A Primer on Oil Prices

Oil Prices: Cause and Effect: "Oil prices did not quintuple after 1999 because Americans suddenly switched from mini-cars to SUVs. On the contrary, if all passenger cars, pickups and SUVs were replaced with bicycles, the United States would still import a lot of oil.

We import nearly 58 percent of all petroleum, yet only 45 percent of each barrel is used to produce gasoline, and a significant portion of that gasoline is used in delivery vans and taxis. Commuter and leisure driving accounts for little more than 40 percent of the oil we consume -- far less than the amount we import. The rest of each barrel of crude is used for heating oil and diesel fuel for trucks, busses, farm machinery and ships (23 percent), petrochemicals (17 percent), jet fuel (9 percent), asphalt (4 percent) and propane (4 percent).

U.S. industries use petroleum to produce the synthetic fiber used in textile mills making carpeting and fabric from polyester and nylon. U.S. tire plants use petroleum to make synthetic rubber. Other U.S. industries use petroleum to produce plastic, drugs, detergent, deodorant, fertilizer, pesticides, paint, eyeglasses, heart valves, crayons, bubble gum and Vaseline.

When the cost of oil goes up, production costs are increased and profits reduced for industries that depend on oil. Producer costs -- not consumer gasoline costs -- are the reason high oil prices threaten to shrink industrial production of goods directly affected and also of energy-intensive products such as aluminum and paper. This threat affects all new and old industrial economies, whether those nations import or export oil. The United States may be least vulnerable because of superior energy efficiency and a larger service sector.

Of these many uses of oil in industry and commercial transportation, gasoline demand among ordinary consumers may be the least sensitive to price. That is why the relatively invariable demand of motorists cannot possibly account for the wide cyclical variations we observe in crude prices. It's the other 60 percent of the barrel that matters most, at the margin.

Just as oil market pundits typically ignore the 60 percent of petroleum not going into passenger cars, they likewise ignores the 60 percent of incremental oil demand not coming from China and the United States.

Want the bad news first? High oil prices have already slowed industrial production in many countries, even China and the United States to a lesser extent. Leading indicators point to wider and deeper trouble ahead.

The good news is that oil prices have proven very sensitive to industrial production, so this problem is self-limiting. Cost-squeezed industrial firms -- not necessarily in the United States -- will be reducing production and thereby reducing world oil demand and prices.

Nobody in Washington shows the slightest awareness of the global nature of the oil market, of the fact that industrial damage from high oil prices has nothing to do with whether a country imports or exports oil, or even the fact that there is a crucial two-way linkage between worldwide industrial production and worldwide oil prices. When it comes to causes and effects of high oil prices, nobody in Washington shows much interest in logic or facts. It might be sad if it wasn't so pathologically pathetic."