administration, Weekly Petroleum Status Report for the Week Ending
May 27, 2005, Table 16, p.30.

Reserves and Production
The long term ability of the oil market to meet demand depends on the
magnitude of available reserves. An important category of reserves are proved
reserves. Proved reserves are those quantities that geological and engineering
analysis suggest can be recovered with high probability under existing technological
and economic conditions. Proved reserves can be augmented through exploration
and development of new discoveries, through technological improvements, as well
as through the existence of more favorable economic conditions. In the past, all of
these factors have contributed to augmenting the proved reserve base.
Whether the proved reserve base grows over time or not depends in part on the
level of production. As production proceeds, the level of proved reserves declines.
As new oil discoveries are made, recovery technologies improve, or as the price of
oil rises, the stock of proved reserves increases. A standard measure of the potential
availability of oil over time is the reserve to production ratio (R/P). The R/P can be
interpreted as the number of years that the existing reserve base can sustain the
current level of production. Since both proved reserves and production can change
year-to-year, the value of the R/P is more descriptive as a measure of potential market
viability when considered over time. Table 1 shows the R/P over the past 20 years
for the world as well as various regions.
Table 1 shows that on the world level there appears to be little cause for
concern that oil is physically running out. While the R/P is lower in 2003 than in⁷
1993 it is actually higher than it was in 1983. A reasonable estimate, given the
political changes since 1983 might be that the ratio has remained roughly constant
over the past 2 decades, leading to the inference that 2003 levels of consumption
seem to be about as sustainable as 1983 and 1993 levels of consumption were at
those times, even though 2003 world consumption levels were 17% greater than
those of 1993.

⁷ As noted in the table the numbers for 1983 are not strictly comparable to those from later
years because of the lack of clear data for the USSR. The 1983 data might be interpreted
as reserves available to the market economies, as Soviet production and reserves did not
enter the world oil market as a normal matter of commerce in 1983.

Table 1. Oil Reserve/Production Ratios, Selected Years
198319932003
World 31.6 42.5 41.0
U.S.7.07.711.3
North America14.617.912.2
South and Central America25.542.941.5
Europe and Eurasia*Incomplete16.217.1
Middle East76.492.388.1
Africa 32.9 23.8 33.2
Asia Pacific21.418.616.6
Source: For 2003 and 1993, BP Statistical Review of World Energy, June 2004. pp. 4, 6;
and for 1983, U.S. Energy Information Administration. International Energy Annual 1983.
Tables 14, 30. pp. 30, 84.
* Europe and Eurasian data incomplete because of lack of USSR data for 1983.
The reserve portion of the ratio shows that the world had access to more
reserves in 2003 than in 1993 or 1983. Reserves in 2003 totaled 1.147 trillion
barrels. Reserves in 1993 were 1.023 trillion barrels, and in 1983 were 723 billion
barrels. These data represent over a 12% increase in reserves for the decade since
1993, and a 36% increase compared to 1983. Similarly, world production is greater
in 2003, at 76.7 million barrels per day (b/d), than in 1993 when production was 66
million b/d, or 1983 when production was 57.9 million b/d. This represents an
increase in production of over 32% compared to 1983.⁸
On a regional level, the most important change between 1993 and 2003 is the
weakening reserve position of North America, and the reserve position of the United
States. On one level, the data suggest that the U.S. position is improving. The U.S.
R/P has increased from 7.7 years in 1993 to 11.3 years in 2003 and total U.S. reserves
have also increased to 30.7 billion barrels from 30.2 billion barrels in 1993.
However, the U.S. R/P has increased because U.S. production has declined, from 8.6
million b/d in 1993 to 7.4 million b/d 2003. As U.S. total consumption has increased
over the period, the result has been that U.S. imports of oil have increased along with
our dependence on other nations and the world oil market. The declining reserve
position of North America in general means that, absent new major discoveries, the
United States will continue to depend on the world market, and the OPEC, Persian
Gulf nations for a large part of its supply.⁹

⁸ BP Statistical Review of World Energy 2004, June 2004, pp.4-6.
⁹ In 2003, the United States imported over 9.6 million b/d of crude oil. OPEC provided the
United States over 4.5 million b/d of crude oil, or about 47% of total imports. Saudi Arabia
provided about 1.7 million b/d of total U.S. imports, or about 18%. Source: Energy
Information Administration, Petroleum Supply Monthly, July 2004, Table S3, pp.8-15.

