For producers and consumers, this situation is not better news: they would rather that rising prices were accommodated with increasing output and profits, instead of even falling prices straining the budgets of users, who must cut back on consumption.

Most of the discussion of increasing crude prices has centered on increasing demand from emerging economies, such as China and India.  And for good reason: emerging economic crude demand growth is 65per cent of total world demand increase, and has been for several years.  However, they start their growth path from very low initial levels, so demand will increase at an increasing rate in the first decade or more.  But even so, India consumes just 1.95 million bbd, while China consumes roughly 5.9-6.2 million bpd. 

But America already consumes 25 per cent of the entire world’s crude oil production of 84 million bbd, and additionally imports over 1.2 million bpd of gasoline.  American Gross Domestic Product (GDP) is also about 23 per cent of total world output.  And even while energy intensity in production is just 50 of what it had been in the 1970s, recent energy price increases must eventually have their effect on American buying habits.

Additionally, the world supply-demand balance is historically very tight, with a change in either demand or supply having great influence on prices.  So, it makes sense to ask how the American economy is adjusting to the two-year petroleum price run up.

America’s central banking authority, the Federal Reserve—or the Fed, estimates that it takes about 18-24 months for any monetary policy change of theirs to have an appreciable effect on economic behaviour. For instance, if the Fed raises interest rates on borrowed capital, it will take 18-24 months to before this largest of world economies shows any evidence that it is slowing down.

Like a supertanker, even if the captain orders "All ahead full," or "All stop," it takes a long time to see a change.  Higher oil and product prices should be expected to work the same way and take just as long to alter economic behaviour. Rising oil prices mean spending more for things that use energy, beginning especially with transportation and things dependent on transportation.  This increase acts the same as would a tax increase, making consumers virtually poorer. They have less money for the things they used to buy, especially for discretionary expenditures, which comprises such a large part of the American preferred diet.  The American economy is over 64 per cent consumption spending driven.  And while it is true that more intermediate and durable goods are imported into the US than in years past, much of these are also discretionary goods and not necessities. Sales of such goods will certainly be curtailed if Americans perceive that they are beginning to fall on harder times.

What all this means is that with the US consuming so much of the rest of the world’s goods and services, the world’s export-driven economies will also slow down because Americans have stopped buying.  It is just a matter of time.  When this happens a cascading process would cause the world economy to experience a recession, cutting demand for energy, even while upstream investments are beginning to increase crude supplies. In China a real estate bubble may be forming in spite of concerted efforts of the China central bank to curtail commercial and retail building construction. So much money has flowed into China recently that speculative real estate construction has been rampant in some Chinese markets.  If prices fall, banks and investors will have no way to get their money back. Look what happened to Japan after the bursting of its own real estate bubble in 1990.  It stumbled along with zero growth, deflation and negative bond interest rates, and even today, its GDP growth is considered eneamic.

China’s central planners still are proposing a vast growth in transportation and communication infrastructures, and they certainly have the money to do it.  But except for certain key commodities, this will likely not be the engine of demand the world has come to expect from China.  What this will mean for energy markets is unclear, because much of China energy demand will continue to increase even without robust building construction, as more and more Chinese gain access to electrical appliances, autos, better food and other energy-intensive goods.

While the combination of circumstances needed to cause outright reductions in crude prices back to levels seen two years ago are not expected, yet, with the slow but deliberate increases in upstream capacity, it is almost certain that crude prices will begin to moderate or reduce their rate of increase within two years. 

As intimated above, supply and demand relationships are relatively inelastic, meaning that a small percentage change in supply or demand will cause a large percentage change in the market price.

That is the fundamental analysis; but not much of the current crude price run up is explained by fundamental analysis, while most of it is explained by market psychology—expectations.  If expectations continue to fear a shortage—even in the face of increasing supply and moderating demand—prices will remain stubbornly high.  Indeed, much of the crude price climb, according to current Opec Chairman, is due to downstream bottlenecks in refining capacity. Crude is therefore likely more plentiful now than its price would indicate.  Lee Raymond, Chairman of ExxonMobil, stated on MSNBC over a month ago, that they are able to get all the oil they need and in the grades they need.  But supplies of heating oil, jet fuel and diesel fuel, and of gasoline, are clearly in short supply at prevailing prices.  Therefore, prices are expected to rise for these products, especially as we head into winter for Europe and North America.  Estimates from the Energy Information Administration (EIA) of the US Department of Energy and from other sources are predicting that home heating oil (and natural gas) is expected to go up in price by as much as 70 per cent.   

Then came Hurricane Katrina: With 25 per cent of US refinery and transshipment capacity located in the Gulf Coast states, the price for unleaded gasoline jumped from roughly $2.00/gallon to $3.00/gallon in just two days, before falling back.  In response to the hurricane’s damage to production, the US government released crude oil from its Strategic Petroleum Reserve, or SPR.  But, as with other releases in the world, such as that of the International Energy Agency, the IEA, even though this had the expected calming effect on the markets, it was not crude that was needed, but refined products, of which the SPR has zero; it only stores crude.  But it was refined products that markets needed not more crude. The total result is that Americans are experiencing significant energy cost increases. Even while the price for unleaded gasoline for October delivery has fallen back to around $2.00/gallon, the price at the retail level has barely fallen back at all from $3.00-plus levels. 

The worldwide refinery shortage has been well documented, and no surprise to readers of these pages.  Countries that had made a good living buying crude and selling refined products to the world, are seeing domestic demand increase to the extent that they have sometimes had to curtail refined product exports entirely.

In Europe and North America new refining capacity has not been added for as long as thirty years.  North American refineries have been working at 96per cent of capacity, causing immediate refined product price increases for any hint that a refinery will be off-line.  Now about another 500,000/bpd of refined products is off-line due to damage from Hurricane Katrina.  While expected news of refining capacity utilisation restoration in the next few weeks will certainly bring refined prices down—even lower than they were before, undershooting longer term expectations—this will only be a temporary reprieve from inexorably rising refined product prices in the US and elsewhere.  In these markets, there is nothing inaccurate about market expectations.

Where is the tipping point for American spending?  When will the ship of indomitable consumption behaviour founder—the expectational gravy-train finally grind to a halt  Economists believe that when direct energy costs reduce disposable income—and its discretionary expenditure component—by 3 per cent economic recession may ensue. The spike in prices from Hurricane Katrina could result in just that, and could cause Americans to have an "attitude adjustment." The next article will discuss the increases in efficient technologies installed when economies come out of recessions, and what this might do to energy demand.

The  author of this article is Dalton Garis, Associate Professor of Economics, The Petroleum Institute, Abu Dhabi.