The Worldwide Oil Market:
Are High Oil Prices Here to Stay?

During the last four years, the oil market has experienced substantial price volatility, as well as historically high prices for crude oil and the major light products: gasoline and diesel. In mid-April 2005, the Light Sweet Futures New York Market Exchange (NYMEX) contract rose above US$60/barrel (bbl), and the futures contracts through 2011 predict crude prices in the $50s. West Texas Intermediate (WTI), the U.S. light sweet crude oil marker, has consistently been above US$40/bbl since July 14, 2004, with an average price of $53.91/bbl for the first quarter of 2005. The latest short-term projections from the U.S. Energy Information Administration (EIA) suggest average prices staying above $50/bbl through the end of 2006. At the same time, the prices for gasoline and diesel in the United States have reached historic highs.

PDF Version of Article   This article was published in the Spring/Summer 2005 issue of Perspectives. Please refer to our Terms of Use policy regarding acceptable use of content on the ICF International Web site.

Is this a temporary phenomenon, or are high oil prices here to stay? What has changed in the market?

Much of the price increase is being driven by market fundamentals. Underestimated demand has been a widespread and consistent problem in developing countries, such as India, China, and Brazil, as well as the United States. Estimates are that this demand growth will continue, albeit at a somewhat lower rate. On the supply side, the previous decade of low prices resulted in general underinvestment in oil production. Investment levels continue to be low due to uncertainty over whether the high prices will continue.

The International Energy Agency (IEA) recently completed a detailed study of energy investment requirements out to 2030. Total estimated investment requirements total US$16 trillion, or one percent of world gross domestic product. Oil accounts for $3.1 trillion, with conventional oil production accounting for the bulk of the investment at $2.2 trillion, and an additional $205 billion needed for nonconventional oil. The investment needs of tankers and pipelines amount to $260 billion, while $410 billion is needed for refineries, predominantly in the Middle East, Africa, and Asia.

Refining also is faced with considerable uncertainties. The continual push worldwide for more stringent product specifications will be challenging for many of the refiners in the developing world. Refinery inflexibility in a world of changing specifications is resulting in a widening margin between light sweet crude oils and the heavier, sour crude oils, as well as upward pressure on the prices of sweet crude oils.
Compounding the impacts of a tight supply/demand picture are changes in stock levels, spare capacity, the decline of the dollar, changes in market structure, and geopolitical events that reduce the flexibility of the market to respond in a timely manner. Each of these factors is described below.

Stock Levels. Substantial efficiency advances in the management of liquid inventories have been made during the past decade. The advances in electronics and software management systems allow industry to monitor stock levels much more effectively and in real time, facilitating a more optimal use of stocks. This, combined with similar efficiencies and advances in shipping technology, has allowed the petroleum industry to adopt a version of the just-in-time inventory approach.

Spare Production Capacity. Historically, the Organization of Petroleum Exporting Countries (OPEC) maintained that spare capacity needs to be four percent of world demand to regulate the market. Data from 2004 shows that spare capacity fell to approximately one percent of world demand. Much of the current nervousness in the market is based on the realization that little spare capacity exists in the event of a major supply crisis.

Decline of the Dollar. Oil is denominated in U.S. dollars in the international market. Thus the oil-producing countries are concerned that the declining value of the dollar will reduce their ability to purchase on the world market. The former OPEC price range of US$22 to $28 translates into $29.26 to $37.24 in Euro-adjusted dollars.

Market Structure. In the 1990s, the trend was toward market liberalization and globalization, and the oil market was an active participant. A characteristic of this trend was the lessening role of states or state entities in the markets. However, the four years of the 21st century have seen increasing involvement in the market by states through national oil companies. The world appears to be evolving into several markets, ranging from a free market to a restricted, government-controlled market, with variations in between.

Geopolitical Events. A substantial percentage of the crude oil on the market today (and in the future) is from the Middle East. The concern over this region’s political instability has been heightened by similar concern about other major producers, such as Venezuela, Nigeria, and Russia. In addition, some major new findings, such as the discovery of oil in Kazakhstan, are far from markets. Oil from these distant locales must be transported over pipelines running through some of the most politically unstable parts of the world.

All of these factors will continue to exercise a large impact on the oil market and prices. Tight markets like this tend to be inflexible in their response to crises and are marked by price spikes and volatility. ICF International analyses indicate that the oil market will continue to be tight at least until 2010 to 2015.

Learn more about ICF International’s fuels market forecasting.