OIL MARKET RESPONSES TO CRISES:

Transcription

1 . A C I L A L L E N C O N S U L T I N G REPORT TO DEPARTMENT OF INDUSTRY 28 JUNE 2014 OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY

2 ACIL ALLEN CONSULTING PTY LTD ABN LEVEL FIFTEEN 127 CREEK STREET BRISBANE QLD 4000 AUSTRALIA T F LEVEL TWO 33 AINSLIE PLACE CANBERRA ACT 2600 AUSTRALIA T F LEVEL NINE 60 COLLINS STREET MELBOURNE VIC 3000 AUSTRALIA T F LEVEL ONE 50 PITT STREET SYDNEY NSW 2000 AUSTRALIA T F SUITE C2 CENTA BUILDING 118 RAILWAY STREET WEST PERTH WA 6005 AUSTRALIA T F ACILALLEN.COM.AU SUGGESTED CITATION FOR THIS REPORTACIL ALLEN CONSULTING, OIL MARKET RESPONSES TO CRISES: AN HISTORICAL SURVEY, JUNE 2014 ACIL ALLEN CONSULTING 2014

3 C o n t e n t s Executive Summary i 1 Introduction 1 2 The Global Oil Market Global Oil Production and Sources History of Oil Shocks, Prices and Evolution of Oil Market References to Crude Oil Prices Pre Oil Shocks and Prices since Institutions Organisation of Petroleum Exporting Countries (OPEC) International Energy Agency International Energy Forum 8 3 Australian Economy, Policy and Oil General Economic Context Oil and the Australian economy Petroleum market arrangements General background Regulation and taxation of petroleum to to to present day 19 4 Markets and Oil Shocks, Types of Oil Shocks Crude Oil Shocks Refined Oil Product Shocks Oil Market Responses to Shocks Roles of Oil Markets and Prices Price Elasticity of Demand and Supply Estimates of Price Elasticity of Demand and Supply Effects of Highly Price Inelastic Demand and Supply Physical Oil Markets, Derivatives Markets, and Inventories 35 ii

4 5 Repudiation of agreements and Yom Kippur Arab-Israeli War, Preceding Circumstances Political Conflict Trigger Policy Tactics and Market Responses Causes of the Price Shock United States Price Control Impacts on the Australian economy Policy Issues and Policy Responses 49 6 Iranian Revolution and Iran-Iraq War, Preceding Circumstances Iranian Revolution Unfolding of Events Market and Policy Responses Petrol Queuing Returned in the United States Causes of the Oil Shock Iran-Iraq War The Conflict and Its Origins Market and Policy Responses Causes of the Oil Shock Impacts on the Australian Economy Australian policy issues and responses 65 7 Responses to high oil prices and withdrawal of Saudi Arabian support for the oil price, Oil Market Circumstances, Saudi Arabia s Abandonment of Price Support Market Responses to Positive Oil Supply Shock Causes of Oil Shock Impacts in Australia Australian Policy Issues and Responses 74 8 Iraq s invasion of Kuwait, Preceding Circumstances Invasion Market and Policy Responses Causes of the Price Shock Impact on Australia Australian Policy Issues and Responses 84 iii

5 9 Venezuelan oil supply crisis and Iraq War, Preceding Circumstances Closely-Spaced Supply Shocks Market Responses Causes of the Small, Short-Lived Price Spike Impact on Australia Policy Responses and Issues Multiple Shocks, Preceding Circumstances Multiple Interacting Shocks Strong Global Economic Expansion, OPEC Production and Capacity Constraints Conventional Supply Shocks, Hurricanes Katrina and Rita, Plethora of Small Supply Shocks, Speculative Demand, Global Financial Crisis and Recovery, Global Financial Crisis Libyan Revolution Iran Tension Impacts in Australia Policy responses and issues Economic Effects of Oil Shocks Economic Effects Depend on Shock Type and Nett Energy Exports/Imports Position Oil Supply Shock Aggregate Demand Shock Speculative Oil-Specific Demand Shock Refined Products Supply Shocks Compound Shocks Changes Across Time and Countries Nett Energy Export/Import Balances Energy Intensity Price Elasticity of Supply and Demand Magnitudes of Oil Shocks OPEC s Changed Price Control Policy Productivity Shocks Monetary Policy and Real Wage Flexibility 123 iv

6 Exchange Rate Flexibility Implications for Australia Conclusions 126 Appendix A Fuel taxation A-1 Appendix B References B-1 List of boxes Box 1 Import parity pricing (IPP) 18 Box 2 Speculative Demand and Taxes in First Oil Crisis 40 Box 3 Yergin on Petrol Queuing in United States 56 Box 4 Daniel Yergin on Panic, Speculative Demand and Inventories 57 Box 5 Mined-Commodity-Intensive Growth 98 Box 6 OPEC Capacity Constraint 100 Box 7 Katrina and Rita Supply Shocks and Market Forces 103 List of figures Figure 1 Global oil supplies (million tonnes) 3 Figure 2 Share of production (million tonnes) 3 Figure 3 Production by country grouping 4 Figure 4 Crude oil prices from 1918 to Figure 5 Crude oil prices quarterly from 1970 to 2014 (US$ per bbl) 6 Figure 6 Growth in GDP 10 Figure 7 Australian/US Dollar Exchange Rate 11 Figure 8 Unemployment rate Australia (seasonally adjusted) 12 Figure 9 Change in Consumer Price Index 12 Figure 10 Percentage change in automotive fuels price index 13 Figure 11 Primary energy consumption in Australia by fuel source (energy units) 13 Figure 12 Consumption of petroleum by end use 14 Figure 13 Consumption and domestic production of petroleum fuels in Australia 14 Figure 14 Oil intensity of the Australian economy (PJ/$billion GDP) 15 Figure Oil Price Surge 39 Figure 16 Crude oil price, US$ and $A 45 Figure 17 Crude oil prices and petrol prices 45 Figure 18 Capital city petrol prices 46 Figure 19 Consumption of petroleum products 46 Figure 20 Production and imports of crude oil and refinery feedstock 47 Figure 21 Refinery production 47 Figure 22 Net imports of petroleum products 48 Figure 23 Billions of km travelled 48 v

