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Oil Boom… And Risk Management

by Blake Clayton
December 19, 2012

A story on NPR yesterday morning, “The Downsides of Living in an Oil Boomtown,” had an interesting portrait of the economic effects of high oil prices and booming oil production on Williston, North Dakota. The frenzied pace of job creation has led to high wages but also high turnover. A leap in demand for local goods like housing has caused massive inflation in housing prices and day care services. A similar story could be told of many other rural communities in states like Pennsylvania and Texas where the ramp up in oil and gas drilling activity has been a sudden shock on an otherwise rather static business scene.

The underlying message of the NPR piece is straightforward: Every economic change has its tradeoffs. Taking into account the massive joblessness problem in the United States right now—what Fed Chairman Ben Bernanke recently called “an enormous waste of human and economic potential”—there’s some irony in a news story focused on the downside of too much hiring happening too fast and too much money flowing into the hands of a local workforce. But the report is right to get people thinking about the economic tradeoffs involved anytime local economic growth is tied closely to the extractive sector.

I was interested to see that Carmen Reinhart and Kenneth Rogoff’s This Time is Different singles out commodity price fluctuations as having played “major role in precipitating sovereign debt crises” over the last two centuries. Analyzing the co-movement between defaults and real global commodity prices, they write:

Peaks and troughs in commodity price cycles appear to be leading indicators of peaks and troughs in the capital flow cycle, with troughs typically resulting in multiple defaults…

Emerging market borrowing tends to be extremely procyclical. Favorable trends in countries’ terms of trade (meaning high prices for primary commodities) typically lead to a ramping up of borrowing. When commodity prices drop, borrowing collapses and defaults step up.

So what’s the link to the NPR story? The extractive industry is a cyclical business; and so, too, will be the economic fortunes of the those local, or even state, economies that depend heavily on it. Unforeseen fluctuations in commodity prices can carry local consequences  entirely different from, and at times much stronger than, what a country as a whole experiences, if a particular local economy is insufficiently diversified and unhedged.

Typically, discussion of what the American energy boom could mean for the U.S. economy has focused on aggregate outcomes in areas like domestic output or employment. But what about for smaller slices of the country, which may be more exposed? Yes, the good times can be pretty heady—but the bad times can be especially tough. Texas, for instance, went into recession when oil prices collapsed in 1986, though lower prices were a net economic benefit to the rest of the country, which breathed a sigh of relief after the oil crises of the 1970s. The state’s economy is more diversified now, making it less sensitive to oil prices. But the link’s still there, as it is in other producing regions.

Energy economists in major hydrocarbon-producing states like Texas have known this for a long time, so they’ve devoted lots of attention to understanding how a change in prices affects their part of the country. Mine Yücel at the Dallas Fed is among those who have done years of excellent research on these localized oil-related macroeconomic dynamics. Policymakers in states less accustomed to these levels of hydrocarbon-driven economic activity will now need to follow suit, and those in the oil patch may need to re-learn old lessons.

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