The Middle East, and especially Saudi Arabia, continue to be the largest holders
of reserves in the world. Some of the other regional changes in the data reflect
changing national and political borders as well as oil positions. European reserves
are now dominated by members of the former Soviet bloc, including Azerbaijan,
Kazakhstan, Romania, and others. Overall, the data suggest the continuation of an
integrated world oil market. Any region, or nation, might well experience difficulty
in trying to implement a singular oil policy, independent of the world market.
Another conclusion that might be drawn from the R/P data is that it provides
little support for the escalated prices of the first quarter of 2004. Since little has
changed in the long term balance between reserves and production, it is unlikely that
the R/P has been the source of upward price pressures. Long term oil prices might
be affected by reserve and production positions in the future, but R/P ratios do not
appear to be a major cause of recent oil price increases.
The world R/P has stayed roughly constant over the past 2 decades because
investments have been made in exploration, development, and production. The
International Energy Agency estimates that over $3 trillion, or $103 billion per year
will need to be invested in the oil sector through 2030 if its projections for increased
demand materialize. It estimates that 70% of this total will be spent on exploration
and development, with the remainder in refining, transportation and the development
of non-conventional oil sources.¹⁰
Oil industry investment is only partly required to meet new demand. Only
16% of total investment is projected to meet new demand growth. The remaining
84% is required to compensate for declining production from the reserve base. The
reason so much investment is needed to compensate for declining fields lies in the
decline rates observed in producing fields. Decline rates depend on a wide variety
of factors, including geology, extraction technology, field age, and production
policies. Decline rates range from 4% to over 11% per year. If production levels are
to be maintained, new reserves and production must continually be developed to
compensate, financed by investment in exploration and development.¹¹
Price and Markets
After averaging about $23 per barrel for the five year period 1998 to 2002, the
average price of oil increased to $31 in 2003. For 2004, price remained high,
reaching a peak of $53.28 per barrel in October.¹² As of April 2005, the price of oil
continued to remain over $50 per barrel, and peaked at $54 per barrel in March

¹⁰ International Energy Agency, Paris, World Energy Investment Outlook: 2003 Insights,

2003, pp.101-115.

¹¹ Ibid. pp.107-112.
¹² Energy Information Administration, Weekly Petroleum Status Report, May 20, 2005,
Table 14, p.27.

2004.¹³ R/P analysis showed that there has been little change in the underlying long
term balance in the oil market that might be used to justify high prices. However, a
number of short term economic fundamentals as well as the coincidence of a set of
singular events affecting the market may have interacted in such a way that prices
were pushed up.
Economic Growth
Economic growth in oil consuming nations increases the demand for oil and
pushes up oil prices. The world economy continued its recovery in 2003 and 2004
with gross domestic product (GDP) growth rates increasing in many regions. The
strongest growth performances were in oil importing United States and China, but
better performance was also observed in Japan and Russia, as well as the emerging
growth nations of Asia. U.S. growth was 3.1% in 2003, and forecast to reach 4.6%
during 2004. Chinese economic growth was 7.4% in 2003 and projected to be 6.8%
in 2004, moderating only slightly for 2005.¹⁴ In the United States, economic growth
has been linked to high levels of oil consumption, of which increasing gasoline
demand is an important component. In China, expanding exports have increased the
industrial demand for oil, and rising consumer income has increased consumers’
demand for gasoline. U.S. oil demand increased by 1.9% in 2003 to over 20 million
b/d. Chinese oil demand increased by 11.5% in 2003 to almost 6 million b/d.¹⁵
In both the United States and China the increase in GDP growth, and economic
activity in general, has led to increases in energy demand. However, a feedback
relationship exists which can mitigate this effect. To the extent that oil prices rise,
reflecting increased oil demand, GDP growth rates might decline for two reasons.¹⁶
If the monetary authorities interpret increasing oil costs as generalized price inflation,
they may adopt restrictive monetary policies which could slow the economy’s
growth. Also, if oil product prices rise, and consumers are unable or unwilling to
reduce oil product consumption, consumers may reduce expenditures on other goods
and services, again potentially slowing the rate of GDP growth.¹⁷

¹³ Prices are for West Texas Intermediate crude oil located at Cushing Oklahoma. Analysts
frequently monitor two prices in the oil market, the spot price, and the futures price as traded
on the New York Mercantile Exchange. Both provide useful information. The spot price
is a good measure of current tightness in the physical product market. The near month and
succeeding futures prices measure the markets’ expectations for future supply and demand
balance. The two price sets are related because at expiration, the near month future price
must equal the then current spot market price, to avoid an arbitrage opportunity.
¹⁴ International Monetary Fund, World Economic Outlook 2004, April, 2004, Table 1.1, p.3.
¹⁵ BP Statistical Review of World Energy 2004, June, 2004, p.9.
¹⁶ Both of these reasons are relevant to current monetary policy decisions. See Washington
Post, Predicting Growth, Fed Lifts Key Rates, August 11, 2004, p.1.
¹⁷ For further analysis on the effects of oil price shocks on the macroeconomy, see Marc
Labonte, The Effects of Oil Shocks on the Economy: A Review of the Empirical Evidence,
CRS Report RL31608, updated June 25, 2004.

