Editorial - Heeding demand growth

Sept. 27, 2004
Edward M. Gramlich, a governor of the US Federal Reserve System, recently pointed to an important but insufficiently noticed distinction between the recent oil-price leap and its predecessors.

Edward M. Gramlich, a governor of the US Federal Reserve System, recently pointed to an important but insufficiently noticed distinction between the recent oil-price leap and its predecessors. He made his observation in a Sept. 16 speech on oil shocks and monetary policy in Kansas City, Mo.

"In the 1970s and 1980s," he said, "most oil shocks seemed clearly to be on the supply side in that international producers withheld production from the world market either because of attempts to gain more oil revenue or because of other supply interruptions, such as the Iranian Revolution. Today, the high price of oil is much more likely to be due to demand growth in the United States, China, India, and other countries."

Diminished surpluses

As has been noted here many times recently, an oil-consuming world accustomed to a market in which the ability to deliver supply comfortably exceeds consumption, at least most of the time, now confronts something different: a market with greatly diminished surpluses and intensified worry about future supply.

An important question is whether the surge in demand that created these conditions will continue despite the consequent elevation of price. Gramlich suggests that it might, citing the energy needs of rapidly growing economies and the market expectations evident in high prices of futures contracts for delivery of oil years from now.

Analogous to these strains in the global market for crude oil is a squeeze looming for a specific oil product in the US. If recently reported expectations about vehicle preferences come true, trouble with diesel will be difficult to avoid.

Sulfur-content regulations coming into effect in 2006 will limit US capacity to produce compliant diesel and increase dependency on imports. Predicting supply and price effects is difficult. Large refiners are building or already have completed the new equipment needed to make ultralow-sulfur diesel. Many small refiners won't make the necessary investments, although recently healthy refining margins probably encourage most of them to delay fateful decisions. Closure of some unpredictable number of small refineries remains likely, along with exits by others from diesel markets covered by the new regulations.

US capacity to make diesel thus appears destined to shrink or at best stagnate as production costs rise. Unless demand falls, this is a prescription for higher prices and increased sensitivity to variations in supply from abroad.

Yet demand looks set to rise. This month, the US Department of Energy's Oak Ridge National Laboratory reported findings of a study predicting 4-7% growth in the light-duty diesel vehicle fleet by 2012. The Diesel Technology Forum, which represents manufacturers of engines and fuel and emission-control systems, thinks growth in that period will be 10-15% (OGJ, Sept. 13, 2004, p. 7).

The DOE study says consumers in significant numbers consider diesel engines more powerful and efficient and less polluting than gasoline counterparts. The validity of those assumptions isn't at issue here. The point here is that vehicle buyers acting on environmental and efficiency assumptions without considering prospective limits on diesel supply might be headed for unpleasant surprises on fuel cost.

The market will sort all this out, of course, and maybe provide compensating surprises with supply. Still, forecasts for demand growth in a market now shedding capacity to deliver the product are cause for worry.

Need for adjustment

Policymakers especially should pay attention to the oil market's new and possibly protracted tightness. In comments filed with the US Environmental Protection Agency Aug. 30, the National Petrochemical & Refiners Association issued a gentle warning to this effect in the context of diesel pressures. EPA wants to apply the low-sulfur requirement, initially covering highway vehicles and later off-road vehicles, to diesel-powered boats and trains as well. NPRA supports the extension but wants EPA to take supply questions into account as it sets timing and implementation rules (OGJ, Sept. 13, 2004, p. 25).

That's good advice, not only for EPA and not only for regulation of sulfur in diesel. As Gramlich noted in his Kansas City speech, a supply-limited market in which demand needs to grow differs from one in which price surges come from supply disruption alone.

For consumers and regulators, oil markets growing without the twin cushions of brimming inventories and idle production capacities represent something new. Both groups need to adjust.