7 Figure 24 Percentage change in CPI from previous quarter 49 Figure 25 Annual GDP growth rate 49 Figure 26 Crude oil price 54 Figure 27 Crude oil price A$ and US$ 60 Figure 28 Crude oil prices and petrol prices - A$ terms second oil crisis 60 Figure 29 Capital cities petrol prices (nominal) 61 Figure 30 Consumption of petroleum products 61 Figure 31 Production and imports of crude oil and refinery feedstock 62 Figure 32 Refinery production 62 Figure 33 Net imports of petroleum products 63 Figure 34 Billions of km travelled 63 Figure 35 Percentage change in CPI from previous quarter 64 Figure 36 GDP growth rate 64 Figure 37 Crude oil price in A$ and US$ 70 Figure 38 Crude oil prices and petrol prices 70 Figure 39 Capital cities petrol prices (nominal) 71 Figure 40 Consumption of petroleum products 71 Figure 41 Production and imports of crude oil and refinery feedstock 72 Figure 42 Refinery production 72 Figure 43 Net imports of petroleum products 73 Figure 44 Billions of km travelled 73 Figure 45 Percentage change in quarterly CPI from previous year 74 Figure 46 GDP growth rate 74 Figure 47 Crude oil price in A$ and US$ 80 Figure 48 Crude oil prices and petrol prices 80 Figure 49 Capital cities petrol prices (nominal) 81 Figure 50 Consumption of petroleum products 81 Figure 51 Production of crude oil and net imports of refinery feedstock 82 Figure 52 Refinery production 82 Figure 53 Net imports of petroleum products 83 Figure 54 Billions of km travelled 83 Figure 55 Percentage change in CPI from previous quarter 84 Figure 56 GDP growth rate 84 Figure 57 Crude oil price in A$ and US$ 89 Figure 58 Crude oil prices and petrol prices 90 Figure 59 Capital cities petrol prices (nominal) 90 Figure 60 Consumption of petroleum products 91 Figure 61 Production and of crude oil and net imports of refinery feedstock 91 Figure 62 Refinery production 92 Figure 63 Net imports of petroleum products 92 Figure 64 Billions of km travelled 93 Figure 65 Percentage change in quarterly CPI from previous year 93 Figure 66 GDP growth rate 94 Figure 67 Singapore Export Petrol Price and Crude Oil Price Movements Compared, vi

8 Figure 68 Crude oil price in Australian and US dollars 109 Figure 69 Crude oil prices and petrol prices 109 Figure 70 Capital cities petrol prices (nominal) 110 Figure 71 Consumption of petroleum products 110 Figure 72 Production and imports of crude oil and refinery feedstock 111 Figure 73 Refinery production 111 Figure 74 Net imports of petroleum products 112 Figure 75 Billions of km travelled 112 Figure 76 Percentage change in quarterly CPI from previous year 113 Figure 77 GDP growth rate 113 List of tables Table A1 History of fuel taxation in Australia A-1 vii

9 Executive Summary Australia s vulnerability to a major interruption to global oil supply has been addressed in previous ACIL Allen reports to government for National Energy Security Assessments, and considered by the House of Representatives Standing Committee on Economics in its 2012 Inquiry into Australia s Refining Industry. These recent reviews found that Australia s supply security was high with a watch point concerning increasing net imports underpinned by the ability of international markets to supply crude oil and refined oil products to Australia, and to respond to international and regional perturbations in supply and demand. This position has been reinforced by the availability of surplus refining capacity in Asia. This report builds on previous work by ACIL Allen. It examines historical oil market responses to global oil market crises. The examination is based on a wide-ranging literature review, and consultations with people with experience in the oil market over the period. It discusses in detail how Australian and international oil markets responded to selected oil shocks of different types. It also discusses the economic consequences of different types of shocks in the context of changing economic and policy circumstances over time, particularly in the Australian case. It aims to answer five key questions. How has the international oil market changed since the 1970 s? Does the oil continue to flow? How does the oil price respond during shock episodes and what role does it play? How have Australia s oil and refined products markets performed historically? What conclusions can be drawn? Six oil market events are considered: first oil crisis : Arab-Israeli War and repudiation of agreements, second oil crisis : Iranian revolution and Iran-Iraq war, withdrawal of Saudi Arabian support for oil price, first Gulf war: Iraq s invasion of Kuwait, Venezuelan oil supply disruption and invasion of Iraq (second Gulf war), multiple oil shocks, The six case studies serve to illustrate the changes in both the global market over time and the way in which the responses of the market and economies to oil shocks have changed. The case studies also consider the effects on Australia as distinct from global impacts. Developments in the Global Oil Market since 1973 The report sets out how the global market has developed over the period from the first oil crisis in to the present. Some key developments identified within the report and the case studies include: change in the structure of the international crude oil market the move from long term contracts to spot transactions the emergence of oil futures and other financial oil derivatives markets i

