JANUARY 28, 1999




Testimony to the Senate Energy and Natural Resources Committee

January 28, 1998

By Jay Hakes, Administrator

Energy Information Administration

U.S. Department of Energy



I wish to thank the Committee for the opportunity to testify today on the state of the petroleum industry, which is experiencing unusually low crude oil prices. As you may be aware, the Secretary of Energy established an internal task force to develop recommendations to address this situation. As Administrator for the Energy Information Administration (EIA), which is an independent analytical and statistical agency, I have been asked to set the stage for the other speakers by focusing mainly on what is behind the low prices, and on some of the effects we are already seeing in the United States -- both good and bad.

For example, inflation has benefited from low energy prices. Declining energy prices, particularly in the oil sector, have been a significant factor contributing to the low inflation rate during the past several years. Inflation can be measured from changes in the Consumer Price Index (CPI), which is calculated from data representing a wide variety of goods and services across the nation. As of December 1997, "Energy" was calculated to represent approximately 7 percent of the overall CPI. Energy prices rose less than other prices in 1994 and 1995, reducing the inflation rate by about 0.2 percent. In 1996, when energy prices increased substantially, they boosted the inflation rate by about 0.2 percent, but when energy prices began to weaken during 1997, they lowered the rate by 0.2 percent. But a large 7.7 percent decline in the energy category of the CPI in 1998 reduced the overall index 0.7 percent from what it would have been without the energy price decline. Thus, instead of inflation being about 2.3 percent in 1998, we only saw about a 1.6-percent increase.


Gasoline Prices Lowest Ever (Figure 1)

Today, the cheapest liquid you can buy at a service station is gasoline. Figure 1 shows that in 1998, consumers enjoyed the lowest gasoline prices in inflation-adjusted terms since 1942, and possibly the lowest ever. Regular gasoline prices averaged only $1.03 in 1998, but this obscures the fall off at the end of the year. In November and December gasoline prices averaged less than $1.00 per gallon ($0.995 and $0.945 per gallon respectively), and the latest weekly Energy Information Administration (EIA) data shows them at $0.936. This is about $1.33 per gallon less than we paid in 1981 in inflation-adjusted terms, and $0.37 cheaper in nominal terms. That 30-cent-per gallon gasoline that some people may recall buying in the 1950’s and 60’s is equivalent to about $1.50 in today’s dollars.

All petroleum products have fallen in price as a result of a 55-percent decline in crude oil prices since December 1996 (West Texas Intermediate monthly averages). Crude oil is the raw material from which gasoline is made, and in 1998, represented about 30 percent of the price of gasoline. Taxes (federal and state) on average represented over 35 percent; although, taxes vary significantly from state to state and even among localities within states. The remaining one-third of the price represents refining, marketing, distribution costs and profit margins. When petroleum product prices move as much as they have recently, it is primarily due to changes in crude oil prices.


Low Crude Oil Prices Not Likely to Rebound Soon (Figure 2)

Figure 2 provides a perspective on the recent decline in crude oil prices relative to other recent declines and increases. Monthly average crude oil prices fell about 55 percent ($14 per barrel) from about $25 per barrel in late 1996 to just over $11 in December 1998. The West Texas Intermediate (WTI) crude oil price shown in Figure 2 is not what all producers receive for their crude oil. Heavier crude oils normally sell at a discount. EIA data are showing many transactions for low quality crude oils at less than $6 per barrel.

The decrease in price since 1996 occurred in two steps. The first $5-6 per barrel drop represented a retreat from unusually high prices at the end of 1996 before Iraqi crude oil returned to global markets. By spring 1997, prices settled briefly into the typical historical trading range of $17-$21 that has existed since 1986 (excluding the Gulf War). The second $8-9 decline began at the end of 1997 with the drop in demand caused by the Asian financial crisis, and continued through 1998 as Iraqi production increased even more after UN Security Council limits were raised. Average refiners' crude oil prices have not been this low in real terms since 1972, and in nominal terms since 1978.

The current decrease approaches the size of the drop in prices experienced in early 1986, but there are differences in the factors driving the decline. At the end of 1985, Saudi Arabia was no longer willing to be the major swing producer, reducing its production to balance worldwide markets as demand declined in the early 1980's and non-OPEC production increased. Saudi Arabia therefore announced a new pricing regime and increased production. In the four months from November 1985 through March 1986, prices plunged about 60 percent (over $18 per barrel) from almost $31 to about $12.50. In contrast, the current $14 per barrel decline occurred over 24 months. In 1986, prices didn't bottom out until July when they averaged $11.60; however, they rebounded fairly quickly and settled into a $17-$21 trading range by January 1987. A quick rebound is not likely in the current situation. EIA projects WTI oil prices reaching $15/barrel by the end of 1999, but they are not likely to return to the historical $17-$21 trading range until the end of 2000 or 2001. I will explain shortly why the recovery may take some time.

The 1986 price drop marked the transition from a world dominated by long-term contracts and official prices to one driven by spot and futures trading and of supply (production) and demand imbalances driving immediate price responses. We now see crude oil supply and demand moving in cycles like other commodities -- shifting from too little supply to too much relative to demand, with prices reflecting the changes. Figure 2 shows the shift from a weak price market in 1993, to a strengthening one through 1996, ending with our current weak-market cycle.


