Argonne Economist Predicts Gas Price Bump and Following Recession: Part 2

How did we get here?

Economist Dan Santini believes in conserving energy resources by driving an energy-efficient, four-cylinder car.

How did the 20th Century's $11-per-barrel real oil price low in 1998 jump to $27 in 2000, with national average gasoline prices rising from $1.11 to $1.56? According to Santini's model, the U.S.-based 5% indicator signaled him to look carefully at the global oil supply vs. demand view while the price was dropping to $11— the indicator was expanding toward 5% at the same time. Here are some of the complicated reasons behind the latest price shock:

• The Organization of Petroleum Exporting Countries (OPEC) 1998 oil production increase was poorly timed.
• The recession in Asia then lowered the demand for oil.
• Oil prices plummeted with increased world output and decreased demand.
• Meanwhile, OPEC oil supply logistics and internal politics changed. With declining oil revenues causing problems, several member-nations changed leadership during this period. "Because production was dropping for many OPEC producers outside the Middle East, the Persian Gulf producers were gaining power within OPEC and finding themselves in a position where they could agree to make production cuts without fear of cheating by other members," Santini explained. Importantly, the new president of Venezuela also committed to production cuts.
• U.S. drilling and exploration was sharply cut due to the low cost of oil and the simultaneous rise in costs of exploration and drilling. In 1998 and 1999, U.S. companies cut domestic production, bought foreign oil and bought each other.
• American oil demand rises. American car buyers, lulled into a false sense of continuing low gas prices, bought more trucks, especially sport utility vehicles (SUVs). Sales of SUVs are increasing, while car and minivan sales are in slow decline. SUVs tend to be much less fuel efficient than cars and less efficient than minivans, which are classed as trucks.
• Vehicle fuel economy drops. By the 1990s the fuel economy of the vehicle fleet first leveled off, then, as SUV sales continued to rise, began to drop in 1997. The leveling off in the 1990s followed 15 years of steady gains that began in response to the first of the two 1970s oil price shocks.
• Car and truck sales and production drop. Record auto sales followed the 1998 oil price drop in both 1999 and 2000, but the sales increases actually ended early in 2000, after the effects of rising oil, diesel, and gasoline prices took hold. The economy boomed in 1999 and especially early 2000, when motor vehicles sales peaked at a rate 20% higher than the 1998 average. But then economic growth slowed sharply, and the motor vehicle sales rate dropped by 13% from the first to last quarter of 2000, with production down 19% from the first quarter of 2000 to the first quarter of 2001.

"The low gas prices were temporarily good, but it set us up for this price increase," Santini said. "And while U.S. oil production has stabilized due to a rebound in drilling, the evidence has only recently indicated that total U.S. oil demand in 2001 is dropping— but an actual drop has not yet been reported in monthly gasoline demand, and gasoline-petroleum demand growth still doubles the recent drop in diesel demand. Yearly average growth is still positive, with total oil demand up about 3%." He is not surprised, since he says it takes a long time to change the patterns of transportation oil use, even when more efficient vehicles are bought.

Summer 2001 brought a welcome drop in oil and gasoline prices promoted by the late May, early June decline in U.S. oil demand. Santini compared the first quarters of 2000 and 2001 for United States oil demand vs. OPEC oil supply. In 2000, OPEC oil supply was down 4%; U.S. petroleum products supplied were down only about 1% even though transportation demand rose by 3%. According to Santini's logic on the importance of differences of rates of change of supply vs. demand, these differences would push oil prices up, and did.

In 2001, OPEC supply was up 6%. U.S. petroleum products supplied were up 4 % — transportation only 2%. This should push oil prices down and — with the spring's actual drop in U.S. oil demand — now appears to be doing so.

The swing was 10% for OPEC supply vs. 5% for U.S. demand (1% for transportation), so OPEC actions have recently dominated. While these short-term trends are consistent with recent price movements, Santini emphasizes that his oil price prediction models are based on yearly averages and multiyear trends. They explain only a portion of yearly oil price movements, much less quarterly or monthly changes.

Transportation is the reason U.S. oil consumption increased throughout the 1990s. Transportation oil consumption rose negligibly between 1978 and 1991 (0.5% a year) when it then began to climb at a rate of 1.9% a year through 1997. From 1997 to 2000, transportation consumption growth rose to 3% per year. For the period 1973 to 2000 (for which Energy Information Administration data are available), the only other years when the average rate of growth for the prior three years equaled 3% or more were 1977, '78 and '88. Thus, significant world oil price shocks have followed — or, most recently, accompanied — each of the periods of oil demand growth in U.S. transportation equaling or exceeding 3% per year over a three-year period. The price shocks were in 1978-81, 1988-90 and 1998-2000.

"Under present circumstances, the short-term indicator discussed here does not imply that oil prices will fall back to 1990s levels within the next couple of years," Santini said. "The longer term model that I have developed is more ambiguous, indicating that prices will stay high in most of the next decade, but might again drop to 1990s levels in the 2010-2020 period, followed by another shock. However, I suspect that the 1990s level of prices will not be seen again."