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					                                                                $200                                                                                                                                       THE MAGAZINE OF INTERNATIONAL ECONOMIC POLICY
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                                                                  Oil!                                                                                               When oil was $35, he predicted a $60
                                                                                                                                                                     per barrel price. Then he predicted
                                                                                                                                                                     $150. Why the price will now go higher.

                                                                                                                                                                      BY PHILIP K. VERLEGER, JR.




                                                                                                                                                            P
                                                                                                                                                                                etroleum is the most misunderstood commodity in the world.
                                                                                                                                                                                For decades, policymaker ignorance regarding this “black
                                                                                                                                                                                gold” has had few consequences. Today, however, the world
                                                                                                                                                                                sits on the verge of recession because very few people in
                                                                                                                                                                                responsible positions comprehend the market. Furthermore,
                                                                                                                                                                                the advice of knowledgeable people who might counsel pol-
                                                                                                                                                                                icymakers is dismissed out of hand. As a consequence, the
                                                                                                                                                                                world faces a likely rise in crude prices to $200 per barrel or
                                                                                                                                                            higher, the permanent closure of many airlines, and the potential bankruptcy
                                                                                                                                                            and shutdown of the American icon General Motors. Billions across the globe
           The                                                    BY PHILIP K
                                                                              . VERLEGER,
                                                                                          JR.


                                                                                                                                                            will suffer.
         Oil-Dollar                                                                                                                                               Start from a very simple fact. The price of crude oil in the summer of 2008
                                                                                                                                                            should be $70 per barrel, not $140. The rise from $70 to $140 has not been caused
              Link                                                                                                                                          by a shortage of crude. Instead, it has resulted from bad policies, bad luck, and
                                                                                                      the dollar’s exchang
                                                                                                                             e rate and oil prices
                                                                       he relationship between decades. Oil-exporting countries jus-                        incredible inattention to market details by certain officials.

                                                T
                                                                                                    for
                                                                       has been debated now                                     per barrel in late
                      The Fed,                                                                        of price hikes to $10
                                                                       tified their first round inflation and the falling dollar. Oil-


        hedge funds, and
                                                                        1973 by blaming
                                                                        exporting countrie
                                                                        second major round
                                                                        the dollar’s
                                                                                               global
                                                                                               s again blamed the
                                                                                                  of price
                                                                                        resurging value was
                                                                                                                        weakening dollar
                                                                                                            increases in 1978.
                                                                                                                                             for the
                                                                                                                                  Eight years later,
                                                                                                                   cited as a cause of
                                                                                                                                           the 1986
                                                                                                                        and the dollar’s exchang
                                                                                                                                                    e
                                                                                                                                                                  The absence of a shortage can be seen clearly from satellite images of the
         why oil could hit                                               price decline. More
                                                                                                  recently, oil prices


               $150 a barrel.
                                                 rate have seemed to
                                                                         move as one.
                                                       However, the mechani
                                                  never been
                                                                                 sm that links the moveme
                                                                satisfactorily explaine
                                                                                                                nt of oil prices and
                                                                                            d. Indeed, a credible
                                                                                                       d a convinci
                                                                                                                                       the dollar has
                                                                                                                       explanation may never
                                                                                                                    ng theory for their
                                                                                                                                                   be
                                                                                                                                           coincident
                                                                                                                                                            Persian Gulf. There one can view some of the twenty or thirty tankers Iran has
                                                                         one to date has advance
                                                  found. Certainly no
                                                  movement.
                                                        Yet the relationship
                                                   Figure 1. This graph
                                                                                clearly exists, particula
                                                                           presents the spot price
                                                                                                             rly since 2007, as
                                                                                                         of “Dated Brent,”
                                                                                                  and the dollar’s exchang
                                                                                                                                   can be seen from
                                                                                                                               the world’s crude
                                                                                                                                                    oil
                                                                                                                              e rate against the right.
                                                                                                                                                            chartered to store oil it cannot sell. Even as crude oil surges toward $200 per bar-
                                                                         the left vertical axis                           st to observe the linkage.”
                                                   benchmark, against                            need to be an economi
                                                   To paraphrase Bob
                                                         Why does one observe
                                                    way to answer the
                                                                         Dylan, “You do not
                                                                                     this linkage and what
                                                                          question would be
                                                                                                   to
                                                                                                                does it portend
                                                                                                       construct a detailed
                                                                                                                                  for the future? One
                                                                                                                              econometric causality
                                                                                                           one group of brilliant
                                                                             were made, I am sure oil price movements were caused by
                                                                                                                                      econometricians       rel, Iran cannot move a good portion of its output.
                                                    study. If such efforts                               that
                                                                           linkage which showed equally brilliant group would find the
                                                    would find a causal                                                                                 a
                                                                                 e rate while a second                          although I was once
                                                    changes in the exchang to conduct this kind of examination,
                                                                                                                                   nt movements of oil
                                                     reverse. I do not propose Instead, I suggest that recent coincide                          Federal
                                                     practicin g econometrician.                              declinin  g confidence in the
                                                                                  exchange rate reflect                                rise in oil prices
                                                      prices and the dollar’s                                  ore, I show that the
                                                      Reserve’s ability to
                                                      over the
                                                                             contain inflation. Furthermsince January 22, 2008—shares many
                                                               last six months—particula
                                                                                               rly the surge