World Supply/Demand Imbalance Behind Current Low Prices (Figure 3)

This cyclic effect is demonstrated more directly in Figure 3, which shows quarterly world petroleum production (in gray shading) and world demand (the dotted line). Normally world petroleum demand is seasonal -- being higher than production in winter when heating needs increase, and lower than production in summer. As a result, petroleum stocks normally build in summer and are then drawn down in winter (black areas) when demand exceeds production, as seen in 1994-1996.

As with other commodities, longer-term supply/demand cycles are overlaid onto this seasonal pattern. When production exceeds demand for petroleum worldwide for a year or more, prices weaken. Since early 1997, we see little or no seasonal stock draws, mostly stock builds, a pattern that is due to both supply and demand factors. We had a similar pattern in 1993 when the lingering effects of the 1991 world recession and the collapse of the former Soviet Union’s economy, coupled with a warm winter, kept demand below supply all year. During that period, crude oil prices also fell, but only about $7 per barrel. That weak cycle ended when increased demand from a cold first quarter and renewed economic growth removed the surplus supply. The current market imbalance is larger than that in 1993, as shown on the next chart.


Stocks Reflect the Supply/Demand Imbalance (Figure 4)

The present oversupply cycle has resulted in an unusually long interval of building stocks. OECD country stocks are now at very high levels, as seen in Figure 4. OECD stocks generally follow the seasonal patterns just discussed. But this chart shows very small winter inventory reductions during the last two years. There are mainly four reasons behind the oversupply and weak prices:


Until the large stock overhang is eliminated, prices are not likely to return to the historical $17-$21 trading range. We may be seeing recent signs of both a more normal seasonal demand-supply cycle and the beginning of a reduction in the surplus inventories, but the EIA projects that prices may not return to the historical trading range until the end of the year 2000 or 2001. The re-balancing of production and demand to remove the current stock excess and to support a higher crude oil price depends on the four highly uncertain factors just discussed.


Low Oil Prices Reduce Production and Increase Imports (Figure 5).

Low oil prices stimulate higher demand growth and a steeper U.S. production decline. Imports must increase to meet both higher consumption and the loss of domestic production. Even if prices eventually recover to levels more typical of the mid 1990’s, we expect to see some net increase in import requirements lasting through 2005 as a result of today’s low prices. Our current forecast has WTI prices remaining low for the next several years before rebounding to about $25 per barrel by 2005. This forecast generates an expected increase in U.S. net petroleum imports of 3.2 million barrels per day between 1997 and 2005. That is about 0.4 million barrels per day higher than what we would expect if oil prices remained in the historical trading range of $17-$21 per barrel. The forecast also generates production declines of 1.1 million barrels per day between 1997 and 2005, which is about 0.4 million barrels greater than had oil prices remained in the historical $17-$21 trading range.

Two scenarios using crude oil prices ranging $3-$4 per barrel higher and lower than in the expected price case show the interesting result that production responses are not symmetric to upward and downward price changes. An oil price decline of $3-$4 could reduce production 0.4 million barrels per day more than in the expected price case. But a price increase of $3-$4 might result in a production decline of 0.7 million barrels per day less in the high price scenario than in the expected price case. The asymmetry of these results is due to a number of leases in the Gulf Coast, which are not developed in the expected or low price scenarios, but reach their economic threshold in the high price scenario.

We already see the industry responding in a number of areas. From December 1997 through November of 1998, operating oil rigs have fallen 47 percent, gas rigs 23 percent, and footage drilled 28 percent. Exploration and production expenditures are also falling. According to Salomon Smith Barney’s expenditure survey, total U.S. exploration and production expenditures planned for 1999 are 21 percent below 1998 expenditures, following a 0.2 percent decline in 1998.

Production in 1998 and 1999 is not expected to show the full impact of these reductions. Production exhibits inertia, responding slowly to oil price changes. Price changes tend to retard exploration and development plans to a greater extent than production; although, marginal wells begin to be shut in as prices decline. Generally, significant production changes lag large price changes.

As exploration and development slow, U.S. onshore areas see the effects first, since U.S. offshore drilling projects are of much longer duration and therefore trail off more slowly. Additionally, onshore activities contain more small firms that have fewer resources to continue operating during a price downturn. Production shut-ins are more likely onshore as well, since this area contains more marginal wells with high lifting costs, such as those associated with enhanced recovery, heavy oil production, and small volume wells. Since independent producers represent the majority of onshore production (almost 60 percent in 1997), they are likely to bear a larger portion of the U.S. production decline than the major oil companies.

In conclusion, oil prices are not likely to return to the $17-$21 trading range until the end of the year 2000 or 2001. This is good news for consumers and the general economy. The downside is that imports will likely rise as the domestic oil industry reduces costs, increases productivity, or contracts, with accompanying regional economic impacts, including job losses, business losses, and reduced severance tax revenues.

This concludes my testimony before the Committee. I would be glad to answer any questions at this time.



1.  OPEC – Organization of Petroleum Exporting Countries

2.  OECD - Organization for Economic Cooperation and Development