- The Washington Times - Saturday, June 25, 2005

Why is crude oil so expensive? Why does it matter? The crude price didn’t rise from $12 in early 1999 to nearly $60 because the world suddenly ran out of oil. On the contrary, the world petroleum supply has since risen 10 percent, the International Energy Agency (IEA) says, from 65.8 million barrels a day (bpd) in 1999 to 72.5 million bpd in 2004.

Cambridge Energy Research Associates estimates global oil production capacity will increase at least twice as rapidly over the next five years — by as much as 16 million bpd by 2010.

Oil prices did not quintuple after 1999 because Americans suddenly switched from mini-cars to SUVs. On the contrary, if all passenger cars, pickups and SUVs were replaced with bicycles, the United States would still import a lot of oil.

We import nearly 58 percent of all petroleum, yet only 45 percent of each barrel is used to produce gasoline, a significant portion of which is used by delivery vans and taxis. Commuter and leisure driving account for little more than 40 percent of the oil we consume — far less than what we import.

The rest of each barrel of crude is used for heating oil and diesel fuel for trucks, buses, farm machinery and ships (23 percent), petrochemicals (17 percent), jet fuel (9 percent), asphalt (4 percent) and propane (4 percent).

U.S. industries use petroleum to produce the synthetic fiber used in textile mills making carpeting and fabric from polyester and nylon. U.S. tire plants make synthetic rubber from petroleum. Other U.S. industries use petroleum to produce plastic, drugs, detergent, deodorant, fertilizer, pesticides, paint, eyeglasses, heart valves, crayons, bubble gum and Vaseline.

When the cost of oil goes up, production costs rise and profits decline for oil-dependent industries. Producer costs — not consumer gasoline costs — are why high oil prices threaten to shrink industrial production of goods directly affected and also of energy-intensive products such as aluminum and paper.

This threat affects all new and old industrial economies, whether those nations import or export oil. The United States may be least vulnerable because of superior energy efficiency and a larger service sector.

Of these many uses of oil in industry and commercial transportation, gasoline demand by ordinary consumers may be the least sensitive to price. That is why the relatively invariable demand of motorists cannot possibly account for the wide cyclical variations in crude prices. The other 60 percent of the barrel matters the most, at the margin.

The U.S. index of industrial production peaked at 116.4 in June 2000 then fell to 109.1 by December 2001; the price of West Texas crude simultaneously fell from $32 per barrel to $19 pb. U.S. industrial demand for petrochemicals declined, as did the need for fuel to transport industrial supplies and products.

Similar effects were magnified worldwide. Falling industrial production in any region has the same effect on oil prices, so crude fell from $25 to $12 pb in the wake of the 1997-98 Asian currency crisis.

It is common to blame rising oil prices on industrial expansion in China, but that is a misleading exaggeration. Long before China’s rediscovery of capitalism, earlier Asian Tigers accounted for a rising share of world petroleum demand. From 1978 to 2004, oil consumption rose 28.6 percent in the world but only 8.9 percent in the U.S. That difference was exemplified by a 344 percent increase in South Korea’s demand.

The U.S. still accounts for 25 percent of world oil consumption, but a declining 10 percent share of oil production. China accounts for 8 percent of consumption and 4 percent of production. China looms much larger, however, in the incremental increase of demand. The IEA estimates China will account for 25.8 percent of this year’s demand increase and the U.S. will account for 14.6 percent. This leaves nearly 60 percent of the year’s added demand coming from the rest of the world. Or maybe not.

Just as oil market pundits typically ignore the 60 percent of petroleum not going into passenger cars, they likewise ignore the 60 percent of incremental oil demand not coming from China and the United States.

Recall how regional industrial contraction collapsed the oil price in 1998 and 2001, then examine the last pages of the Economist to see what happened to industrial production over the most recent 12 months. U.S. industrial production looks strong — up 2.7 percent in May — but that same figure a year earlier was up 4.8 percent. For Japan, industrial production is up only 0.6 percent, though a year ago it was up 8.3 percent.

Countries with industrial increases of 12 percent to 22 percent a year ago — such as Taiwan, Brazil, South Korea and Singapore — are now up only 1 percent to 4 percent. For the euro area, industrial production is down 0.1 percent. For Britain — which exports oil — it is down 1.9 percent. For Mexico — which exports oil — it is down 4.7 percent.

The Organization for Economic Cooperation and Development (OECD) tracks all major economies plus one midsized economy (Mexico) that accounts for 13.7 percent of U.S. exports. A six-month trend of the OECD leading indicators was up 7.5 percent at the start of 2004, but has fell to minus 0.5 percent in April.

Want the bad news first? High oil prices have already slowed industrial production in many countries, even China and the United States to a lesser extent. Leading indicators point to wider and deeper trouble ahead.

The good news: Oil prices have proven very sensitive to industrial production, so the problem is self-limiting. Cost-squeezed industrial firms, not necessarily in the United States, will reduce production and thereby world oil demand and prices.

Meanwhile, some clueless senators are oddly eager to push up the Chinese currency, which would make oil cheaper for Chinese industry and more expensive at home. The White House seems oddly eager to enact more tax-financed subsidies for those who buy Japanese hybrid cars, German diesels and ethanol made from corn or sugar. It is difficult to imagine a more irrelevant “energy policy.”

The only policy that might actually shrink the “fear premium” in oil prices (estimated at $10-$20) is strategically using strategic petroleum reserve strategically — to quell panic during hurricanes, strikes, wars and the like.

But the U.S. has instead imported oil to add to the reserve when oil prices were unusually high (1981-1985 and now) and sold oil when the price was low (1997).

Nobody in Washington shows the slightest awareness of the oil market’s global nature, of the fact industrial damage from high oil prices has nothing to do with a country importing or exporting oil, or even a crucial two-way link between worldwide industrial production and worldwide oil prices.

On causes and effects of high oil prices, nobody in Washington seems much interested in logic or facts. It might be sad if were it not so pathologically pathetic.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.

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