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Revisiting High Oil Prices and the U.S. Economy

by Daniel P. Ahn
March 4, 2012


Given how oil is back in the media spotlight and as oil markets brace for the implementation of the Iranian oil embargo, it seems as good a time as any to revisit the question of high oil prices and their impact on the U.S. economy (as well as revitalize my hitherto moribund blog output), discussed at length in this post.

According to the U.S. CPI, the average U.S. (urban) consumer currently spends about 9% of his or her income on energy. About 5.2% is on gasoline alone.

With the surge in Brent prices again to $125/bbl or near 100 euros, gasoline prices (even in cheap New Jersey) are getting close to the psychologically significant $4/gallon threshold. Some media still discuss WTI crude oil prices which are still trading at a significant discount to Brent but most refined product prices, especially in the U.S. Gulf and East Coast, are tracking more closely the Brent market, which is waterborne and a better recent indicator of global tightness.

So how high do Brent prices need to go for the economy to slow down or even go into a recession? One way to answer this question is to look at it historically.

Back in the late 1970s, we spent a whopping 8% of GDP on oil. In 2008, we spent 4.8% of GDP on oil, with a peak of 6.6% in the month of June. Currently, we are spending about 4.5-5% on GDP.

So are we uncomfortably close to reaching stall speed again? The problem with this historical analysis is that our economy is a lot different of that in the 1970s or even 2007-08. Notably, as everyone knows, the economy is now a lot more energy efficient than the 1970s.

Even compared to 2008, U.S. domestic oil consumption has trailed previous consumption levels despite regaining our previous level of output and despite fairly strong output and labor numbers recently, as my colleague emphasized recently in this post. I believe we are seeing the delayed impact of the previous price spike on consumption behavior and improved conservation/efficiency. Also, we are enjoying a domestic production boom, particularly in natural gas, which may moderate the impact.

So where is the new pain threshold? 7% of GDP? 8%? 9%?

Another way to tackle this is to explicitly simulate an oil price shock using a U.S. macroeconomic model. There are certain advantages to doing this. For one, we can take into account feedback loops and second round effects.

For example, as consumers fork over more for gasoline, that also means less savings that will be put to use for investment. That also slows economic growth. Or higher oil prices may stimulate inflation, forcing the Fed to raise rates earlier, with consequences for growth.

The main disadvantage is the sheer hubris of trying to model something so complicated as the U.S. economy. Even with the most sophisticated and complex model, there is always something missing.

Still, as an intellectual exercise, I simulated what would happen to the current economy if real oil prices went any higher. I considered two types of shocks: a 10% price increase that either happens gradually over 5-6 quarters or that happens quickly within two quarters, and the same shock only with a 50% magnitude price increase. They would roughly correspond to Brent prices increasing to $135/bbl and $180/bbl respectively. (By the way, these are meant to be oil supply shocks, not a price increase that happens from stronger domestic demand.)

What I find is that it matters a lot whether the price increase is gradual, giving the economy time to adjust to it, or whether it happens quickly. It is also nonlinear, so a 50% price increase hurts more than five times as much as a 10% price increase.

Most economists are saying that the U.S. economy would otherwise be growing at somewhere between 2% and 3% this year. Hence, at least the model is saying that a 50% additional price increase or Brent oil prices at $180 (WTI at $150) for a sustained period may be enough to push the economy into an actual recession. That in turn would probably cause oil prices to slingshot back as the United States and global demand contracts.

So it looks like we still have some breathing room at least in terms of price. On the other hand, it may not take much for oil prices to rocket to these levels. Observe how jittery the markets were in reaction to rumors of a fire in Saudi Arabia recently. There is a lot of military hardware floating out near the Strait of Hormuz. Or take Russia or Nigeria. The oil supply side has plenty of hotspots to choose from.

The supply-side revolution from shale oil/gas may be promising better energy security soon but it’s not quite yet. There may be room for discussion of another stockpile release, something I plan to tackle in subsequent posts.

Post a Comment 5 Comments

  • Posted by Jack Rivkin

    While we may not get the spike immediately your analysis points out that when such a spike occurs in can have significant impact on economic growth–not just in the US. Such spikes will occur at some point. And as long as the world is dependent on hydrocarbons as its fuel source, the economic and geopolitical risks are large. As other countries move toward alternative energy the US is beginning to look silly and continues to put itself in a position of narrower policy responses to anything affecting oil prices.

  • Posted by Fred

    @Jack Rivkin – which countries are actually moving towards “alternative energy”? Germany isn’t (or they buy nuke power from E. Europe). Etc. Meanwhile, we choose to not make use of our proven oil reserves. That’s not the same as not having them (Germany for example doesn’t have the luxury of having oil fields but not choosing to use them).

    In any case, even if the USA were on a “full alternative energy” path, it takes years to build the power-generation and distribution infrastructure, which is outside the scope of this quarter-by-quarter analysis. And nobody is claiming the USA will get a significant amount of energy from alternative sources.

  • Posted by James

    Seems like markets are always looking for a justification to trade at higher prices rather then reaction to any actual event that dramatically decreases available oil.

  • Posted by Mike Docent]

    @Jack Rivkin – any economic analysis you pretend that excludes the results of simply firing up new coal mining without artificial (read non-economic) constraints is worthless. There is literally hundreds of years worth of coal energy for the USA that is currently regulated out of economic viability. Some of the reasoning is to “save the planet” from invisible theoretical warming as the last 15 years of temperature records shows; some has to do with other similar ridiculous claims like the “acid rain” debacle. There is no honest bar to a major increase in the output of US energy resources. Notice that this statement is completely independent of current reality of hundreds of years of new natural gas reserves in the US, of huge US reserves of petroleum in shale, and of hundreds of years worth of domestic uranium and thorium. I’m not even including the tremendous quantities offshore of CA and FL and other areas that can be tapped at a whim and would be producing major quantities in ten years.

    Those who truly look silly are the CAGW alarmists and the Europeans who have been crippling their economy for no good reason.

    James: talk to some local owner of a gas station about the economic problems that they have to deal with when prices of a tanker of oil costs more versus when the price goes down. It is easy to find such an owner. Most will be very happy to discuss the situation with you if you are willing to ask and listen. The situation is not “reversible” for several reasons. Distributors have similar situations to the local station owners, but it is easier to understand the reality if you start with understanding the smaller operator in this case. Major buyers and suppliers such as airlines and Agway Oil and other investors including speculators have problems and considerations you can’t fathom until you understand the distributors’ situations. Until you actually try to educate yourself about the operational problems of buying trucks full of gasoline that costs tens of thousands of dollars, or tankers costing millions, and the effect of price changes in the presence of competition, you will continue to make foolish statements.

    There is hope. To cure ignorance, it only requires that you educate yourself.

  • Posted by Mike Docent]

    Oops – changed the sentence and didn’t correct, James –

    to: “… talk to some local owner of a gas station about the economic problems that they have to deal with when prices of a tanker of oil costs more versus when the price goes up and when it goes down. “

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