Q&A: The Demand/Supply Dilemma, Consumer Impacts and the Need for Sound Policy

Mark Green
Posted July 1, 2021

In recent weeks API Chief Economist Dean Foreman has noted the return of petroleum demand, as economies strengthen in the U.S. and globally, to a level that’s outpacing supply (see here). In the Q&A that follows, Dr. Foreman discusses the impacts of the supply-demand mismatch on American consumers and markets, as well as the consequences of the Biden administration’s energy policy signals.

Q: What’s happening with gasoline prices this summer and is it unusual?

Foreman: Recent U.S. average regular gasoline prices have been about $3.10 per gallon for regular gasoline and $3.72 per gallon for premium grade, per the AAA. Month to month, these are up about 5 cents per gallon – and up by a little over 90 cents a gallon since last year. However, last year was an anomaly due to the pandemic. This year, June gasoline prices look like they've been averaging about 11% above the average for the year so far. If we compare to historical norms for June, that’s about right.  The summer driving season with its higher demand would typically be about 8% higher than the annual average. So, this year isn't standing out as structurally different.

Let's also keep in mind that crude oil prices are the main contributor to gasoline prices and also are up this year along with the rebound in the economy and oil demand. Higher oil demand and solid but relatively flat supply has spurred higher prices for crude oil and consequently gasoline so far this year, and the rough magnitude of these changes has actually worked out to be about what one would expect based on history.

Q: Is there an energy supply/demand mismatch that’s somewhat reflected in pump prices?

Foreman: The thing that has really stood out in API’s primary data, which we’ve seen for most months so far this year, is that U.S. petroleum demand has returned to within a hair of where it was in 2019. And in 2019, that's a high benchmark, because for the months of April and May these were some of the strongest demand U.S. petroleum numbers for the months in 11 years. For gasoline in April, it was the highest demand ever for the month. In the U.S. Energy Information Administration’s Weekly Petroleum Status Report, demand in the U.S. was 20.8 million barrels per day – basically, where it was in the same week in 2019. The question isn't whether petroleum demand is back. The question is whether the U.S. is representative or just ahead of where the rest of the world. From the EIA’s perspective, we notice that for June the demand is less than 3% off from where it was in 2019 – remarkably close for all the changes that we went through with the pandemic.

At one point in late 2019, the U.S. was close to 13 million barrels per day of crude oil production. Now we’re around 11 million barrels per day – we're down by roughly 2 million barrels per day. As that's happened, we have drilling activity that's like half what it was in 2019. We have supply that remains solid, but it's not growing back toward 13 million barrels per day at this point. Rather, it’s been wavering in a range and hasn't shown a consistent trajectory to recover back to 2019 levels. Yet, demand is right back where it was in 2019. The International Energy Agency (IEA) sees this as well and has noted that supply has outpaced demand. Actually, Saudi Arabia and Russia have echoed the same about a potential supply crunch.  If that leads to even higher crude oil prices, that risks gasoline prices moving higher in response.

Q: What other impacts may be seen from supply not meeting demand?

Foreman: In 2020, the U.S. was a petroleum net exporter on an annual basis for the first time since 1958. But for most months so far this year and projecting into next year, EIA has the U.S. reverting to being a petroleum net importer. This is a real and tangible cost to not having domestic supply. It's pretty clear in the data that the growth of domestic supply over the last five and 10 years basically ended the stranglehold that OPEC traditionally had on crude oil prices. That's reversed now, and unless and until U.S. supply comes back, it could affect the overall price level globally and in the United States.

It could also affect the cost advantage that some sectors of U.S. manufacturing have had both domestically and in exporting things internationally. Then there's the straight-up trade balance and the fact that if we’re running a trade deficit on top of federal budget deficit, then we're losing value, and the real value of the U.S. dollar, our economic security and our national security ultimately is weakened as a result of this. It's all tied together in a pretty holistic system. Having energy policies that have the end goal of fostering U.S. economic and energy security, maximizing the use of our resources in an economic way and also providing market mechanisms to allow the progress there to also be complementary with environmental progress, it takes some real foresight. That's the challenge for policymakers.

Q: With demand rising, why is investment in new U.S. production at record lows?

Foreman: This is the question of the day. In API’s monitoring of the company financials, industry-wide capital expenditures fell to about $38 billion in the first quarter of 2021 – their lowest for any quarter on record, including the weakest quarters of the Great Financial Crisis in 2009 and 2009. 

