Do oil price spikes really slow economic growth and harm people’s disposable incomes? Or is this just “nonsense,” to use the words of Caroline Baum, a Bloomberg columnist, in a recent op-ed pooh-poohing the idea that oil price increases harm the economy. That op-ed prompted several emails from readers seeking a second opinion on her views.
The answer is that Baum makes at least one good point, but that higher oil prices really do have harmful effects on the overall U.S. economy.
Start with the good point. As she notes, some economic sectors do benefit from higher prices. Rising prices make oil production more profitable and motivate greater drilling and resumed pumping from existing wells that are not worth pumping when prices are lower.
Greater drilling and production increase employment in the oil sector itself, and in secondary ones that supply inputs like tools, machinery, pipe, diesel fuel and the myriad other items needed for increased production. The input supply firms themselves have higher profits and may invest in new plant and equipment. So there are further effects that spread through the economy like concentric circles after a stone is dropped in a pond.
Moreover, the higher profits that result from higher prices mean greater dividends paid to shareholders in oil-related corporations. Landowners selling drilling rights get higher payments. These dividend and royalty checks get spent somewhere.
All of this offsets some of the reduction in business activity and consumption that higher prices cause elsewhere in the economy.
That higher prices increase activity in the oil industry is not an original observation. Any economist would assume this to be true, since it is an application of introductory micro theory. And anyone who follows the North Dakota economy or that of the traditional “oil patch” centered on Texas, Louisiana and Oklahoma knows how important higher oil prices can be to regional economies.
The crucial question, however, is how large this increase in activity in the energy sector is compared with reductions in other parts of the economy.
Baum cites the 30,000-worker increase in oil and gas employment since December 2009 as an example. In relative terms, that is nearly a 20 percent increase in that employment category. But it is only two one-hundredths of 1 percent of the nation’s total employment of 140 million and only 1.5 percent of the total increase in employment over the past 25 months. Since the oil sector is highly capital intensive, the boost to output almost certainly is proportionately larger than this, but still small compared with total Gross Domestic Product.
To understand this better, consider simplified examples from the “real economy” of resources and goods. (In actuality, the economic interactions would be more complex, but let’s stick with the basics for now.)
Take a nation that produces all its own oil. The wells are owned by a small number of companies that suddenly collude to raise prices. (To do so, they need to reduce output, so there is no increase in hiring and investment and no diversion of real resources from other sectors.) Households would have to pay more for gas and hence have less to spend on other goods. Demand, sales and production of the goods consumed by the adversely affected households will fall. So will employment in the sectors that produce these goods.
But higher prices would mean higher executive compensation and higher dividends for the oil companies. Managers and shareholders would spend more. In theory, the increased consumption by these groups might completely make up for the decreased consumption by fuel-purchasing ones. The overall economy need not shrink, even though purchasing power would be distributed less equally.
Consider a second case in a similarly self-sufficient nation. For some reason the distance oil must be lifted in existing wells suddenly doubles. And all new wells now require drilling through twice as much rock before hitting oil. Producing the same amount of oil will thus require much more electricity or diesel to operate pumps and twice as much labor, fuel, drill pipe and bits, etc., for new wells.
These real resources are ones that now cannot be used to produce other goods and services. So production of these other things must fall. Overall output of the economy, and hence the society’s real income, must fall. A scarcer, harder-to-extract natural resource has reduced real living standards.
Consider a third case, in which a nation produces none of its own oil and thus must import 100 percent of what it uses. Because of global factors, world oil prices rise. To pay the additional cost of this oil imported from abroad, the nation will have to export more of other things to the rest of the world. Or it will have to sell off domestic assets to new foreign owners. Consumption of all other goods and services must fall now or fall in the future. People are poorer.
In the real world of 2012, the United States is closer to a combination of the second and third cases than to the first.
Oil drilling in places like western North Dakota is booming because prices are high. That justifies spending money to drill many wells that are viable at $100 but would not be at $60. But those high costs reflect the fact that this drilling consumes more real resources than did older wells. These resources thus cannot be used to produce other goods and services. Society must consume less and thus is poorer in real terms.
Moreover, we are still net importers of nearly 50 percent of crude and refined products combined. So when world prices rise, we are in the position of needing to export more of other things or sell off assets to the rest of the world. We consume less now or later.
Of course the real-world economy is far more complex than this. Add in that complexity, and the net effects on economic growth and household consumption are negative and even greater. This is one case where the conventional wisdom is correct. On the whole, oil price spikes are bad for the U.S. economy.