While the United States and China increased their demands for crude oil and
petroleum products as a result of their GDP growth, Russia, an oil exporter,
improved its GDP growth rate as a result of the expansion of the petroleum industry.
For Russia, it is likely that expansion of the oil sector led the growth in Russian
GDP. This behavior is typical of nations whose oil exporting sector is a major
component of their GDP. For nations in this category, high oil prices, based on rising
oil demand, create an inflow of oil derived revenue, increasing GDP growth. The
danger for these nations is that if prices go too high, and stay high, GDP growth in
the consuming nations might decline, reducing the demand and price of oil. An
additional factor is that high prices lead to increases in exploration and development
budgets around the world. As new oil is found and brought to market, supply
increases and prices might be reduced, damaging the oil exporting nation’s growth
or high oil prices can make alternative fuels more competitive potentially reducing
the demand for oil.
Exchange Rates
Changes in the exchange rate of the U.S. dollar can affect the level and
distribution of world oil demand. The U.S. dollar achieved a recent peak value in
February of 2002. Since that time, the index measuring the value of the dollar has
declined by over 20%.¹⁸ The decline in the dollar’s value has not been uniform
against all currencies. Most of the change has been against nations in the Euro area.
The Japanese and some of our other Asian trading partners have intervened in the
currency markets in an attempt to prevent the dollar from declining in value relative
to their currencies. China maintains a fixed exchange rate against the dollar; as a
result, the yuan has experienced no appreciation against the dollar.
Exchange rate variations in the U.S. dollar can affect the world price of oil
because oil is priced in dollars and generally paid for in dollars. Several results may
follow from this relationship. First, if the value of the dollar declines against other
currencies the dollars received by oil exporting nations are worth less in terms of
world purchasing power. If oil exporters are able to exert market power in setting
prices, or if market conditions permit oil exporters to dictate higher prices, they have
incentives to increase the money price of oil in an attempt to preserve the purchasing
power they earn through selling a barrel of oil.
The effect of a declining dollar on oil importing consumer nations varies with
respect to how their currency has adjusted to the changing value of the dollar. For
the United States, of course, any increase in the dollar price of oil is immediately felt
as an increased price burden, possibly leading to decreases in demand. For the Euro
area consumers, the situation is different. Since the value of the euro has increased
in terms of dollars, the effect of any increase in dollar denominated oil prices is offset
by the amount of euro appreciation. For example, if the euro appreciates by the same
percent that the price of oil in dollars increases the two effects cancel each other. The

¹⁸ Federal Reserve Board of Governors, Price Adjusted Major Currencies Dollar Index,
available at [http://federalreserve.gov/releases/] viewed on August 10, 2004.

result is that the demand for oil in the euro area is less likely to be affected by high
oil prices as long as the euro appreciates.¹⁹
Nations that intervene in world currency markets to prevent the dollar from
falling relative to their currencies, for example, Japan, Korea and Taiwan, are
implicitly choosing to forego the associated real reduction in oil prices an
appreciating currency would bring, to preserve the export advantage for their goods
that a lower exchange rate brings. Since these nations are both large oil importers as
well as major exporters on world markets, the choice can have important implications
for their economies. China, which maintains a fixed exchange rate against the U.S.
dollar, also foregoes any exchange rate based benefit with respect to oil purchases in
favor of supporting export industries.
Gasoline Prices
Crude oil is the major physical input in the production of gasoline and accounts
for over 40% of its cost.²⁰ As a result, changes in the cost of crude oil will be
reflected in gasoline prices. Recently, it might be that the relationship has been
reversed: the high price of gasoline may have become a factor in keeping the price
of oil at elevated levels, especially on the New York Mercantile Exchange
(NYMEX).
Gasoline prices have achieved record levels since they began increasing in the
first quarter of 2004. Although the rising price of crude oil is one factor, other
factors exist which are independent of the oil market in general. The high utilization
rates of refinery capacity in the United States, the lack of investments in new refining
capacity, the extra costs associated with producing the variety of different gasoline
mixes to satisfy environmental requirements in various regions of the country, low
inventories as the summer driving season 2004 approached, and the high cost of
refinery investment to meet both product and site environmental requirements all
contribute to the record levels of gasoline prices. Additionally, on the NYMEX a
condition known as “backwardation” was common during the first half of 2004. In
this situation the near-month futures contract, in this case regular grade gasoline
delivered to New York harbor, is persistently priced higher than the price level of the
same gasoline, scheduled for delivery months further in the future. The effect of this
pricing condition is to make the acquisition of inventories in the present month more
expensive than acquiring them further in the future. Backwardation provides an
incentive to keep current inventories low. The low current inventory position then
acts as a factor keeping prices high, because low inventories are taken to be
indicative of a tight supply situation in the market.
It is possible that the high price of gasoline, a price that is highly visible in the
U.S. market, might contribute to keeping the price of oil high through an expectations