When you think about the energy industry and most production around the world, it takes time to invest, to produce and then reach consumers with it. It’s really only been since the first quarter of this year that we've seen a real recovery in the prices and therefore company revenues, profitability, cash flows broadly across the industry. But their budgets coming into this year were pretty much set based on the way things looked at the tail end of last year.

I've spoken with leaders at many of these companies. Some have indicated that the availability of liquidity and cash flows to support their investments – their drilling and production – this year continues to be an issue and that they are enduring effects of the dislocation experienced last year. That is, risk appetites have changed, and some must see the recovery before they’ll believe it and expand their risk on that basis.

Others have added that they're people-limited, having cast off so many employees over the last year or so. In some cases, this is preventing the ability to add back drilling rigs and completion crews. In other cases, it has destroyed the capability to develop certain kinds of oil and gas, for example, offshore.  In either case, a company likely has to re-hire or contract to expand its activity level, and these aren’t month-to-month decisions. A company might need to sign contracts for the next year or more, so it’s about commitment and conviction that the recovery could continue.

Q: How have policy signals affected the demand-supply equation?

Foreman: Policy choices have natural consequences. The fundamentals of supply and demand are the primary driving factor of market prices. But for oil and refined petroleum products, these are global commodities. They have deep financial markets, and direction of energy policies certainly can influence price expectations. And futures prices are tethered back to today's wholesale and consumer prices.

When the Biden administration signals that it wants to incentivize a shift away from oil and other fossil fuels, and then it takes actions like we've seen – freezing oil and natural gas leasing on federal lands, killing the largest U.S.-Canadian pipeline project in Keystone XL, considering that the oil and gas industry be taxed more so and differently than every other U.S. manufacturing sector – these add uncertainty about whether long-lived investments in fossil fuels will be worthwhile, which is completely the wrong signal for the industry to be able to meet consumer demand in the immediate and near future.

Q: What else is going on to affect domestic production? Why hasn't shale production increased?

Foreman: We’re coming back to what we were saying about budgets coming into this year and the availability that’s there, both from a capital standpoint and from a people standpoint. It wouldn't be fair to blame prices and where they stand now on the companies. If anything, the companies stepped up strongly to keep operations integrity throughout the pandemic and its recovery so far. But just as the dynamic has affected the supplies of so many things – cars, computer chips, lumber and certain kinds of meats and other foods – we're seeing a really strong increase in demand for these things as economies in the U.S. and worldwide are coming back to life. 

It's going to take time for this stuff to normalize. After a record dislocation, we have to give companies time to get their sea legs and respond. These are competitive markets, so – if the demand is there as we’re seeing – one generally expects producers to go flat out and produce all they can to participate in the recovery. However, when you see some hesitancy in the speed with which the supply is coming back here, it's reflecting the fact that there is still structural damage from what we went through last year.

Q: In this situation, with demand outpacing supply, what policies should the U.S. pursue?

Foreman: The key lesson of this past year is the economy and oil demand, liquid fuels demand, have basically moved in tandem. That’s people's livelihoods and economic prosperity being intertwined. The need for energy – especially liquid fuels – continues to go hand at hand. Consequently, we need policies that set a level playing field, that are economywide where possible, and promote efficient price signals that motivate the creative forces across the economy to bring investments and influence consumption decisions that move the economy toward the goals of fostering prosperity and at the same time advancing environmental progress. It's a big ask, but it's only market-based incentives that have a realistic possibility of achieving these outcomes.

Q: It sounds like oil and natural gas not only are needed but will be leading energy sources for some time.

Foreman: Liquid fuels are still very much among the leading energy sources for the world economy. When you see the economy picking up – and oil and natural gas demand along with it – the connection between them is evident and likely to remain that way for decades to come. EIA and IEA projections reinforce this fact. Even the IEA’s Sustainable Development Scenario, which meets the Paris Climate Agreement goals for emissions reductions, foresees that nearly 50% of the world’s energy will come from natural gas and oil in 2040. 

This is because oil and liquid fuels continue to be essential to the economy and, frankly, enabling of the economy's growth going forward. The fact that we've seen some $20 trillion of economic stimulus globally, policymakers are pumping up the entire system with a lot of liquidity. It's making things go, and you need energy and fuels enable the growth. Just as we saw during the downturn, where you had to explicitly shut down certain sectors and destroyed economic value in the process, energy is the key economic enabler.

Q: At what point does reverting to net importer status start to harm the U.S.?