                                                                            Jr., is principal of PKVerle
                                                                                                             ger LLC.
                                                                                                                                                            Philip K. Verleger, Jr., will become the David Mitchell-Encana Professor of
                                                       Philip K. Verleger,


        46   THE INTERNATIONAL
                                 ECONOMY   SPRING 2008                                                                                                      Strategy and International Management at the Haskayne School of Business at
                                                                                                                                                            the University of Calgary in September.

12   THE INTERNATIONAL ECONOMY                                                                                                        SUMMER 2008
                                                                                                                     VERLEGER




Shell refinery at Hemmingstedt, Germany. The European demand for diesel and Congressional ethanol rules have created a
dilemma for refiners: how to make jet fuel and diesel fuel containing essentially no sulfur while cutting gasoline production.


     Iran’s dilemma frames the current situation. The coun-          Demand growth for diesel and jet fuel has been partic-
try produces a very heavy crude oil with a high sulfur con-     ularly strong in Europe. There, government tax policies have
centration. In today’s modern refineries, these crudes can be   encouraged consumers to buy diesel rather than gasoline-
processed aggressively to make substantial gasoline volumes.    powered vehicles. The logic of the policy was compelling.
In the best facility, a 42-gallon barrel of heavy sour crude    Diesel-powered cars get better mileage. Thus substitution of
can be cooked and split to produce as much as 21 gallons of     diesel for gasoline would cut the continent’s use of oil. This
gasoline.                                                       policy today has run up against a supply constraint.
     Unfortunately, world consumers do not want gasoline             European consumers are also very insensitive to changes
today. Instead, they seek diesel fuel and jet fuel. Most mod-   in the crude oil price. At retail, they pay around $420 per
ern refineries are not yet configured to produce jet fuel and   barrel for diesel. Of course the pumps do not display this
diesel fuel from heavy sour crudes. By 2012, this constraint    number; rather they show €1.7 per liter. The very high diesel
will be remedied. Today, though, refiners must choose other     price requires crude prices to increase by as much as $40 per
alternatives to satisfy consumer demand.                        barrel to get a one percent cut in use, given the very low
                                                                short-run price elasticities of demand for petroleum prod-
                                                                ucts in industrialized economies.
                                                                     The simplest way to satisfy consumer demand for diesel
  Ironically, U.S. refiners are struggling                      and jet fuel is to process light sweet crude oils. Such oils
                                                                are produced in Nigeria in large volumes, in the North Sea,
                                                                in Libya and Algeria, and in the United States. When
    to meet European demand thanks to                           processed at technically advanced refineries, these crudes
                                                                can produce as much as 30 gallons of diesel and jet fuel
                                                                from a 42-gallon barrel. In contrast, the same facilities can
      renewable fuel legislation passed                         extract perhaps 12 gallons of diesel and jet fuel from a bar-
                                                                rel of heavy sour crude.
                                                                     Total global production of these light sweet crudes totals
              by the U.S. Congress.                             roughly 12 to 15 million barrels per day out of a worldwide
                                                                crude production of 81 million barrels per day. Nigeria is the
                                                                leading producer of light crude with a capacity of 2.6 million

                                                                                     SUMMER 2008    THE INTERNATIONAL ECONOMY     13
VERLEGER




     barrels per day. However, civil strife has lately reduced out-
     put. The recent peak in production was 2.3 million barrels
     per day in December 2006. This last April, it dropped to 1.766                            Diesel War
     million barrels per day as rebel attacks disrupted operations.


