Washington File
May 4, 2006
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State Department (DOS)
State Department (DOS)

High Oil Prices Due to Limited Production Capacity, Say Analysts

Production capacity fails to match demand growth, experts say

By David Shelby
Washington File Staff Writer

     Washington--The global oil market is suffering from a "slow-motion supply shock" as productive capacity has failed to keep pace with the strong growth in demand in recent years, according to Cambridge Energy Research Associates Chairman Daniel Yergin.

     "I think we can say the focus of the market, which was on demand, has really now shifted to supply, and that we are experiencing a slow-motion supply shock," Yergin told members of the House Committee on Energy and Commerce during a May 4 hearing on the current dynamics of the oil market.

     Both Yergin and Guy Caruso of the U.S. Energy Department's Energy Information Administration told committee members that the margin of excess oil production capacity has become extremely narrow in recent years.

     Caruso explained that excess production capacity serves as a cushion against unexpected shifts in demand and supply, but he said, "Today, the cushions just aren't available to make an effect on this market, and as a result of that, the only pressure relief valve is price."

     Caruso said that oil producers built substantial new production capacity following the two oil price shocks of the 1970s, but after the price fell in the 1980s, they reduced production, leaving a large part of their new capacity as unused surplus. As demand grew through the 1990s, he said, producers raised their production without creating new capacity, thereby narrowing the margin of surplus.

     Caruso said the excess capacity margin was 3 million to 4 million barrels per day in the mid-1990s and as high as 11 million barrels per day in the mid-1980s but that it is currently only 1 million to 1.5 million barrels per day, meaning that the world is using about 98 percent of its total capacity. He said that if there is one key factor driving the sharp rise in oil prices, it is the lack of surplus production capacity.

     He said the current strain in the market dates to 2003 and 2004, which saw dramatic rises in global demand. Even though the growth in demand slowed during 2005, Yergin explained, several geopolitical and natural events kept supplies tight.

Forces Driving the Oil Markets

     He said the prime risks in the oil market "are not the resources underground but what is happening above ground--politics, geopolitics, policies, and a rebirth in some parts of the world of what sure looks like a 1970s-style resource nationalism."

     Specifically, he mentioned recent political unrest in Nigeria's oil-rich Niger delta. Armed conflicts have removed 550,000 barrels per day from the market. In addition, the market has seen a 400,000 barrel-per-day drop in Venezuelan production, a 900,000 barrel-per-day drop in Iraqi production. Another 324,000 barrels per day are still off-line from the 2005 Gulf of Mexico hurricane season.

     On top of this, he said, the rising tensions over Iran's nuclear program raise fears in the market about the future of Iran's 2.5 million barrel-per-day output. "In this market, the risk of escalation is enough to send oil prices up," he said.

     He said, "On the one hand, maybe we're seeing a demand response which takes the pressure off, but on the other hand, where's the next problem going to come from that might take out another couple hundred thousand barrels a day? And I think the other thing, of course, everyone is worried about is that hurricane season begins in a month."

     Both Caruso and Yergin also cited a potential supply bottleneck in refining capacity. Caruso noted that global excess refining capacity is shrinking, with refinery utilization currently running at 90 percent of capacity, up from 85 percent in 2002.

     Caruso said that the supply side of the market is slow to respond to rising prices because capacity-expansion projects take time. Yergin noted, however, that Saudi Arabia has committed $50 billion to capacity-expansion projects.

     He also warned that as oil producers around the world seek to increase capacity, they are bidding for the same experts and equipment, making the cost of new projects sharply higher than five years ago.

• (The Washington File is a product of the Bureau of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)

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