Foreman: We’re harmed today, with the direct import costs being compounded by having less domestic activity, production and employment. But the highest stakes concern whether the U.S. energy revolution can continue and remain strong.

For this, it's hard to put a specific timeframe on it. The EIA's estimates, which are an artifact of modeling as well as futures markets, assume a healthy U.S. response to oil prices with more drilling and production coming rapidly. That could still happen from this point forward, as there’s nothing fundamentally flawed about the health or the resources in the United States that should fundamentally prevent our ability to respond. However, now where we run into challenges, for example, with the Biden administration’s lack of support for oil and gas infrastructure and state challenges as well. You can have all of the resource development in the world, but if you can't move it to market and deliver it to consumers, it doesn't do any good. It’s not just the Keystone XL pipeline. It’s the Dakota Access Pipeline out of North Dakota and the renewals of Lines 3 and 5 from Canada through the Midwest U.S. On the natural gas side, it was the Atlantic Coast Pipeline and the need for more pipeline infrastructure to enable production growth in Pennsylvania, Ohio and West Virginia.

We have a real need, especially if you're looking at natural gas out of the Appalachian region, to continue to grow pipeline access to serve customers throughout the United States and potential exports. Without more infrastructure connecting the most economic U.S. resources, demand shifts towards higher-cost or imported resources. We need a coherent system that works in concert to enable U.S. economic growth, jobs, investment, trade and ultimately prosperity.

Q: How important is U.S. production in the world energy mix?

Foreman: The U.S. is important, but there currently are big differences in official projections from different energy agencies on the role the United States plays as global oil markets rebound. If the U.S. is unable to respond with higher drilling and production, it that means OPEC and Russia almost by definition must do so, because everything else in the world is running pretty much flat out. In other words, most other nations don't have spare capacity sitting around that ramp up quickly. The Middle East does have spare production capacity that appears adequate for this year, but it’s looking like a stretch next year with global oil demand broadly expected to come back by a record extent this year and next – that’s more than 9 million barrels per day of combined growth over two years, per EIA – compounded by the natural decline in oil production. For context, if the global oil market is close to 100 million barrels per day of recent demand, replacing the natural decline of production that IEA estimates at 4% to 6% per year means we need another 4 million to 6 million barrels per day each year just to stay in place.

If you take 9 million barrels per day of demand recovery over two years and another 8 million to 12 million barrels per day of decline replacement, you absolutely must invest. I think we can all agree that industry-wide investment of $38 billion in the first quarter was well short of what’s needed now that there’s robust demand.

This is a major challenge, because if you can't get quick oil out of the United States or the Middle East/North Africa (MENA) region – and all that remains is the roughly 5 million or 6 million barrels per day of spare capacity that exists between Russia and OPEC – once you run out, there is limited flexibility within the system.

When we look at next year with economic growth as the consensus expects, the strong demand appears to be coupled with a weakness in supply, so it's difficult to see how the numbers add up. That isn't completely factored into futures markets right now, and there are divisions where several major investment banks and financial players are now calling for a structural bull market for commodities and high oil prices.

Q: What does the mismatch between demand and supply mean for U.S. consumers?

Foreman: This ultimately comes back to your pocketbook. Now, API does not make or publish price predictions, this is a what-if. But if you ask, only as a hypothetical, what an additional 80 cents per gallon could mean, based on 2019 consumption levels from the Bureau of Labor Statistics, it implies differences in annual expenditures of about $640 or almost 1% of after-tax income for an average household, all else being equal. For the top 20% of households by income, you're talking closer to $1,000 and a little over a half-percent of income. For the lowest 20% of households by income, you're talking about $300 or about 2.5% of income.

In short, these numbers would be meaningful as percentages of households’ income, and at a time when we've been relying most of the last decade on oil and natural gas prices having gone down and enabled households to spend more on food, education and health care – each of which tremendously outpaced the overall pace of U.S. consumer price inflation. Income rises only so much, so household budgets really only work because some things like energy have given leeway. Now we're seeing broad price inflation across all of these categories – food up a lot, housing up by a record amount, and car prices as well.

In fact, car prices -- especially for used cars – recently reached an all-time high. If you add up the spending on housing, vehicles and energy, that's more than half of what a typical household expends in a year. So, the idea that households can make ends meet especially when upwards of 40% of households by income almost never make ends meet, this is a serious challenge. Economists debate how long these increased prices may last, but consumer price inflation is stress factor in more than theoretical economic perspective. It’s where the rubber hits the road and affects real equity issues across America.