¹⁹ The results of an appreciating currency are not all positive. Economists believe that an
appreciating currency raises the cost of that nation’s exports on the world market. This cost
increase reduces their sales, and if the reduction in sales is large enough, might reduce the
GDP growth in the nation with the appreciating currency.
²⁰ Energy Information Administration, A Primer on Gasoline Prices, 2004, p.2.

based effect. Traders could hypothesize that since the price of gasoline is high, this
might be the result of tight oil markets. If not, there would be more oil refined, and
gasoline produced, driving down the price. These expectations could be acted upon
through the NYMEX futures markets. This position ignores the importance of the
independent factors, cited in this report, that suggest that gasoline prices in the
United States would likely have risen even if the price of crude oil moderated.
Industry Structure
A recent study by the Government Accountability Office (GAO) asserted that
a total of over 2,600 merger transactions took place in the oil industry from 1991
through 2000. These mergers fell into two main classes: asset mergers and corporate
mergers. Asset mergers accounted for approximately 80% of the total, and the
remaining 20% were corporate mergers. Asset mergers are defined by the GAO as
one company purchasing a part, or a specific asset from another company. For
example, Tosco Petroleum’s acquisition of Unocal’s refining and marketing assets
on the West Coast in 1997 was an asset merger. Corporate mergers are defined as
those in which one company acquires the other company’s total assets, resulting in
one company. Examples include Exxon-Mobil and Chevron-Texaco, which
produced two of the super major oil companies.²¹
A possible outcome of mergers and acquisitions is that the resulting companies,
larger and more capable of exerting market power, raise prices to the detriment of
consumers. GAO carried out econometric analysis on a set of these mergers and
found that mergers and the resulting higher concentration ratios observed in the oil
industry resulted in wholesale price increases of about 2 cents per gallon in six of the
eight specific cases it examined.²² The Federal Trade Commission and its staff have
challenged the GAO finding on methodological grounds and question the validity of
their conclusions.²³
If the mergers that took place in the U.S. oil industry did raise wholesale
gasoline prices, it is possible that retail gasoline prices also increased as a result. If
that was so in a period when oil markets were perceived to be tight, those price
increases might have fed back through the futures market process described in a
previous section of this report to help support high oil prices.
OPEC Policy
OPEC seeks to create favorable oil prices for its members by assigning
production quotas to its member nations with the goal of limiting the supply of crude
oil available on the world market. The ability of the quota system to control price has
been questioned because of the well known propensity for OPEC members to
produce beyond their assigned production levels. Even so, the very existence of

²¹ United States General Accounting Office, Energy Markets Effects of Mergers and Market
Concentration in the U.S. Petroleum Industry, GAO-04-96, May, 2004. p.34.
²² Ibid. p.6.
²³ Ibid. pp.153-158, 171-193.

OPEC has influenced conditions in the petroleum market as buyers and sellers await
decisions taken at OPEC meetings, and monitor the institution’s behavior. At certain
times in its history OPEC has had relatively clear influence on oil prices, as in 1996,
when a flood of Saudi crude oil came on the market and drove down prices
.
In response to recent price increases, OPEC has maintained that a shortage of
crude oil on the world market is not the reason. OPEC has asserted that the market
is well supplied, and its actual production has exceeded quota levels. OPEC official
production for June 2004 was announced as 25.5 million b/d by the OPEC 10, to
increase to 26 million b/d on August 1, 2004.²⁴ Actual OPEC production for June
was thought to exceed 29 million b/d.²⁵
Although gross volumes are consistent with a market that is not suffering from
supply tightness, the effects of product segmentation must be considered. A
fundamental breakdown in the crude oil market exists between sweet, or low sulfur
content, and sour, high sulfur content, oil. It may be that OPEC volumes of sour
crude make the over-all market appear in balance while a tightness in the sweet crude
market underlies this over-all balance. Sweet crude oil is useful in efficiently
producing the low sulfur transportation fuels, both gasoline and diesel, that
environmental regulations increasingly require, and is important to nations with
relatively strict air quality standards.
The role of OPEC in the 2004 market price may be more traceable to actions
taken in 2002. In 2002, OPEC production declined from an average of over 30
million b/d to approximately 28.5 million b/d, a decline of some 5%. This
production cutback changed the nature of the market in 2003, as economic growth
began to recover and enhance oil demand growth. Production in 2003 not only had
to satisfy the growing demand requirements of 2003, but also to compensate for the
reduced availability in 2002 which reduced inventories. The result of these
conditions is that as the market evolved in late 2003 and into 2004 with economic
growth strengthening, persistent shortfalls in inventory levels were observed.
Inventories
The United States holds petroleum stocks in three ways. The oil industry holds
stocks of crude oil in inventory as well as stocks of petroleum products. These stocks
are held to insure the efficient operation of refineries in the face of shifting seasonal
product demand and potential disruptions in crude oil supply. Seasonal fluctuations
in product demand are managed through varying the stocks of petroleum products,
mainly gasoline. If inventories of either crude oil or gasoline are low relative to the
past average, or in the perception of market traders, this is taken to be an indication
that the market is tight, implying that demand is nearly equal to, or might even
exceed, potential supply at current price levels. As a result, upward pressure on price
occurs, even if there is no physical shortage observable.

