What does $50 a barrel oil mean for the U.S. economy? It may sound flip, but one answer is that $50 oil won’t make much difference compared to $48 oil.
The point is that while symbolic milestones — whether a 50th birthday or 1,000 U.S. deaths in Iraq — catch people’s attention, passing some magic number alters underlying fundamentals very little. We are not going to see a dramatic change in our lives next month just because the nominal price of oil passed $50 per barrel this month.
Yet, there are broader issues. How will oil prices nearly twice as high as those experienced in the 1990s affect the U.S. economy? Which sectors will be hurt and which, if any, may be helped? Are these higher prices likely to be temporary or should we get used to them? How will households respond, and what effects will this have on our economy?
Some historical perspective: Adjusted for inflation, oil is no higher than it was in the mid-1970s and is well below the $80 per barrel (in 2004 dollars) of 1981. We survived those oil “crises.” We will survive this one with less pain than many expect. Moreover, we entered the current “crisis” with an economy that is fundamentally stronger than it was 30 and 23 years ago. Panic is not called for.
Even so, $50 oil is not good news for U.S. households. The immediate effect of a price increase such as this is similar to that of a tax. After paying a tax, households have less money available for consumption or saving. One of the two must fall. Higher gasoline and heating oil prices have the same effect. If a higher proportion of income goes for fuels, then there is less to spend on alternative purchases. Consumption of non-fuel items falls. Across millions of households, this slows the economy.
This first effect is not the only one, however. When households pay a tax, the government spends it, thus increasing its share of gross domestic product. Overall spending in the economy need not fall, but the composition of what is produced changes – fewer goods for households, more for government.
Something similar happens, for example, when meat prices rise significantly. After paying grocery bills, consumers have less to spend on other things or must curtail savings. Farmers, however, enjoy higher income. They spend it on new machinery, buildings or their own consumption. The meat price rise shifts the pattern of what is produced and consumed in the economy, but need not slow the economy as a whole.
Crude oil is complicated for two reasons. First, it serves as an important input for many industries. Second, we import a substantial proportion of our consumption so a shift from consumers to producers, as with higher meat prices, also entails some income shift from the United States to oil-producing countries.
Oil-consuming industries can respond to a price increase by raising their own product prices or by cutting profit margins, which already may be thin. From 1973 to 1983, there was much less competition in the U.S. economy. Raising product prices seemed the automatic solution to higher oil prices.
That is much harder to do today. Competition is intense and firms that raise prices can rapidly lose market share to rivals that don’t. This is good news for the Federal Reserve in that inflationary pressures are transmitted much more slowly now than before, but it’s bad news for corporate profits and, by extension, stock markets.
Because we import much of our oil, higher oil prices globally means that we either have to sell more of other U.S. products abroad — or borrow more abroad — to pay for the same quantity of imported oil as before. This is daunting in the face of an already unsustainable current account deficit.
Not all oil is imported, however, and high energy prices are good news to oil-producing firms and regions. Drilling new oil wells in western North Dakota, for example, rises and falls with oil prices.
Towns like Dickenson, N.D., and Farmington, N.M., are buzzing with activity right now.
The question of how long prices will stay high is crucial in determining how households and businesses will respond to higher prices. Prices are high right now because of turmoil in the Middle East, but also because China’s imports of crude are burgeoning. It is anyone’s guess when either of these factors will change.
The longer prices stay high, the more adjustments businesses and households make. Households buy smaller vehicles and drive less. They turn thermostats down and insulate more. Firms spend money on new machinery or processes that use less fuel.
Both shift to alternative energy sources. Electricity that is expensive for home or industrial heating when oil is cheap becomes attractive when oil is expensive. In the United States, increased electricity use means burning more coal, which is not good for the environment, but does reduce pressure on oil imports.
When all of these factors are taken into account, higher oil prices tend to slow the economy somewhat. One widely cited estimate is that each $10 per barrel increase in oil prices cuts annual growth of output by 0.3 percent. If oil is $25 per barrel more expensive than four years ago, growth may be 0.75 points lower than if prices had not risen. GDP grew at a 3.3 percent annual rate in the second quarter. Four percent would have been better, but 3.3 percent is not bad by historic standards.
Higher oil prices should motivate prudent responses by households and businesses, but they are not an economic catastrophe.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.