Brad Setser

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Adjusting to $125 a barrel oil

by Brad Setser
May 14, 2008

This is not a post about the gas tax. Nor is it a post about how the United States existing energy-inefficient capital stock makes it harder for the US to adjust to higher oil prices. Dr. Krugman has already covered that ground well. It is rather a post about how the global balance of payments has to respond to what increasingly looks like a significant oil shock.

If oil — using the price for sweet light crude — stays to $125 a barrel for the rest of the year, the average price of oil over the course of 2008 will be around $115 a barrel. The average 2007 price was around $70 a barrel. The $45 a barrel y/y increase in the average price of oil is equivalent to going from $25 a barrel oil to $70 a barrel oil in a single year. It is a large jump.

It would lead to something like a $650-700 billion transfer of wealth from the oil-importing economies to the major oil-exporting economies

Assuming that the oil exporters don’t spend and invest all that much more than they already were planning to do in 2008, the rise in the oil export revenues will translate into a comparable increase in the oil exporters’ current account surplus – and a comparable rise in the oil importers deficit. Of course, there will be some adjustment in the imports of the oil-exporting economies. But spending and investment in the oil-exporting economies tends to adjust with a lag to rises in the price of oil. And it was already on a sharply upward trajectory, in part because of the exceptionally low real interest rates in the oil-exporting world. If oil had stayed at its 2007 level, it is safe to assume that the oil exporters surplus – roughly $425 billion in 2007 according to the IMF – would have fallen by $100 billion, if not more.

The Spring IMF World Economic Outlook assumed that oil would rise from $70 a barrel to $95 a barrel average oil price — pushing the oil exporters (Fuel exporters in the WEO) current account surplus up to $620 billion. If oil says at $125 a barrel for the rest of the year and oil averages $115 a barrel for the year, the oil exporters’ current account surplus could approach $900 billion range.

That forecast assumes that the oil exporters collectively would need an oil price of about $55 a barrel to cover their import bill. It relies on a lot of ballpark math too — I haven’t done a detailed update of my 2007 paper on oil and global adjustment.

But in some sense, the precise details do not matter all that much.

We know that there will be a big rise in the oil-exporters collective surplus.

And we also know that there will also have to be a big fall in the oil-importers collective deficit.

This adjustment though could happen in a bunch of different ways.

The world, broadly speaking, has three oil importing regions – Asia, Europe and the US – and each imports roughly 15 mbds of oil. The US and Europe import a bit less, Asia a bit more. The EU (which excludes Norway) actually imports a bit less than the US these days – 13 mbd v 14 mbd. So the “shock” will in the first instance have a roughly similar impact on all three regions (all data comes from BP). Each region should see its deficit rise (or surplus fall) by around $200 billion.

Nothing though guarantees that the adjustment of various regions to an oil price shock will be symmetric. In the past, it actually has often been asymmetric. MORE FOLLOWS

From 2002 through 2007, Asia surplus actually rose even as the oil surplus rose, largely because of the enormous increase in China’s surplus. If that happens again, the rise in the US and Europe’s deficit needed to balance the rise in the oil surplus would be corresponding larger.

But let’s assume that doesn’t happen again. Oil’s rise to $125 a barrel should single-handedly knock $60-70 billion off China’s trade surplus, and the US isn’t quite as robust a market for Chinese goods as it once was.

The adjustment could be asymmetric in another way. If an oil shock hits one oil-importing region with a large pre-existing deficit (the US), one oil-importing region with a small pre-existing deficit (Europe) and one oil-importing region with a large pre-existing surplus (Asia), the easiest way for the aggregate deficit of the oil-importing region to adjust would be for the fall in the surplus of the surplus region to be bigger than the rise in the deficits of the deficit regions.

A surplus country after all doesn’t need to attract any financing or run up its debt stock to sustain large deficits, while a deficit region both needs new financing and has to add to its outstanding debt stock.

So how is the world adjusting?

Well, so far China’s surplus is roughly flat. It hasn’t though absorbed the full impact of the rise in oil prices — though the gap between oil prices in q1 of 2007 and q1 in 2008 is actually about as wide as the gap that one would expect for the entire year. But with China’s exports are still growing at a nice clip (20% y/y) it isn’t at all obvious to me that China’s surplus will fall. Its surplus should fall in q2 – but in the second half ongoing export growth would interact with slower import growth to bring the surplus back up.

If China’s surplus doesn’t fall even as its oil import bill rises sharply, that means the rise in the deficit of other oil-importing regions has to be bigger. That rise could come from other Asian economies, squeezed on their exports by China and facing a much higher bill for imported oil. Think India. It could come from Europe. Or it could come from the US.

Right now I would expect the US trade and current account balance to expand by roughly $100 billion, as say a $100 billion improvement in the non-oil balance is offset by a $200b or more deterioration in the oil balance.

If China’s surplus doesn’t fall and the US deficit doesn’t rise by as much as its oil import bill, that implies the rise in the deficit of the rest of the world has to be bigger. Europe and emerging Asia (ex China) almost by necessity will have to run bigger deficits to accommodate the absence of any fall in the Chinese surplus and the smaller than might otherwise be expected rise in the US deficit.

That at least is what I am thinking around now.

The FT understands this.   Their leader last Friday noted that the rise in the Euro had been overdone – and threatened to undermine Europe’s growth. Hence they welcomed the dollar’s mini-rebound. But they also noted that many Asian currencies need to appreciate against both Europe and the US to reduce the world’s imbalances.