²⁴ The OPEC 10 nations does not include Iraq which is excluded from quota restrictions.
²⁵ Oil Daily, Opec Turns Up the Volume, But Will Markets Respond in Kind?, Vol. 54, No.

123, June 29, 2004. p.6.

Figure 3 shows the behavior of crude oil stocks in the United States, excluding
the Strategic Petroleum Reserve. The level of reserves in 2003 is relatively low
compared to 2002. Stocks are increasing in 2004 on a month to month comparative
basis with 2003, but satisfying growing demand at the same time that stocks are
growing contributes to the strong demand that has been a major factor in oil price
increases. It has been reported that U.S. crude oil inventories during the last week
of July 2004 reached 298.6 million barrels, which on its own was judged to be
consistent with a price of oil of around $26 per barrel.²⁶
Figure 3. U.S. Crude Oil Stocks Excluding Strategic
Petroleum Reserve
Several factors have contributed to the decline in stocks held by the private
sector. A long term trend in the refining sector particularly, and the oil industry in
general, is cost reduction. Inventory is expensive to hold, and one way to minimize
costs is to reduce the size of inventory and expand the use of efficient inventory
management techniques. While this strategy benefits the profitability of the
companies, it has the side effect of providing less of a buffer in times of surging
demand. Second, when the futures market for commodities is in a “normal” price
relationship, prices for future delivery tend to be somewhat higher than current
prices, making inventory accumulation economically viable. Recently, oil future
markets have reversed the more typical price structure, and the future price has been
lower than the current price, providing a disincentive to accumulate inventories at
current prices. The third factor contributing to low inventories in the private sector
is the tight market. Refineries are near full capacity production, and supplies of

²⁶ Oil Daily, Analysts Weigh Impact of Fear in Oil Price, Vol.54, No.151, August 9, 2004,
p.1.

light, low sulfur crude oil are perceived to be tight on the world market.²⁷ Taken
together, this is a difficult set of circumstances within which to expand stocks of oil
for inventory. However, since inventories remain low in the view of some market
traders, they are one more factor contributing to the high price of oil.
The third way the United States holds stocks, in this case crude oil, is in the
Strategic Petroleum Reserve (SPR). This government-held reserve was established
to provide a buffer against a physical disruption in the delivery of imported crude oil.
Recently, there have been calls to either suspend deliveries to the SPR, or to release
oil from the SPR to the market with the intent of increasing market supply, reducing
speculation, and moderating prices.²⁸
Exceptional Events
This section briefly identifies and discusses a set of factors that may exert an
influence on oil prices, but seem to be more in the nature of a “one time” event rather
than a trend or cyclic factor. The effect of each of these factors tends to be made
more important by the general tightness of the market. In some cases, there is an
interactive relationship between two or more of these factors, again possibly
increasing the over-all effect on price.
The war in Iraq has contributed to high oil prices in different ways as events
have progressed. The predominant effect of the conflict on oil prices has been an
increase in uncertainty. During the early stages of the conflict, concerns about a
possible disruption of oil supply out of the Persian Gulf and disruption of Iraqi
production due to military operations were prominent, until it became clear that the
military would quickly oust the government of Saddam Hussein. Later, market
uncertainty revolved around the ability of Iraq to export oil in the midst of political
transition in which pipeline and other oil facilities were attacked by hostile groups
within the country. Uncertainty with respect to terrorist attacks, both in Iraq, and
spilling over to other Gulf nations, including Saudi Arabia, continue to unsettle the
oil market and contribute to a “fear factor” being built into the price of oil.
Recent terrorist attacks in Saudi Arabia, directed at the oil industry and its
personnel, are more than a psychological influence on the market. Recent reports
have asserted that as of July 2004, world spare production capacity was between one
and two million b/d, almost all in Saudi Arabia.²⁹ This level of spare capacity is
close to the minimum amount required to cover a supply disruption from one
exporting nation. A major disruption in Saudi oil production would cause that
cushion to disappear and would likely cause upward volatility in world oil markets.

²⁷ Energy Information Administration, Weekly Petroleum Status Report, for the week ending
August 6, 2004, Table 2, p.2.
²⁸ Use of the SPR to moderate gasoline prices is discussed in Robert Bamberger and Robert
Pirog, The Strategic Petroleum Reserve: Possible Effects on Gasoline Prices of Selected Fill
Policies, CRS Report RL32358, April 19, 2004.
²⁹ Oil Daily, Robust Demand Propels Crude Oil Past $41 Despite Solid Supply, Vol. 54, No.

136, July 19, 2004, p.3.

