The Energy Information Administration (EIA), in its recent Short-Term Energy Outlook, reported that in May, average crude oil prices rose as continued reports of low oil inventories trumped expectations that Iraqi oil production would quickly return to pre-war levels. Those hopes faded on the news that post-war looting would postpone for some months the return of the Iraqi oil sector to normal operations. In addition, a terrorist attack in Saudi Arabia and estimates of lower production in Saudi Arabia by some analysts combined to push prices upward. By early June, the OPEC basket price had risen to its highest level in two months, and is now in the upper end of OPEC’s target range of $22-$28 per barrel.

U.S. Natural Gas Markets

The natural gas spot price has remained well above $5 per million Btu on a monthly basis since the beginning of the year, and was above $6 in early June. The low level of underground storage is the principal reason for these unseasonably high prices. Natural gas prices will likely remain high as long as above-normal storage injection demand competes with industrial and power sector demand for natural gas. Above average prices and strong gas-directed drilling efforts this year will be needed to ensure that gas in storage reaches at least minimally adequate levels by the beginning of the next heating season. If adverse weather intervenes, the task could be made more difficult and even place additional upward pressure on prices. Moreover, if the summer is unusually hot, particularly in the Western and South Central regions, where natural gas is heavily used for the power generation needed to meet cooling demand, marginal gas prices may experience additional pressure. Indeed, occasional sharp price increases could occur as the difficulty of building adequate storage increases. Assuming normal weather, spot prices in the $5.50-$6 per million Btu range are expected for the rest of 2003.

Summer Motor Gasoline Outlook

Pump prices were expected to average about $1.46 per gallon during the remainder (June-September) of the driving season. The price of regular motor gasoline in California in early June ($1.73 per gallon) was about 26 cents per gallon higher than the average price for the nation ($1.47 per gallon), down from the 45-50 cents per gallon price difference of the previous month. Earlier in the driving season, unplanned refinery shutdowns and the phase-out of MTBE (methyl tertiary butyl ether) created supply problems that impacted the price. (MTBE is being replaced with ethanol in California gasoline). The transition from MTBE to ethanol created two essentially incompatible distribution systems, which exacerbate the tight gasoline market. However, market supply adjustments and improved economies of scale in the refining and blending process have narrowed the price differences between California and other regions.

International Oil Markets

Average May crude oil prices were slightly above $28 per barrel. However, it should be noted that May oil prices actually rose about $3 per barrel through the month, offsetting a comparable decline during April. May prices rose in response to continued low oil inventories and uncertainty about when Iraqi exports would resume. Market expectations never materialized that oil inventories would rise sharply in response to a "wall of crude" oil supplies from the Middle East. Instead, hopes that Iraqi production would quickly return to pre-war levels faded on the news that post-war looting would postpone for months the return of the Iraqi oil sector to normal operations. In addition, a terrorist attack in Saudi Arabia and estimates of lower production in Saudi Arabia by some analysts combined to push prices upward. By early June, the OPEC basket price had risen to its highest level in two months and was in the upper end of OPEC’s target range of $22-$28 per barrel.

International Oil Supply

Prior to the increase in oil prices over the past few months, OPEC had openly discussed whether to cut production beyond the reductions that took effect on June 1. OPEC Secretary-General Alvaro Silva had warned that a decline in global oil demand and the return of Iraqi oil to the market could prompt OPEC to cut target output quotas, effective on July 1, to stabilize markets. OPEC 10 oil production (excluding Iraq) in May was an estimated 26.8 million barrels per day, unchanged from April levels, and 1.4 million barrels per day above the new June 1 OPEC production targets. These new targets are projected to lower OPEC 10 production to slightly under 26 million barrels per day. However, when this cutback and the loss of Iraqi production following the war are factored in, total 2003 OPEC crude oil production (including Iraq) is still expected to be 1.5 million barrels per day above 2002 levels. This fact, combined with an expected aggregate increase of a little over 1 million barrels per day from non-OPEC sources in 2003, indicates a total world oil supply increase in 2003 of over 2.5 million barrels per day, which is expected to allow for a global stock build this year. However, until inventories are rebuilt above observed 5-year lows, WTI oil futures prices should remain around current levels, then gradually slide toward $25 per barrel by the end of 2004 as Iraqi oil exports return.