And right now, unfortunately, it seems like China isn’t willing to help out. The fast rise in the RMB against the dollar didn’t produce broad based nominal appreciation, as the RMB fell against the euro. And now the RMB is stable against the dollar. The RMB will still rise in real terms so long as inflation in China outpaces inflation elsewhere.   But with productivity growing faster in China than elsewhere that may not be enough. And right now the world economy would benefit more than usual from a fall in China’s surplus, as it would help to dissipate some of the global impact of a major oil price shock away from the big deficit countries.


  • Posted by don

    Brad: An excellent post. Think India? I wonder what will happen to the Japan, particularly as China seems to be moving upstream to more technology-intensive industries.

    Is the euro area more, or less dependent on oil imports than the U.S.?

  • Posted by koteli

    Sorry Brad,

    Copying and pasting:

    ( Some ) Americans tend to believe that they own the planet, that they can consume and pollute without limits, even if this threatens the future of ALL people on the planet. And they obviously expect that even people in very poor countries cut back in their consumption habits to allow the continuous over-consumption in the U.S.. That’s a pretty primitive attitude.

    America has never proved over the last century that it has any special sense of responsibility toward the environment or the living standards in other, especially poor nations. It consumes more than any other nation, pollutes more than any other nation, gives less in foreign aid than most rich nations, blocks regularly international attempts to improve environmental standards, uses often military force to push through its economic interests and is often at the front line when it comes to boycott the very moderate attempts to improve labor or social standards in China and other developing nations.

    Against this background the whining about the declining American living standards and the evil Chinese or Indians that take away a part of the American wealth or American jobs looks pretty ridiculous. America has never shown any kind of special consciousness for the price many people in the third world pay for the excess consumption in the U.S.. Why should Chinese or Indians bother now about the fate of the "American worker" or the "poor" American citizen from suburbia with his over dimensioned SUV?

    And by the way the people that will be hit the hardest by a steep increase in energy prices or a dramatic climate change would be citizens in poor countries ( as we currently can see in Myanmar ). The adjustment costs in rich nations will be moderate in comparison. And different from most poor nations rich countries have the economic means to rebuild their societies for a more sustainable future. It’s not the fault of the Chinese or Indians that America has missed for decades to make its economy more energy efficient or reduce the enormous waste of natural resources in the U.S..

    Most problems that plague America today are home made. No one has forced Americans to consume more than they earn. No one ( at least no foreigner ) has seduced them to start a stupid war in the Middle East. To lower the social protection of U.S. workers and undermine the labor standards in the U.S. was the result of domestic political decisions in the U.S., not a consequence of globalisation ( but globalisation the way its currently organized is a typical result of the neoliberal domestic policy of the last decades).

    The creeping impoverishment of millions in the U.S and rising inequality are a typical outcome of neoliberal supply-side politics. The short breathed style of capitalism which treats workers like removable things is a classical American invention. No Chinese or Indian is responsible for the messed up health care system in the United States which leaves many millions without appropriate protection. Exploding college fees are not the guilt of poor people in foreign countries. And so on and on and on.

    If Americans feel uncomfortable with their situation they should start at the home front and begin to change their own country, not expect people in much poorer countries to renounce for the well-being of the American consumer.

    Besides: The people which profit the most from globalisation are not workers in the third or second world. It’s the capitalist "elite" of the Western world which makes the highest gains – on the back of workers in developing countries AND in rich nations. And they should be those, who pay the price.

  • Posted by Guest

    Gregory (detective): "Is there any other point to which you would wish to draw my attention?"

    Holmes: "To the curious incident of the dog in the night-time."

    Gregory: "The dog did nothing in the night-time."

    Holmes: "That was the curious incident."

  • Posted by Aim


    What will happen to the value of the dollar during all of this? I think if China doesn’t help out, it will depreciate even more.


    So in your mind "two wrongs must make a right"? How immoral of you…

  • Posted by Cassandra


    …or China just needs buy yet more dollars (at least the jetsam sold back into the market by GCCs and other exporters unwilling to hold dollars). In other words, "more of the same"….no?

    I think back to 1986 and my concern about rising US private & govt debt-to-GDP ratios, and even though I was vindicated for about a nanosecond in 1987, I can’t help but muse "Wow, was I early on THAT one!"

  • Posted by bsetser

    Cassandra — yes, "China doesn’t adjust but instead finances" is a potential outcome, and one that keeps the game going. But given China’s new jihad v hot money and Russia’s efforts to squeeze the speculative longs betting on the ruble, it sure seems like China and Russia would rather avoid sucking up other people’s dollars. But in Russia’s case that means depreciating the ruble in the face of inflation … The level of monetary and exchange rate policy incoherence among the oil exporters in particular has reached epic proportions.

  • Posted by bsetser

    koteli — there are many things that are the united states own fault. its energy policy first among them. at the same time, the pattern of global adjustment to an oil shock isn’t something that is determined by policy actions in the US alone. global balance of payments equilibrium is determined jointly. the us has taken some actions (countercyclical fiscal) that would tend to push the US deficit up. China has recently taken some actions (repegging to the $) that would tend to keep its surplus up. Europe has taken some policy actions (holding rates well above us rates) that have tended to strengthen the euro and thus increase its deficit. Here though i think there is an unusually strong case that the big oil importer with the largest pre-existing surplus has the most scope to help the overall global economy adjust by accepting a smaller surplus.