The concern the market has shown regarding supply disruption has been borne
out by events. Political unrest and strikes have disrupted oil exports from both
Nigeria and Venezuela. Indonesian oil production has been declining, leaving it
unable to meet its OPEC quota. The legal conflict between Yukos, the major
Russian oil company and the Russian government over back tax obligations threatens
to bankrupt the company, or force the sale of producing assets. Markets are
concerned that bankruptcy, or significant asset sales, might lead to an oil supply
cutoff, or reduction, of exports from Russia, the world’s largest non-OPEC
producer.³⁰
Another factor that some feel might be influencing the price of oil is the
influence of financial investors and financial instruments. At the time of the first oil
shock in 1973/1974, the primary market for oil price formation was the Rotterdam
spot market, where physical cargoes of oil for near term delivery were bought and
sold, generally by traders who had a real commodity interest in the market.³¹ Today,
the primary market in price formation may be the NYMEX, supplemented by the
International Petroleum Exchange (IPE). In these markets, the focus is not on
physical supply for current delivery, but on the open interest in a financial contract,
generally a future or options contract, that will expire in the near month, generally the
month after the current month. The goal of financial traders is to make a profit on
the contract, which may necessitate the price of the contract rising or falling
depending on the trader’s position in the market and current prices. The implication
of this is that financial traders may have an interest in the price moving either up or
down, almost without regard to the underlying fundamentals of the market.
The rationale for this view is that financial traders have entered the NYMEX oil
market in large numbers seeking profits that stock and bond markets have not
produced since the boom years of the late 1990s. Profits can be earned on futures
and options markets when prices of the underlying commodities go steadily up, or
down, stay the same, or even when they exhibit more or less random volatility,
depending on the strategic position the trader has created.
Sectoral Demand Patterns
Global oil demand was over 79 million b/d in 2003, an increase of about 1.8%
over 2002 levels. Demand for 2004 was over 82 million b/d, an increase of about 3%
compared to 2003 levels. Demand projections for 2004 were increased for nine
consecutive months by the IEA since its estimate in November 2003. World oil³²
demand is expected to exceed 84 million b/d in 2005. Within this pattern of world
growth, differences among regions, as well as individual countries, exist. In addition,

³⁰ Oil Daily, Opec’s Output Pledge Fails to Check Price, Vol. 54. No. 140, July 23, 2004,
p.1.
³¹ Most oil bought and sold at that time was by long term contract between the major
international oil companies and the oil producing nations.
³² International Energy Association, Oil Market Report, June 10, 2005. p.5.

increased demand is not evenly spread across the product mix that is produced at
refineries.
Countries and Regions
As shown in Table 2, North America was the largest oil consuming region in
the world, with the United States accounting for about 83% of the total. However,
growth in the region was less than world growth, and the growth in Canada, at 4.5%,
was more than double that of the United States at 1.9%. Asia Pacific was the second
largest consumer of oil, with China moving ahead of Japan in total consumption, to
be the second largest oil consuming country in the world. The Asia Pacific regional
growth of 4% was the highest in the world, and China had the highest yearly growth
in demand of any of the major consuming countries at 11.5%.
Table 2. World Demand for Oil, 2003
(millions of barrel per day)
% Change 2003
20022003over 2002
U.S. 19.7 20.0 1.9%
North America23.624.12.1%
South/Central America4.74.6-1.2%
Europe/Eurasia 19.6 19.7 1.0%
Middle East4.44.50.8%
Africa 2.5 2.6 2.2%
Asia Pacific21.722.64.0%
Source: BP Statistical Review of World Energy, June 2004. p. 9.
European/Eurasian oil demand growth was roughly flat, with demand falling in
Germany, Italy, and the United Kingdom, by -1.8%,-0.9%, and -1.8%, respectively.
Within the region, most of the large gains in demand are in nations with small initial
consumption levels led by Azerbaiijan, Belarus, Austria, and Poland. These nations
account for 1.2% of world demand. Although lower than average European oil
demand growth may be tied to levels of economic activity, they may also be tied to
changing consumption patterns and conservation, especially in Western Europe
where motor vehicle transportation costs are very high.
Russian oil consumption grew by 23,000 b/d, to 2.5 million b/d in 2003, while
production rose by 845,000 b/d, to over 8.5 million b/d, enhancing the nation’s role
as a major exporter. However, the Russian economy has been in trouble for many
years. If economic growth picks up and the economy restructures and stabilizes,
consumption might return to levels similar to those in 1993 when 3.8 million b/d
were consumed. Russian consumption at that level might reduce the amount of oil
available for export, pushing other consuming nations to become increasingly
dependent on Middle Eastern supplies.