International Oil Demand

World oil demand is still projected to grow by about 1 million barrels per day in 2003, as projected in EIA’s previous outlook. About one third of the growth in world oil demand in 2003 is projected to come from the United States. China and other non-OECD countries are projected to provide a total of another 0.5 million barrels per day of demand growth next year. As world economic growth continues in 2004, led by a projected 4.2 percent per year increase in the U.S. economy, world oil demand growth could increase by as much as 1.2 million barrels per day.

U. S. Energy Prices

Distillate Fuel Oil (Diesel Fuel and Heating Oil): Diesel fuel oil prices are expected to maintain stability over the next several months. Retail heating oil prices, on the other hand, should decline through the cooling season (assuming our base case holds) until the next winter begins. Then, we see home heating oil prices heading upward, averaging about $1.25 per gallon for the 2003/2004 winter. At the end of May, distillate fuel oil inventories were about 103 million barrels, a level below the lower band (106 million barrels) of the 5-year min/max range.

At the end of May, working gas in storage stood about 38 percent below end-of-May 2002 levels and 28 percent below the previous 5-year average. In 2003, wellhead prices are projected to show an increase of about $2.40 per thousand cubic feet (the largest U.S. annual wellhead price increase on record) over the 2002 annual average, pushing the annual average for the year to over $5.30 per thousand cubic feet. For 2004, prices are projected to ease only moderately, as supplies are expected to remain tight.

U. S. Oil Demand

Total annual U.S. petroleum demand is projected to increase by an average of about 340,000 barrels per day per year, or 1.7 percent, between 2002 and 2003. Petroleum consumption is projected to vary widely by product in a manner similar to the contrasting product-specific demand patterns seen in the previous two years. This variability is due to weakness in industrial activity, the effects of the terrorist attacks of 9/11, year-to-year shifts in weather patterns, and substantial shifts in product prices. Nonetheless, continued moderate economic recovery–which is expected to accelerate in 2004–and increasing supply/demand tightness in natural gas markets are expected to contribute to the anticipated rise in petroleum demand, especially toward the end of 2004. The assumption of normal weather patterns is also expected to contribute to the firmness in demand.

Motor gasoline demand has been virtually flat since the beginning of the year. An average 20 percent increase in real per-mile fuel costs has been constraining consumption along with anxieties surrounding the conflict in Iraq. The second half of this year, however, is expected to witness a year-to-year demand increase of 1.2 percent. During that period, retail gasoline pump prices are projected to continue to decline from their recent highs. In 2004, motor gasoline demand is expected to increase 3.1 percent, reflecting a projected rise of 3 percent in highway travel and some continued erosion of the fleet-wide fuel efficiencies seen during the last several years. Both the 3.9-percent increase in real disposable income and an 8.1-percent decline in real per-mile fuel costs are expected to contribute to the recovery in highway travel growth. Reflecting shifts in travel patterns over the past several years, growth in highway travel is projected to be substantially less than the projected average annual growth in real disposable income.

Distillate fuel oil demand registered growth of more than 7 percent during the first 5 months of the year as a result of substantial year-to-year weather differences and fuel switching due to high natural gas prices. Distillate demand is expected to increase at an annual average rate of 3.4 percent during the forecast interval, boosted by accelerating growth in industrial and transportation output.

Residual fuel oil deliveries are projected to grow sharply (by about 10 percent) to 740,000 barrels per day in 2003 on the strength of electric power generation demand, then fall below 700,000 barrels per day once again in 2004. Liquefied petroleum gas demand growth is projected to weaken in 2003 as a result of continued firmness in natural gas prices, then resume moderate growth in 2004 as a result of growth in petrochemical demand and the decline in feedstock prices.

