Essay on Oil Prices by Mark Zandi : LUSENET : TB2K spinoff uncensored : One Thread

The Macroeconomics of Oil By Mark Zandi

Oil prices have surged during the past year. Since its nadir of just over $10 per barrel early last year, the price of a barrel of West Texas Intermediate has recently been trading near $30. This is the highest oil prices have been since just prior to the Gulf War nearly a decade ago. Gasoline and home heating oil prices have spiked as a result. The average price for a gallon of gasoline is currently near $1.40 compared to under $1.00 a year ago.

Behind the jump in oil prices is a quickly improving global economy, which has supported much stronger global oil demand. Adding to demand has been the recently colder weather in the U.S. OPEC has also resolutely stuck to its production quotas, which the cartel had significantly lowered in 1998 and again in early 1999 when global oil demand was caving under the weight of the global economic crisis.

Not surprisingly, if sustained, the higher oil prices will have a negative impact on the U.S. economy's performance. U.S. inflation will be higher, corporate profits will be lower and the economy's growth will be slower as a result. The impact on inflation is already evident in the higher gasoline and home heating prices, which has translated into higher producer and consumer price inflation. The CPI would currently be rising closer to 2% than its actual 2.7% if not for the higher oil prices.

Aside from airline ticket prices, however, inflation for other retail goods and services, even for those products that are intensive in their energy use, have seemingly yet to be impacted by the higher oil prices. This is due in part to the ability of businesses to avoid paying substantively higher oil prices, at least to date, through the use of various financial hedging techniques and longer-term oil contracts that were set when prices were much lower. It is also likely due in part to the inability of businesses to pass through higher energy costs in higher prices for their own products. Corporate profitability is thus eroding, particularly in the energy-intensive transportation, textile, lumber, paper, chemical, rubber and plastics and steel industries.

The economy's growth will ultimately be impacted as the higher energy prices bite into consumer's purchasing power and the lower profits crimp business expansion plans. If oil prices remain near $30 per barrel for the remainder of the year, up from an average of close to $20 per barrel for all of 1999, then this will shave approximately one-half a percentage point from real GDP growth. Instead of expanding by an expected 3.4% between the fourth quarters of 1999 and 2000, real GDP will expand by 2.9%. Higher oil prices will thus take some of the shine off the new economy's luster.

While measurable, the economic impact of higher oil prices today will be much less pronounced than it would have been in years past. The U.S. economy has become substantially more energy efficient. Twenty-five years ago, the economy used 1400 BTUs of petroleum to produce a dollar's worth of GDP. According to the Energy Department, it takes less than 700 BTUs to produce one dollar's worth of GDP today (see Chart). This improvement is the result of the changing structure of the U.S. economy, away from energy-intensive manufacturing and towards service and information based activities that are much less reliant on energy. Households and nearly all industries have also become more efficient at using energy, although this trend has slowed in recent years as energy prices have generally remained very low.

Also mitigating the economic importance of today's higher oil prices is that there is little chance they are or will significantly affect inflation expectations. In previous bouts of quickly rising energy prices during the 1970's and early 1980's, consumers and businesses believed that there would be little future relief from steadily rising oil prices and overall inflation. When energy prices rose so did inflation expectations, which in turn fueled even stronger actual overall inflation. Nary a person or business today believes that today's higher energy prices will be sustained for very long.

Indeed, in all likelihood, oil prices are near a peak. OPEC will more than likely raise its production quotas this year, and this may happen as soon as the next meeting of the cartel in March. OPEC is not anxious to see oil prices remain at $30 per barrel or more for very long, as this would induce other more marginal global oil producers to ramp up their exploration and development efforts. Long dormant conservation efforts would also be reexamined.

Higher oil prices matter to the U.S. economy. While not expected, if today's $30 per barrel oil prices are sustained, then inflation will be higher, corporate profits will be lower and real GDP growth will be weaker this year. The economy will have another good year, just not as good as currently envisaged. Higher oil prices matter much less to the economy than they did in the past, however. Ten years ago sustained $30 per barrel oil prices were enough of a catalyst to push the economy into recession.

-- Ken Decker (, March 06, 2000

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