10 decline in short-term responsiveness of quantities demanded and supplied to changes in price (declining short-term price elasticity of demand and supply) OPEC capacity restraint changing mixes of different types of oil shock. Prior to the first oil crisis, global oil markets were broadly competitive, dominated by seven major oil companies, and oil trading was dominated by long-term contracts. This changed during the period from 1973 to 1980, when OPEC producers found ways of exercising their potential market power. However, their approach to exercising market power was undermined by progressive nationalisation of oil companies in the Middle East and North Africa. Nationalisation meant that governments had to sell oil, agree on production quotas, and rely on other members to comply with their quota obligations. Saudi Arabia has played a critical role in preserving OPEC influence on oil prices. It bore most of the burden of OPEC s desire to maintain high oil prices after the first and second oil crises by cutting production substantially while losing considerable market share to other OPEC countries. When Saudi Arabia abandoned its efforts in the second half of 1985 and increased production substantially over several months, the crude oil price collapsed. This helped restore some discipline within OPEC. Saudi Arabia typically has maintained substantial excess capacity, because of production constraints. Since the 1980s, Saudi Arabia has tended to increase production to take advantage of rising prices following oil shocks, but not enough to eliminate price spikes, and tended to reduce production as prices declined. However, in the oil shock, Saudi Arabia departed from this pattern by cutting production after 2005, with prices already rising strongly. Another development of great importance is that OPEC members have not increased aggregate capacity since Saudi Arabia has deliberately constrained investment in more capacity. Some other OPEC members capacity has been constrained by wars, internal strife, and government budget issues. OPEC capacity constraint has resulted in a persistent negative oil shock that has often been overlooked. It maintains upward pressure on oil prices. Until a decade ago, the conventional view was that major price spikes were caused by major exogenous supply shocks. This view not only overlooked the existence of the persistent supply shock, but also ignored the importance of aggregate demand shocks and speculative demand shocks, as well as oil producers restraining production to take advantage of higher prices later (forms of speculative supply or demand shocks). It is now widely recognised in the relevant economics literature that various types of shocks have often occurred in close proximity in time, and that the mix of shocks has varied between major oil price events. In contrast to the pre-1973 situation, therefore, the market is now characterised by increased diversity, hedging to address price volatility, declining short-term price elasticity of demand and supply, OPEC production quotas and capacity constraints, the swing producer role of Saudi Arabia, and participation of a wide range of entities including commodities and financial derivatives traders. More recently, persistent high oil prices have brought forward a supply response from unconventional oil particularly in the United States. This has the potential to change the oil supply balance between OPEC and non OPEC production. ii

11 Developments in the Australian Economy and Oil Market In addition to identifying the way the global market has changed, the report also sets out key changes to the Australian oil market and structure of the economy, as these are important for understanding how global disruptions have affected Australia differently to other countries. The structure and regulation of the Australian economy changed significantly over the review period. Significant changes included: the move to import parity pricing for crude oil in 1978 the floating of the Australian dollar in December 1983 the progressive introduction of the Petroleum Resource Rent Tax from 1986 deregulation of the petroleum market during the1980s microeconomic reform during the 1980s and beyond more credible monetary policy greater real wage flexibility Australia s increasing nett energy export position declining oil- and energy-use intensity of the economy. In , the price of crude oil was regulated by the Commonwealth Government. When the US$ oil price increased by 255 per cent in , petrol prices only rose 22 per cent. As a result the full price impact of the rise in oil prices was not felt by Australian consumers. Consumption that had been rising at about 6 per cent per annum on average over the previous four years flattened off. No shortages were experienced. In , when the Iran Iraq war pushed the price of crude oil from around US$15 per barrel to US$35 per barrel, the Australian petrol price was more responsive rising from 20 cents per litre to around 30 cents per litre because of the move to import parity pricing for Australian crude oil into refineries. There was no interruption to oil supplies to Australia from international events. During the period from 1981 to 1985, OPEC attempted to support the oil price through production quotas, but some members did not comply with their quotas. Saudi Arabia bore most of the burden of supporting the price via production cuts. In mid-1985, Saudi Arabia abandoned this approach and increased production. The fall in oil prices was not fully transmitted to Australian petrol prices, partly because of depreciation in the exchange rate following the floating of the Australian dollar in December Consumption of refined oil products fell significantly with the recession in and lagged responses to high prices. Consumption recovered from , but by , still had not re-attained the level of about, 37,900 ML per annum. In , Iraq s invasion of Kuwait removed nearly 4.6 million barrels per day of oil from the market, causing oil prices to rise from US$18 per barrel to US$30 per barrel. The price of crude oil in Australian dollars moved proportionately, and petrol prices rose from 62 cents per litre to 80 cents per litre. Growth in consumption of petroleum products that had been 2.5 per cent per annum in the two previous years fell to zero in as a result of the price rise and transmission of a global recession to Australia before the Iraq-Kuwait war. There was no government intervention in the market and no interruption to oil supplies. In , the Venezuelan oil supply crisis and another Iraq war reduced global oil supplies by around 4 million barrels per day. However, the combined Venezuelan and Iraqi supply iii