U.S. Oil Supply

In 2003, average domestic crude oil production is expected to increase slightly (0.3 percent) to a level of 5.83 million barrels of oil per day. For 2004, a 0.4 percent decrease is expected, resulting in a production rate of 5.81 million barrels of oil per day average for the year.

In the lower 48 states, oil production is expected to increase by 44 thousand barrels per day to a rate of 4.88 million barrels per day in 2003, followed by a decrease of 14 thousand barrels per day in 2004. Oil production from the Mars, Mad Dog, Na Kika, Ursa and Dianna-Hoover Federal Offshore fields is expected to account for about 7.9 percent of lower-48 oil production by the fourth quarter of 2004.

Alaska is expected to account for 16.3 percent of total U.S. oil production in 2004. Alaskan oil production is expected to decrease by 2.6 percent in 2003, with a further decrease of 1.1 percent in 2004. The combined production rate from the two significant satellite fields, Alpine and North Star, averaged nearly 170 thousand barrels per day during February 2003. Production from the Kuparuk River field plus like production from West Sak, Tabasco, Tarn and Meltwater fields is expected to stay at an average of 215 thousand barrels per day over the 2003 and 2004 forecast periods.

Natural Gas Supply and Demand

Given current high natural gas prices, natural gas demand is expected to remain flat in 2003 and 2004 compared to 2002. Little or no growth this year is likely despite sharply higher weather-related demand during the first quarter of 2003. Weakness in aggregate industrial output and sharply higher prices this year result in stagnant or falling demand in the industrial and electric power sectors.

Demand for natural gas this summer was expected to fall by close to 1 percent from last summer’s level, due largely to summer weather effects. Cooling degree-days for the season (2003 second and third quarter), under our assumption of normal weather, would be about 8 percent below year-ago levels. Summer natural gas wellhead prices are projected to be 44 percent higher than they were last summer. In the event of a hotter than normal summer this year, natural gas prices would go even higher, as expanded natural gas-fired electric generation to meet cooling demand would compete with the need to build storage inventories.

Working natural gas in storage stood at about 1,212 billion cubic feet (bcf) at the end of May, about 38 percent below the year-ago level. This is the second lowest aggregate inventory level for the end of May recorded by EIA. Eastern and producing regions stocks, in particular, are at low levels. Demand for natural gas to refill working gas storage in 2003 will be higher than average, which means that price volatility can be expected to continue in these tight market conditions.

Natural gas production is expected to increase by 2.2 percent this year. High natural gas prices and sharply higher oil and natural gas field revenues are driving the resurgence in natural gas-directed drilling activity this year following the downturn in 2002. Monthly oil and natural gas field revenues are expected to continue to average over $400 million this year. Domestic production growth should continue in 2004 but, given recent experience, the extra effort might result in increases of less than 2 percent. The prospects for significant reductions in natural gas wellhead prices over the forecast period from the current high levels could hinge on the productivity of the expected upsurge in drilling in terms of expected output.

Electricity Demand and Supply

Electricity demand is expected to increase by 1.7 percent this year in response to the ongoing recovery in the economy. If our assumption of normal temperatures for the remainder of the year proves true, little or no net weather-related demand growth is expected. This situation contrasts sharply with the hot weather conditions that prevailed in 2002. In 2004, annual electricity demand is projected to continue to grow, albeit more slowly than the economy.

Natural gas-generated electricity production is expected to show small growth in 2003. This is in part due to fuel substitution related to high natural gas prices, increasing oil and coal utilization (where possible) beyond what otherwise would have prevailed. In 2003, petroleum-generated electricity production is expected to increase by about 28 percent. In 2004, petroleum-generated electricity production is projected to fall back but still remain above 2002 levels. Hydroelectric generation, while down in the Pacific Northwest, is up in other parts of the country due to high water levels and is expected to increase by 11 percent overall in 2003. Nuclear generation is about the same as last year.

The Short Term Energy Outlook is done by the Energy Information Administration. For more information visit www.eia.doe.gov.