The Asia Pacific region includes some nations with the highest year-to-year
growth rates in the world, while other nations in the region experience declining
demand. In 2003, China strengthened its position as the second largest oil
consuming nation in the world by increasing its margin over Japan from only 20,000
b/d in 2002, to 431,000 b/d in 2003. Given the disparity of economic growth rates,
geographic and population factors, as well as the comparative density of
transportation, it seems that the Chinese lead over Japan may widen. At current
growth rates, a more relevant question might be when China will overtake the United
States as the world’s largest consumer. This is most likely not a competition either
nation will directly benefit from winning. The United States imported about 63% of
the oil it consumed in 2003, and production has fallen every year since 1993. China
imported about 45% of the oil it consumed, and production increased by only 1.5%
for 2003, less than the 11.5% increase in demand. The growing demands in both the
United States and China make it likely that the world oil market will become
increasingly dependent on Middle Eastern oil in the coming years and keep exerting
upward pressure on price.
Petroleum Product Demand
Product demand analysis reveals that there are regional and country differences
in the mix of oil based products consumed. Gasolines, middle distillates, fuel oil,
and other products are the main groups.³³ At the world level, gasolines comprise
31.6% of consumption, middle distillates 35.7%, fuel oil 12.2%, and other products

20.5%.^34,35

The consumption pattern in the United States differs from the world averages.
The U.S. demand is 46.2% gasoline, 29.3% middle distillates, 3.8% fuel oil, and

20.7% other products.³⁶ This mix reflects the U.S. use of oil as a transportation fuel,

with car and light truck use responsible for the relatively high gasoline percentage.
The U.S. refinery industry is unable to supply adequate gasoline to the domestic
market. As a result, imports of finished gasoline and gasoline blendstocks have
increased to almost one million barrels per day. U.S. refineries operate at near full
capacity, but a lack of new capacity expansion by the industry suggests further
increases in imported gasoline, if available on the world market.³⁷

³³ Gasoline includes aviation and motor gasoline as well as other light distillates, middle
distillates includes jet fuel, heating kerosene, and other products, fuel oil includes marine
bunkers and crude oil used as a fuel, others includes refinery gas, lubricants, wax, solvents,
refinery fuels and other products.
³⁴ Product demand data for the world exclude the nations associated with the former Soviet
Union.
³⁵ BP Statistical Review of World Energy, June 2004. p.12.
³⁶ Ibid.
³⁷ Imported gasoline must meet U.S. performance standards, which themselves are a
multitude of federal, state, regional, and local regulations. If these requirements are
different than those a foreign refiner is prepared to meet, product may not be available to
the U.S. market. Foreign refiners must undertake refinery investments to adapt processes
(continued...)

Europe has different preferences in transportation fuels than the United States.
Middle distillates dominate the European product slate at 44%, with gasoline at
24.4%. These values reflect the on-going shift to diesel engines in European
passenger vehicles. As product demand shifts, refiners are following by investing in
the technology needed to produce greater proportions of middle distillates and less
gasoline. As this transformation proceeds, European refiners may find that they have
less surplus gasoline available for export to the United States. This outcome could
lead to tightening U.S. gasoline markets, keeping an upward pressure on the price of
gasoline, and indirectly supporting high oil prices.
The Asian pattern of product demand, especially China’s, includes a larger
portion of demand, 13.8% in the case of China, dedicated to fuel oil. This percentage
is approximately three times that of the United States. The use of fuel oil in industry
accounts for the difference, as well as the lower requirements for gasoline for private
automobile use.
Future Projections
The International Energy Agency recently reduced its forecast for global oil
demand in 2005. It estimated that world demand would be 84.3 million barrels per
day in 2005. This value represents a growth of 1.77 million barrels per day, or 2.2%³⁸
above 2004 levels.
In a typical manufacturing or service market, demand growth of this magnitude
might be welcomed, and met with increased job creation and facility expansion, or
more intensive use of existing facilities. Conditions in the oil and oil products
industries might not be so accommodating. Excess capacity in the crude oil market
is low, with most estimates averaging less than 1.5 million barrels per day. If we add
the increased estimate of consumption in 2004 to the projected increase in 2005 it is
clear that the crude oil industry is likely to be at full production capacity through

2005.

It has been reported that Aramco (Saudi Arabia) has a plan in place to expand
production by 1 million barrels per day within a year. Non-OPEC production is
expected to increase by about 1.4 million barrels per day in 2004, but only smaller³⁹
increases are expected in 2005. High prices, if they persist, can be expected to
increase exploration and ultimately production in the longer term if the current
market follows past patterns.
The EIA’s Annual Energy Outlook, 2004 (AEO) provides a projection of U.S.
energy balance out to 2025, and includes scenarios based on different market price

³⁷ (...continued)
that allow for the production of U.S. compatible fuels.
³⁸ Oil Daily, IEA Again Lifts ‘04 Demand, Sees Slower ‘05, Vol.54, No.133, July 14, 2004,
p.1.
³⁹ Oil Daily, Oil Production Capacity in Saudi Arabia Needs to Rise Soon, Vol.54, No.147,
August 3, 2004, p.5.