12 shocks were more than offset by an unexpected increase in global oil production early in 2003 a countervailing positive supply shock. This reversed the speculative demand shock. The price spike was minor and short-lived. Consumption of petroleum products fell about 4 per cent in , again influenced by a global recession, but by consumption had recovered. There was no interruption in oil supplies in Australia. The period from 2003 to 2008 was characterised by large global aggregate demand shocks, and ongoing OPEC capacity constraint. In addition there were several exogenous supply shocks. For example, crude oil production was reduced by about 1.4 million barrels per day and refinery production reduced by about 2 million barrels per day following Hurricane Katrina in the Gulf of Mexico in the third quarter of However, prices spiked to ration anad reallocate supply, and oil and refined products were released from stockpiles. So, when Hurricane Rita arrived a month later the price impact was minimal. The 2003 to 2008 surge in oil prices was reversed rapidly in The global financial crisis caused large negative aggregate demand and speculative oil-specific demand shocks. Prices had recovered strongly in late 2009, because of the influence of rapid growth of demand from major developing economies. Petrol prices in Australia reflected the change in global oil prices. However, consumption continued to rise at around 2 per cent per year over the period. The global financial crisis caused consumption to fall by 2 per cent in , before recovering the longer term growth trend by At no time over the past 50 years were supplies disrupted as a result of international perturbations in the market. The only occasions in which supplies were disrupted in Australia involved industrial action. This occurred in the late-1970s in South Australia, in late-1988 in New South Wales, and again in 2001 in South Australia. In these cases, State Governments introduced measures to manage demand through odds and evens days or minimum fill requirements. Key Messages Drawing on the discussion of the development of the market and the literature about types of oil shocks along with the lessons gained from the case studies, the report arrived at the following key conclusions. Some are general and others are particular to Australia. Oil continues to flow though prices may be affected The history of oil shocks over the past 40 years has not provided any evidence to suggest that, in response to unexpected interruptions to supply or surges in demand, crude oil and refined product markets would not swiftly ration and reallocate supply efficiently through price movements to avoid shortages. The evidence collected for this report indicates that there were no interruptions in supply caused by global market perturbations, with the notable exception of the United States, which experienced shortages during the first and second oil crises because of selfimposed price controls and administrative allocation arrangements. Over time, the oil market has become more globalised, diverse, and transparent, and therefore, more adept at responding to shocks and restoring market balance, with shocks quickly reflected in price movements globally. While oil price spikes understandably create concerns in the community, they are essential to clear the market and avoid shortages to consumers and business. Short term price spikes encourage consumers to reduce consumption and encourage producers and traders to increase supplies. Consumers and businesses benefit in the longer-term from this important role of prices. iv

13 These price movements have also encouraged oil producers and users to adopt hedging, stock management, and capacity management strategies. Intervention in the market is generally unhelpful The global oil market worked well during the various oil shocks. In Australia, spikes in international prices translated appropriately into rises in the Australian price of fuel after Import Parity Pricing for crude oil was introduced in This ensured that Australia became well integrated into the global market. Price spikes were typically felt uniformly around the nation, as they were globally. Reductions in quantity demanded and some increases in quantity supplied, helped rebalance the market, and avoided shortages. Market-determined prices are far superior at rationing supply and allocating resources efficiently, than queuing and administrative allocation. In the 1970s, when price controls and administrative allocation were applied to oil and refined oil products in the United States, shortages and administrative allocation anomalies that misallocated resources occurred in the wake of major oil shocks. The challenge for policy makers in Australia as well as globally is to ensure that the markets are not impeded by poorly thought out policies involving governments interfering with the efficient allocation of resources during oil shocks. If market or policy failures impede the efficient operation of markets, intervention is warranted, provided that the benefits of intervention exceed the cost. In addition, the chosen form of intervention should be the one that would yield the greatest surplus of benefits over costs. Otherwise, the operation of markets should be left alone. Each oil shock is different and several types of shock may occur in tandem The economic consequences of an oil shock depend crucially on its cause or causes. There are important differences between the economic effects of aggregate demand shocks, oil and refined product supply shocks, and speculative demand shocks. Until a decade ago, the conventional view was that major price spikes were caused by major exogenous supply shocks. It is now widely recognised in the relevant economics literature that various types of shocks have often occurred in close proximity in time and that the mix of shocks has varied between major oil price events. The emergence of a spot market from the early-1980s and increased volatility led to development of financial oil derivatives and markets in which to trade them. This meant that traders were more able to manage volatility of spot prices. This, along with other factors, contributed to reductions in short-term price elasticities of supply and demand that tended to accentuate price spikes during disruptions. At the same, changes in the structure of the Australian economy and its flexibility have reduced the economic impact of such spikes. Importance of energy intensity There have been noticeable reductions of oil-use intensity and energy-use intensity in nearly all developed countries since the 1970s. Australia s oil-use intensity has halved since However, Australia s energy-use intensity has declined at a slower rate over the past 20 and 40 years than most other developed economies. Energy-use intensity is relevant when oil prices spike, because prices of energy other than oil tend to move with oil prices. v

