Price Increases in the Crude Oil Market

Testimony before the US Senate Committee on Homeland Security and Governmental Affairs

December 11, 2007

Mr. Chairman, members of the Subcommittee on Investigation and the Subcommittee on Energy, it is my pleasure to discuss today developments in world oil markets. In my testimony, I will briefly describe the market changes that have occurred this year and then explore some of the widely cited explanations for these changes. My analysis leads to the following conclusions.

First, the rise in light sweet crude prices to almost $100 per barrel in November came about because the U.S. Department of Energy has been removing a significant share of the daily volume of this type of crude from the market for storage in the Strategic Petroleum Reserve. The volumes have amounted to as much as 0.3 percent of the global supply of light sweet crude available. DOE’s actions may have added as much as 10 percent to the light sweet crude price, given the very low estimated price elasticity of demand for crude and the likely even lower price elasticity of demand for light sweet crude. This conclusion is supported by the fact that producers of sour crude oils such as Saudi Arabia have had to institute price cuts of as much as $10 per barrel for sour crude.

Second, prices have been pushed higher because private firms have been reducing inventories. Over the last six months, U.S. refiners liquidated as much as 50 million barrels of crude oil stocks. This liquidation occurred because holding stocks was no longer profitable. The decline in profitability can be traced to the turmoil in financial markets and to greater sophistication on the part of investors who acquire commodities as an asset class. The change in profitability makes it almost impossible for OPEC to inject additional oil into inventories owned by private companies even if commanded to do so by the Secretary of Energy and the International Energy Agency’s Executive Director.

Third, light sweet crude demand has been boosted by new environmental regulations requiring the removal of almost all sulfur from diesel fuel sold in the United States, Canada, and Europe. The need to manufacture diesel containing less than 10 parts per million of sulfur for sale to motorists and truckers—and soon other diesel users—creates an operating hurdle for refiners that is more easily met with low sulfur crudes. This has created added demand for light sweet crude.

Fourth, the price rise cannot be explained by international events such as the dispute between Turkey and the Kurds or concern over Iran’s nuclear program. To the contrary, the international scene has become calmer, as demonstrated by the declining American casualty rate in Iraq. All things being equal, prices would have decreased if the only recent change was one experienced in the international arena. As I suggest below, there is no risk premium for crude.

Fifth, the current oil price increase has not been spurred by speculation. I conclude by suggesting that Congress and the Bush administration could change the current market environment by altering the management of the strategic reserve. A policy where storage of sour crudes is accelerated and stocks of light sweet crudes sold off would allow the United States to fill the strategic reserve faster and relieve some, if not all of, the upward pressure on crude prices. Ultimately, this strategy would leave the U.S. SPR with a billion or more barrels of sour crude that almost all refiners could process. However, it would also require relaxing certain EPA regulations during a severe emergency, as was done after Hurricane Katrina.

More From: 

Philip K. Verleger Former Research Staff

More on This Topic