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The Macroeconomics of Oil By Mark Zandi 2/18/00 5:14 PM ET

Oil prices have surged during the past year. Since its nadir of just over $10 per barrel early last year, the price of a barrel of West Texas Intermediate has recently been trading near $30. This is the highest oil prices have been since just prior to the Gulf War nearly a decade ago. Gasoline and home heating oil prices have spiked as a result. The average price for a gallon of gasoline is currently near $1.40 compared to under $1.00 a year ago.

Behind the jump in oil prices is a quickly improving global economy, which has supported much stronger global oil demand. Adding to demand has been the recently colder weather in the U.S. OPEC has also resolutely stuck to its production quotas, which the cartel had significantly lowered in 1998 and again in early 1999 when global oil demand was caving under the weight of the global economic crisis.

Not surprisingly, if sustained, the higher oil prices will have a negative impact on the U.S. economy's performance. U.S. inflation will be higher, corporate profits will be lower and the economy's growth will be slower as a result. The impact on inflation is already evident in the higher gasoline and home heating prices, which has translated into higher producer and consumer price inflation. The CPI would currently be rising closer to 2% than its actual 2.7% if not for the higher oil prices.

Aside from airline ticket prices, however, inflation for other retail goods and services, even for those products that are intensive in their energy use, have seemingly yet to be impacted by the higher oil prices. This is due in part to the ability of businesses to avoid paying substantively higher oil prices, at least to date, through the use of various financial hedging techniques and longer-term oil contracts that were set when prices were much lower. It is also likely due in part to the inability of businesses to pass through higher energy costs in higher prices for their own products. Corporate profitability is thus eroding, particularly in the energy-intensive transportation, textile, lumber, paper, chemical, rubber and plastics and steel industries.

The economy's growth will ultimately be impacted as the higher energy prices bite into consumer's purchasing power and the lower profits crimp business expansion plans. If oil prices remain near $30 per barrel for the remainder of the year, up from an average of close to $20 per barrel for all of 1999, then this will shave approximately one-half a percentage point from real GDP growth. Instead of expanding by an expected 3.4% between the fourth quarters of 1999 and 2000, real GDP will expand by 2.9%. Higher oil prices will thus take some of the shine off the new economy's luster.

While measurable, the economic impact of higher oil prices today will be much less pronounced than it would have been in years past. The U.S. economy has become substantially more energy efficient. Twenty-five years ago, the economy used 1400 BTUs of petroleum to produce a dollar's worth of GDP. According to the Energy Department, it takes less than 700 BTUs to produce one dollar's worth of GDP today (see Chart). This improvement is the result of the changing structure of the U.S. economy, away from energy-intensive manufacturing and towards service and information based activities that are much less reliant on energy. Households and nearly all industries have also become more efficient at using energy, although this trend has slowed in recent years as energy prices have generally remained very low.

Also mitigating the economic importance of today's higher oil prices is that there is little chance they are or will significantly affect inflation expectations. In previous bouts of quickly rising energy prices during the 1970's and early 1980's, consumers and businesses believed that there would be little future relief from steadily rising oil prices and overall inflation. When energy prices rose so did inflation expectations, which in turn fueled even stronger actual overall inflation. Nary a person or business today believes that today's higher energy prices will be sustained for very long.

Indeed, in all likelihood, oil prices are near a peak. OPEC will more than likely raise its production quotas this year, and this may happen as soon as the next meeting of the cartel in March. OPEC is not anxious to see oil prices remain at $30 per barrel or more for very long, as this would induce other more marginal global oil producers to ramp up their exploration and development efforts. Long dormant conservation efforts would also be reexamined.

Higher oil prices matter to the U.S. economy. While not expected, if today's $30 per barrel oil prices are sustained, then inflation will be higher, corporate profits will be lower and real GDP growth will be weaker this year. The economy will have another good year, just not as good as currently envisaged. Higher oil prices matter much less to the economy than they did in the past, however. Ten years ago sustained $30 per barrel oil prices were enough of a catalyst to push the economy into recession.

-- canthappen (n@ysayer.com), February 27, 2000

Answers

Yup. we don't produce NEARLY as much as we used to, we import it, from OTHER places where the price of oil is rising, too. Maybe we need to look at how many BTU's of energy were used to create each dolar of CONSUMPTION instead of production.

CHuck

-- Chuck, a night driver (rienzoo@en.com), February 27, 2000.

OPEC is not anxious to see oil prices remain at $30 per barrel or more for very long, as this would induce other more marginal global oil producers to ramp up their exploration and development efforts. Long dormant conservation efforts would also be reexamined.

I'm of the school of thought that the marginal oil production won't be tapped. The last time the people who tried it took a bath because oil prices came down, leaving them stuck with big bills.

How many time will they get burned before they learn? I suspect that there will have to be signs that oil prices will be over $30 for a long period of time before it becomes feasible to open up the marginal reserves. In this environment prices would drop like a rock if oil suddenly became available in unlimited (pre-OPEC limits) quantity.

-- rocky (rknolls@no.spam), February 27, 2000.

Funny,now we are going to blame Oil Prices for everything that goes up.I used to hear Business lamenting about the Labor Cost,being the Major Culprit,everytime the Worker wanted a Nickel Raise.

-- It Goes (&&@on.&on), February 27, 2000.

Good post canthappen. Thank you.

-- Dee (T1Colt556@aol.com), February 27, 2000.

---the global rise in oil price will have an impact in our service and information economy. Just because we pay a lower price here than before during the last oil "crisis" doesn't mean that it won't have an impact. As consumers pay a higher premium for imported goods (which we will see shortly here), we'll see a lessening of purchases of "services" that can be considered "luxury", and those businesses and employees will purchase less, leading to further higher prices. It's always this way. Because the world runs on oil, it's inevitable. To say it won't effect the US because of the changing demographics of employment is highly simplistic and erroneous. If all of a sudden family "x" has to pay another 200$ a month for direct fuel purchases, and higher groceries and manufactured goods, then that's 200$ that WON'T be spent on movies, pizza, dot com stocks-whatever. It's just reality.

Although I think the economy is controlled enough to basically mitigate and stop inflation, the perceived nature of "trust" in the system gets hurt. This is actually good in my observations, because I feel that people need to trust being proactive in their own lives more, and to "invest" in becoming more independent of the "infrastructure" as it is currently established via "centralization". Cheap chinawallyworld products are not good for long term stability. Cheap gasoline does nothing to promote energy independence. Exporting jobs in manufacturing, while at the same time importing computer people from foreign nations that don't have our best interests at heart hurts our security. Allowing radical oil producing states access to ship loads of real dollars that are turned into weapons does nothing to insure world pece, either. that money should stay at home, and get reinvested in something besides weapons and gold plumbing fixtures in the middle east.

It's better to take our lumps now in higher, finite fuel sources, then to wait until both radical and permanent oil price hikes occur concurrently with a decades long lack of development of alternatives. The still low price we pay for "energy" needs to be used NOW to develop alternatives, trying to do both at the same time is an invitation to collapse and wars.

-- cheapoil (isn'tgoingtolast@forever.needwork.now), February 27, 2000.