14 Lower oil- and energy-intensity reduces vulnerability of economies to oil price increases. Differences in intensity of use of oil-products and energy-use more generally lead to differing economic effects of oil shocks between countries. Economic effects of oil shocks have been moderated by trends towards declining oil and energy-use intensity, Short-term price elasticity of demand and supply declined over time There has been a substantial reduction in short-term price elasticity of demand and supply of oil since the mid-1980s. The implication is that an oil shock of a particular type and magnitude would lead to a much larger oil price spike now, under similar market conditions, than at the time of the first oil crisis and second oil crisis of the early 1970s to early 1980s. However, economic effects of oil price shocks have been moderated by declining oil- and energyuse intensity, increasing real wage flexibility, exchange rate flexibility, and in some countries better nett energy export/import positions. Australia s is a net energy exporter Economic effects of different types of oil shocks vary between countries in accordance with differences in net energy exports or imports. As these net positions have evolved over time, economic effects of oil shocks have changed. In countries like Australia, that are net exporters of energy, but net importers of oil, there are effects on economic activity working in opposite directions. Higher oil prices tend to cause a contraction of national income, while higher prices for energy commodities in general tend to be expansionary for economies that are net exporters of energy. The net economic effects of an oil supply shock on Australia could be insignificant or positive overall. As Australia s net energy export balance increases because of large increases in exports of coal and liquefied natural gas (including coal seam methane), the likelihood of positive overall economic effects on Australia increases. Conclusion for Australia Australia now has oil and refined products markets that work well and are linked closely to global markets that ration and allocate supply well. Price responses to oil shocks of any magnitude in terms of quantity may now be larger than at the time of first and second oil crises to the extent that short-term price elasticity of demand and supply for crude oil have declined during the intervening period. Moreover, import parity pricing now means that global price movements are translated fully to price movements for fuels in Australia. Australia s susceptibility to economic harm from oil shocks has declined since the time of first and second oil crises because of lower oil-use intensity, improvements to Australia s position as a net exporter of energy, greater real wage flexibility, better monetary policy and the floating exchange rate. vi

15 1 Introduction This report contains an historical examination of oil market responses to global oil market crises. The examination is based on a wide-ranging literature review, and access to Australian archived material. It discusses in detail how Australian and international oil markets responded to selected events. In addition, it investigates the economic consequences of various types of shocks in the context of changing economic and policy circumstances over time, particularly in the Australian case. Six oil market events are considered: first oil crisis : Arab-Israeli War and repudiation of agreements, second oil crisis : Iranian revolution and Iran-Iraq war, withdrawal of Saudi Arabian support for oil price, first Gulf war : Iraq s invasion of Kuwait, Venezuelan oil supply disruption and invasion of Iraq ( second Gulf war ), multiple oil shocks, Chapter 2 of this report provides an introduction to the global oil market, including an overview of movements in oil prices and international institutions that have influenced the market. Chapter 3 provides and introduction to the oil market in Australia, and relevant economic and policy considerations. Chapter 4 provides a general overview of international oil markets and shocks over the 1964 to 2014 period. Chapter 5 examines the impact of the repudiation of company-government agreements and the Yom Kippur Arab-Israeli War in Chapter 6 discusses the impact of the Iranian revolution and the Iran-Iraq war in the 1979 to 1980 period. Chapter 7 explores responses to high oil prices and withdrawal of Saudi Arabian support for oil prices in Chapter 8 discusses the impacts of Iraq s invasion of Kuwait ( first Gulf war ) in Chapter 9 examines the impact of Venezuelan strikes and another Iraq war ( second Gulf war ) in Chapter 10 explores interactions between high aggregate demand growth and supply shock interactions over the period 2003 to Chapter 11 reviews the economic effects of oil shocks for the global economy and for Australia. Chapter 12 provides conclusions. 1