assumptions. Price is taken to be an assumption, rather than a predicted value,
because it is assumed to be determined on the world market. For the base case, the
AEO assumes a crude oil price of $23.61 per barrel in 2010 and $26.71 per barrel in
2025. For the high price case, AEO assumes a price of $32.80 per barrel in 2010 and
$34.90 per barrel in 2025.⁴⁰ If the factors that are influencing the current market
continue in the future, it may be that even the high price case assumptions are too
low.
Conclusions
The world oil market, as a result of the convergence of a number of factors, has
experienced significant tightness since the end of 2003, continuing through 2004 and
the first half of 2005. Some of the factors influencing the market might be
temporary, some may be cyclical, and others may possibly be permanent. While the
high prices that resulted from the tight balance between oil demand and supply
caused increased energy expenditures for consumers, business, and industry, it also
led to higher incomes for energy producers. It is possible that the economy as a
whole might experience macroeconomic effects, not only from the high oil prices
themselves, but as a result of the monetary and fiscal policy responses that might be
taken if the high prices persist and are determined to constitute inflation.
Although it has been under pressure in 2003, 2004, and into 2005, the oil market
has shown that the market process is functioning. The factors discussed in this paper
that affected oil and gasoline demand as well as the supply response of OPEC and
other producers caused prices to rise, but there has been little, or no, evidence of
physical shortage or supply disruption.
Effective policies to mitigate high oil prices are difficult to define at the national
level. The price of oil is determined on a world market. It is unlikely that any
consuming nation can insulate itself from the forces driving the world market. For
example, if a nation decided to reduce or eliminate its direct dependence on the
Persian Gulf, it might succeed in doing that by buying oil from other nations.
However, this would reduce the total amount of non-Persian Gulf oil available to
other nations, increasing their dependence on the region and leaving the level of
world dependence unchanged. If political events in the Persian Gulf caused the price
of oil to rise, that price increase would be transmitted to all oil produced around the
world. It is not possible to isolate oneself from the world market, except perhaps by
cutting domestic consumption to the level of domestic production.
The market in 2004 was likely affected by a “fear factor” premium on the price
of oil, raising its price above that indicated by market fundamentals. Some estimates
of the “fear factor” run as high as $15 per barrel, while others rate it at only a few
dollars, or nothing at all.⁴¹ The threat of supply disruption due to potential terrorism
or political instability appears to be the source of this price factor. An important

⁴⁰ These prices are expressed in 2002 dollars to control for inflation.
⁴¹ Oil Daily, Analysts Weigh Impact of Fear Factor in Oil Price, Vol. 54, No. 151, August

9, 2004. p.1.

question is, how long this factor will influence price? In the past, fears of political
instability, especially in the Persian Gulf, tended to be quelled in relatively short
time-frames. Today, with the war on terrorism perceived as a long term reality, it
may be that oil prices will incorporate a “fear factor” for a significant time.
The nature of the exploration and production cycle in the oil industry encourages
major swings in the price of oil even in more politically stable times. This cycle
makes it difficult for governments to time oil policies effectively. In the past, periods
of high oil prices have led to a rapid expansion of exploration, and given improving
technology, have led to substantial oil finds in many places in the world. As newly
discovered extra oil comes on the market several years later, the increased supply
tends to overwhelm demand, causing price to drop. While demand tends to increase
incrementally, by a few percent per year, supply tends to increase discrete amounts
in response to a period of high prices. This relationship leads to cyclic price
volatility. Set against this record is the opinion of some that world oil production is
soon to peak as a result of geological factors and the likelihood that the largest oil
reserves have already been discovered.⁴²
A major continuing factor in the market is the emergence of China as a major
importer of crude oil. In addition, the possibility exists that India, and perhaps other
Asian nations, might expand their imports of oil as industrial production expands in
those nations. Although the 2005 projection of Chinese import growth moderates to
approximately 7% from the 2003 level of 11.2%, in the longer term much depends
on whether oil use for private automobiles in China expands very quickly or is
moderated by the government. However, either of these yearly growth rates imply
stress for the world oil market. Based on China’s consumption of almost 6 million
barrels per day in 2003, it may generate increases of demand of 500 thousand b/d or
more in the next few years. In a market with very limited excess capacity, and
possibly facing the discovery of fewer giant fields, increases in demand of these
magnitudes promise to contribute to an upward pressure on price.
The 2004, and potentially for 2005, oil market reflects the influence of a number
of factors all of which have led to upward pressure on price. Although some of these
factors might have been judged temporary in the past, there is a danger that in the
current political environment they may perpetuate themselves, keeping oil prices well
above the OPEC price target.

⁴² C.J. Campbell, Industry Urged to Watch for Regular Oil Production Peaks, Depletion
Signals, Oil and Gas Journal, July 14, 2003, pp.38-45.