                                                                             A
          The loss of Nigerian output is the first and most signifi-                   dvocates of free trade should worry that the
     cant contributor to the spectacular rise in crude prices. The                     United States may be forced to limit or pro-
     difficulties there may account for a supply cut of as much as                     hibit such exports. A version of diesel is used
     400,000 barrels per day.                                                for heating in the Northeast. Politicians may suspend
          The effect of events in Nigeria has been made worse by             exports if it appears that stocks will be insufficient to
     EU and U.S. environmental policies. Over the last two years,            meet winter needs. The principles of free trade will
     the U.S. Environmental Protection Agency and its European               be sacrificed to prevent Americans from freezing in an
     counterpart have required refiners to cut sulfur content in             election year.
     diesel fuel to 10 to 15 parts per million from much higher                                                        —P. Verleger
     levels. The U.S. rules went into effect in 2006. EU rules are
     being phased in by the end of this year. Refiners are rushing
     to meet these standards. One way they do this is to make less
     diesel. Europe, for example, has become a large importer of
     the fuel, while the United States has become a significant          make jet fuel and diesel fuel containing essentially no sulfur
     exporter for the first time in years. Traders report that the       while cutting gasoline production. The solution is to aggres-
     United States will export perhaps 400,000 barrels per day to        sively pursue the shrinking supply of light sweet crude. Thus,
                                                                         over the last six months, one can observe an extraordinarily
                                                                         tight link between the price of Brent crude (a sweet crude
                                                                         produced in the North Sea that is a key benchmark) and the
       The world sits on the verge of recession                          spot price of low-sulfur gasoil, an indicator of the spot price
                                                                         of diesel fuel in Europe. The linkage is tight and the econo-
                                                                         metrics are compelling. The conclusion is clear: European
       because very few people in responsible                            demands for very-low-sulfur diesel are diving crude prices
                                                                         up. Prices will continue to be pulled higher until the diesel
                                                                         constraint is broken by falling demand (induced by reces-
           positions comprehend the market.                              sion) or increased supply.
                                                                               In these circumstances, policymakers have very limited
                                                                         alternatives. First, they can relax environmental standards.
                                                                         There are supplies of higher sulfur diesel that would address
     Europe in July. A year ago, no diesel exports were going from       Europe’s current needs. Second, governments can release
     the United States to Europe.                                        strategic stocks. The United States and other IEA members
          Advocates of free trade should worry that the United           hold significant sweet crude inventories. Release of these
     States may be forced to limit or prohibit such exports. A ver-      crudes (perhaps in a swap) would relieve pressure on prices
     sion of diesel is used for heating in the Northeast. Politicians    while preserving environmental restrictions. Third, the United
     may suspend exports if it appears that stocks will be insuffi-      States can suspend the renewable fuel mandate. This action
     cient to meet winter needs. The principles of free trade will       would allow refiners to boost runs and produce more diesel
     be sacrificed to prevent Americans from freezing in an elec-        fuel. Suspension of the renewable fuel act would also take
     tion year.                                                          pressure off food prices.
          Ironically, U.S. refiners are struggling to meet European            Regretfully, none of these actions will likely be taken.
     demand thanks to renewable fuel legislation passed by the           The failure of policymakers to diagnose the causes of the
     U.S. Congress. In November 2007, Congress ordered refin-            crude price increase properly makes the adoption of rational
     ers to blend an extra four billion gallons of ethanol into gaso-    policy improbable. Prices will continue to rise. A year ago I
     line in 2008. Complying with the mandate forces refiners to         wrote this in these pages: “…[L]ooking forward, it appears
     produce less gasoline from crude. Since diesel, heating oil,        that triple-digit oil prices may become a regular feature of
     and jet fuel are other products of refining, Congress, in effect,   the global economy within three or four years, and soon the
     has ordered refiners to make less of these other products.          first digit may be something other than a one.” However, I
          The European demand for diesel and Congressional               did not expect incompetent energy policy to bring $200 oil to
     ethanol rules have created a dilemma for refiners: how to           the fore so quickly.                                         ◆

14   THE INTERNATIONAL ECONOMY      SUMMER 2008

				
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