16 2 The Global Oil Market Global oil supplies have increased from around 2,869 million tonnes per annum (58 billion barrels per day) in 1973 to around 4,142 million tonnes per annum (83 million barrels per day) in Over that time, the share from the Middle East fell slightly from 36.7 per cent to 32.5 per cent. In 2014 real terms, crude oil prices were less than US$19 per barrel in mid Oil prices rose to around US$57 per barrel in January-February 1974 during the first oil crisis. Spot prices rose further to around US$122 per barrel (2014 real terms) at the twin peaks of the second oil crisis in November 1979 and November 1980.Oil prices collapsed to around US$24 per barrel in May 1986, after Saudi Arabia substantially increased production, abandoning efforts to sustain the price at a high level. The oil price spiked briefly to US$66.50 in October 1990 during the Kuwait-Iraq crisis. After trending down in real terms for 21 years, the oil price bottomed around US$13 per barrel (2014 real terms) in January 1999, in the wake of the Asian financial crisis. As a result of strong growth in global aggregate demand for goods and services, and various supply shocks and constraints, the spot crude oil price soared to a peak of around US$162 per barrel (2014 real terms) in July 2008, before collapsing to around US$35 per barrel in December 2008, soon after the onset of the global fincial cris. The price recovered quickly but partly in Since 2011, spot crude oil prices have fluctuated US$100 per barrel (2014 real terms), with small spikes for shocks associated with revolution in Libya, emabrgod on trad ewith Iran, and strife in Iraq. Prior to the first oil crisis global oil markets were broadly competitive, dominated by seven major oil companies, and oil trading was dominated by long term contracts. This changed during the period from 1973 to 1980 when OPEC producers found ways of exercising their potential market power. In contrast to the pre-1973 situation therefore, the market is now characterised by increased diversity, hedging to address price volatility, declining short-term price elasticity of demand and supply, OPEC production quotas and capacity constraints, the swing producer role of Saudi Arabia, and participation of a wide range of entities including commodities traders. High crude oil prices during and after the first and second oil crises induced strong supply and demand responses with a lag of a few years. More recently, high oil prices that have persisted for most of the period from 2006 to 2014 have brought forward a supply response from conventional oil in various parts of the world, and unconventional oil particularly in the United States. This has the potential to change the oil supply balance between OPEC and non OPEC production. This will help offset the effects of rising demand. Also, high prices have induced increasing offerings of, and switching to transport vehicles with better fuel economy, reducing quantity of oil demanded. 2.1 Global Oil Production and Sources Global oil supplies increased from around 2,869 million tonnes per annum (58 billion barrels per day) in 1973 to around 4,142 million tonnes per annum (83 million barrels per day) in 2012 (Figure 1). 2

17 Figure 1 Global oil supplies (million tonnes) Note: Includes crude oil, natural gas liquids, additives and other hydrocarbons. Asia excludes China. Source: (IEA, 2013) Over that time the share of production from the Middle East fell slightly from 36.7 per cent to 32.5 per cent. Figure 2 Share of production (million tonnes) Source: (IEA, 2013) The share of oil production from OECD countries fell from 30 per cent in 1997 to 26 per cent in 2011 (Figure 1). Over the same period the share of oil production from OPEC Countries increased from 30 per cent in 1997 to 36 per cent by

18 D R A F T Figure 3 Production by country grouping MB/d OECD Non-OECD OPEC Source: (IEA, 2012) 2.2 History of Oil Shocks, Prices and Evolution of Oil Market References to Crude Oil Prices Throughout this report, historical prices of crude oil have been mentioned on numerous occasions in the text. In addition, time series of crude oil prices have been displayed in charts. Prices quoted in the text do not always align with prices in charts, because of different bases. Often, prices in the text refer to peak and trough spot prices of available benchmark prices, while prices shown in charts are averaged over months or quarters and benchmarks have changed in long-term series. In addition, prices in charts may be based on an average of contract and spot prices (for example, see Figure 5). When real prices have been quoted or charted, the year to which prices have been adjusted for earlier or later inflation has been specified Pre-1973 From 1918 until the 1940s, crude oil prices trended down. Then, prices rose significantly until the early-1950s, after which they displayed a downward trend for more than 20 years until The real price downtrend was not significantly disrupted by the Suez Crisis in 1956, formation of OPEC in September 1960, or the 6-day Arab-Israeli war in However, the Suez crisis did accelerate the development of much larger oil tankers, and this facilitated globalisation of oil markets. The international market was basically competitive until

19 D R A F T Figure 4 Crude oil prices from 1918 to $US/bbl $ money of the day $2014 Note: US average Arabian Light posted at Ras Tanura Brent dated. Source: (BP, 2013) In circumstances of chronic oversupply in the United States for decades prior to the 1970s, output was constrained by government regulation to levels well below capacity to support prices, and ostensibly, to conserve resources. During the 1960s, this surplus capacity was whittled away and was eliminated by the early-1970s. This also eliminated the world s emergency oil capacity. Booming global economic conditions in the early 1970s, in combination with crude oil prices pegged by agreements between Middle East producers and international oil companies, whittled down spare capacity there too Oil Shocks and Prices since 1973 With spare capacity gone, OPEC producers found a way to exercise their potential market power in They repudiated agreements and demanded higher production-based taxes and participation in production. Fear raised prices and these were supported by tax increases. The Yom Kippur war provided an excuse for Arab nations to cut production. The process of ratcheting up prices through creation of fear and demands for higher producing government revenues continued. The broadly competitive market was replaced by one characterised by exercise of substantial market power. Movements in crude oil prices from are shown in nominal and real terms in Figure 5. During the first oil crisis in , the real price of crude oil tripled to around US$57 per barrel in 2014 terms over a few months. Subsequently, the real oil price fluctuated around US$52 per barrel until the second half of 1978, as circumstances developed to create the second oil crisis linked to the Iranian revolution and then the Iran-Iraq war. The peak price during the second oil crisis was more than double the real price level established as a result of the first oil crisis. The price of about US$122 per barrel (2014 price terms) was the highest crude oil price recorded since 1864 when the price was about US$124 per barrel (2014 price terms). The price spike was driven by a combination supply, aggregate demand and speculative demand shocks. 5

20 Jan 1974 Jan 1976 Jan 1978 Jan 1980 Jan 1982 Jan 1984 Jan 1986 Jan 1988 Jan 1990 Jan 1992 Jan 1994 Jan 1996 Jan 1998 Jan 2000 Jan 2002 Jan 2004 Jan 2006 Jan 2008 Jan 2010 Jan 2012 Jan 2014 D R A F T Figure 5 Crude oil prices quarterly from 1970 to 2014 (US$ per bbl) End of administrative Arab oil embargo priocing nominal prices rise from $2/bbl to $10/bbl Irania n revolution Iran - Iraq war Invasion of Kuwait OPEC target reductions, tight stocks OPEC quota increases, Asian financial crisis Tight spare capacity, crude outages in Nigeria, Iraq, North Sea Demand growth in China takes off Second Gulf crisis Arab spring Hurricanes Katrina and Rita hit the US Gulf Coast Global financial crisis Nominal Real Note: Prices reflect the average price of crude imported into the United States. Real 2014 price curve adjusts nominal prices for U.S. inflation. Source: (EIA, March 2014) As a result of progressive nationalisation of oil companies producing assets in the Middle East and North Africa during the 1970s, governments transitioned from collection of production-based taxes to selling oil. This institutional change made it more difficult to ratchet up oil prices. Instead of raising production taxes on oil companies in concert to put a floor under the oil price, OPEC governments had to agree among themselves on production rates and market shares and rely on others not to cheat. That did not work well. As crude oil prices declined following the second oil crisis in , Saudi Arabia was left with most of the burden of cutting production to try to support the price, while other OPEC members cheated. The price decline was propelled by the global economy sliding into recession in the early-1980s and the operation of market forces. Historically high oil prices for a decade had induced: substantial exploration around the world technical research and innovation in respect of exploration and extraction methods considerable expansion of production in non-opec countries research and innovation regarding more efficient use of oil products conservation of petroleum products and switching to other fuels. In the meantime, a transition from an administered oil price regime involving long-term contracts with pre-determined posted oil prices to a spot trading system in the early 1980s represented a major structural transformation of the oil market. The perceived greater volatility of spot prices, encouraged development of oil derivatives or futures, and markets in which to trade them. These instruments provided hedging mechanisms for producers and users of crude oil. A result was reduction of responsiveness of hedged entities in both groups to spot oil price changes, meaning lower price elasticity of demand and supply. This increased oil price volatility, encouraging further development of markets for oil derivatives. After Saudi Arabia withdrew its support for the oil price, progressively raising its production in the second half of 1985 and the first half of 1986, the crude oil price slumped by nearly 70 per cent. Notwithstanding pervasive suspicion and mistrust among OPEC members, a temporary production agreement was reached in August It resulted in a turn-around in the spot price of crude oil. This was reinforced by another agreement in December

21 to cut production by 5 per cent. By January 1987, crude oil spot prices had risen to around US$45 per barrel in real 2014 terms, compared to about US$68.50 in November Subsequently, crude oil prices remained relatively steady in a range of around US$33 to US$43 per barrel in real 2014 terms from early-1987 to mid Following the short-lived price spike in September and October 1990 that was associated with Iraq s invasion of Kuwait, the real spot of crude settled in the range of US$33-43 per barrel (2014 price terms) for more than two years. Thereafter, the price displayed a strong downward trend until the beginning of 1999, when it bottomed at less than US$13 per barrel in 2014 price terms. The decline had been particularly marked over the preceding two years, helped by the negative (reduced) aggregate demand shock of the Asian Financial Crisis. The clumsy cartel, as Morris Adelman (1995) described OPEC, had not been able to halt a strong 18-year downtrend in the real crude oil price. As global aggregate demand recovered following the Asian financial crisis, OPEC members constrained production. Therefore, the real crude oil price began to recover strongly in 1999 and Then it lost more than half of those gains in A recession in the United States economy was an important contributory factor. The oil price remained in the doldrums for about 12 months, starting to recover in The crude oil price spiked in early-2003, triggered by loss of production in Venezuela and Iraq, following internal political turmoil and a United States led invasion, respectively. However, the price spike was short-lived and not large. In the meantime, events of great economic importance were occurring that would lead to dramatic changes in the crude oil market. First, partly by design (in response to declining real prices and production quotas that had not worked well), and partly because of internal and external conflicts involving major oil exporters, OPEC members had not increased aggregate capacity since Second, short-term price elasticity of demand and supply have declined to much lower levels than applied until the mid-1980s, meaning that a shock to quantity demanded or supplied would have much bigger effect on the crude oil price than at the time of the first and second oil crises. Third, the global economy grew strongly from the second half of 2003, supported by extraordinarily fast, sustained, commodity-useintensive growth in China, India and some other developing economies. As a result of these circumstances, a series of supply shocks, and a preceding 22-year downtrend in real crude oil prices, the oil price surged from under US$35 per barrel in early to around US$162 per barrel (2014 real terms) in July 2008, a record high price. The crude oil collapsed following the global financial crisis, but recovered quickly as a result of continuation of oil-intensive growth in major developing economies and constrained capacity in OPEC countries. The crude oil price has fluctuated around US$100 per barrel (2014 real terms) since 2011, apart from small spikes in and 2012 linked to supply shocks associated with revolution in Libya and embargos on trade with Iran. High oil prices that have persisted for most of the period from 2006 to 2014 have brought forward a supply response from researchers, explorers and producers focussed on conventional oil in various parts of the world, and unconventional oil particularly in the United States. This has the potential to change the oil supply balance between OPEC and non OPEC production. Ultimately, it will help offset the effects of rising demand. But, high prices have also induced increasing offerings of, and switching to transport vehicles with better fuel economy, reducing quantity of oil demanded. 7

22 2.3 Institutions Three international institutions played an important role in oil market developments over the period examined for this report - the Organisation of Petroleum Exporting Countries (OPEC) and the International Energy Agency (IEA) Organisation of Petroleum Exporting Countries (OPEC) OPEC was formed in September 1960, by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. These founding members were later joined by nine others: Qatar (1961); Indonesia (1962) suspended its membership from January 2009; Libya (1962); United Arab Emirates (1967); Algeria (1969); Nigeria (1971); Ecuador (1973) suspended its membership from December 1992-October 2007; Angola (2007); and Gabon ( ). OPEC's stated objective is to co-ordinate and unify petroleum policies among member countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry International Energy Agency The International Energy Agency (IEA) was founded in 1974 by OECD countries in response to the oil crisis. Its stated aim is to help countries co-ordinate a collective response to major disruptions in oil supply through the release of emergency oil stocks to the markets. The organisation s prime focus on maintaining systems for coping with oil supply disruptions, but it also provides a forum for cooperation on energy policy formation, sharing of energy statistics, cooperation in energy programs, and dialogue with non-opec member countries. Membership now includes Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Luxembourg, The Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. The Commission of the European Communities takes part in the work of the IEA (IEA, 1994). As will be discussed later, Australia did not join the IEA until Membership of the IEA carries with it certain obligations with respect to energy security. This includes the requirement for member countries to hold at least 90 days stocks of net oil imports. During declared oil crises, member countries may also be required to reduce consumption or supply oil to other member countries to help member countries manage their oil markets until the crisis has subsided International Energy Forum The International Energy Forum (IEF) was formed in 1991 and now has 76 member countries. The IEF charter outlines a framework for a global energy dialogue through an intergovernmental arrangement. Member countries account for around 90 per cent of global oil supply and demand. One of the projects undertaken under the IEF is the Joint Oil Data Initiative (JODI). JODI is a comprehensive collection of oil market data. 8

23 3 Australian Economy, Policy and Oil The structure and regulation of the Australian economy changed significantly over the review period. Significant changes included the floating of the Australian dollar in December 1983, deregulation of the petroleum market during the1980s, and microeconomic reform and labour market innovations during the 1980s and beyond. The fall in the exchange rate to around US$0.40 by the late 1990s was important to the extent that it tended to offset the impact of falling global crude oil prices. By the same token, the rise in the exchange rate to around US$0.98 was an important buffer to rising oil prices in the in the period. This has been also important in recent years with the rise in the exchange rate to near parity. Petroleum fuels have been a major component of energy in Australia. The share of total energy supply (energy units) provided by petroleum in was 51 per cent. By , this had declined to 39 per cent. The outlook for domestic production of petroleum in the late 1970s was commonly perceived to be a decline in domestic petroleum production leading to a relatively rapid decline in liquid fuels selfsufficiency from the relatively high level of around 70 per cent at that time, unless further oil discoveries were made. There are several reasons why this decline did not occur. First, the rise in oil prices in the 1980s led to further development of petroleum fields in Gippsland and the Cooper Basins. Second, the development of new production associated with the North West Shelf project meant that production of domestically produced petroleum increased to its highest level ever by 2002, before declining again as other fields continued to decline. Before the 1970s, several small onshore fields and important offshore fields in Bass Strait were developed in Australia. By the beginning of the 1970s, there were several oil fields in production: Moonie in Queensland, Barrow Island in Western Australia, Cooper Basin fields, and the offshore Barracuda, Halibut and Kingfish fields in the Gippsland Basin. These developments resulted in a substantial increase in production of crude oil (and gas) in Australia. At that time there were eight refineries operating in Australia, drawing in part on the increasing production of indigenous crude oil. In 2003, Mobil announced suspension of operations at the Port Stanvac refinery in South Australia placing it in a care-and-maintenance mode. The company announced the permanent closure of the refinery in Further closures of refineries were announced after that date. Shell closed its refinery at Clyde in Sydney in November 2013, and Caltex will close its refinery at Kurnell also in Sydney in June On 4 April 2014 BP announced its intention to close its refinery at Bulwer Island in Brisbane. The Australian downstream petroleum market is undergoing significant restructuring of ownership at the time of writing. Changes in the regulation and taxation of petroleum production and consumption in Australia are important to understanding the response in Australia to interruptions in global oil supplies. The price of domestically produced crude oil was regulated in the 1970s, at first to ensure that Moonie oil was absorbed by refineries, but subsequently to hold prices of domestically crude oil below world prices (import parity) as world oil prices rose in response to the first oil crisis. This reduced the price impact on Australia of rises in World oil prices and accordingly the incentives for oil conservation and exploration and development in a world of higher oil prices. Australia introduced import parity pricing for crude oil in However, arrangements for an economically inefficient levy on production of crude oil remained. This situation was gradually overcome with the gradual introduction of the Petroleum Resource Rent tax, commencing with new offshore fields in 1988, and concluding with its extension to all offshore and onshore petroleum projects by General Economic Context Consideration of the impact of global oil supply developments on Australia cannot be meaningfully conducted without reference to general economic and policy settings that 9