Coping with high oil prices

An excellent article talking about the economics of Peak Oil via EnergyBulletin. Among some questions that were approached were: with energy prices so high, why isn’t the “world” suffering from a massive economic downturn? Have firms been taking a hit at all?

Unfortunately, due to its West-centrism, it fails to acknowledge that the high prices have effectively destroyed semi-developed countries such as Zimbabwe, and is working against some countries exporting oil such as Indonesia and Qatar due to outdated domestic policies regarding subsidies. But even more importantly is the talk of “transition”.

Looking at Japan’s post-70s example of transition, while maintaining some of the highest efficiency standards, it remains number three in oil consumption, behind only the US and China.

By Nikos Tsafos

The most surprising feature of the current oil crisis is that it does not
really feel like a crisis. Oil and gas prices may be high and many
people are struggling to cope with rising energy bills, but at a macro
level, the world’s largest economies have grown consistently in the
past two years. Hardly is our fear realized—that high energy costs will
force an economic downturn, much less a recession. What explains this
disconnect between expectation and reality?

To examine this question, take three mechanisms through which oil
prices affect economic performance (there are more, but let’s focus on
three): a reduction in income caused by the need to spend more money on
energy leads to reduced demand for goods and services and this, in
turn, forces an economic slowdown; an increase in inflation generated
by higher prices that firms charge to cover energy costs leads to a
reduction in real income; and worsening performance by firms,
reflecting mainly higher costs and/or reduced overall demand by
shrinking real income.

Begin with the first mechanism: US households spend more money on
energy today—that much is obvious. But as Figure 1 shows, the amount
spent on energy as a percentage of personal consumption is not very
high, certainly not as high as it was in the late 1970s or early 1980s,
when over 9% of personal consumption went to fuel oil, coal,
electricity and gas. In 2005, energy expenditures as a share of
consumption were 5.8%, up a full percentage point since 2003, but still
below peak levels. Granted the data is not unambiguous—for example,
current consumption is linked to high debt levels—but there is a clear
sign that today’s high energy prices are not putting a strain on the
economy that is comparable to that felt in the late 1970s.

What about inflation? Over the past fifteen years (1990-2005), there
has been an observable decline in inflation, driven by a variety of
factors unrelated to oil. As Figure 2 illustrates, the link between
higher oil prices and inflation is all but clear (here is shown the
Consumer Price Index excluding energy prices to gauge the effect of
energy prices on other goods): in 1999-2001 there seem to be a rise in
oil prices that is followed by an increase in inflation; after 2002,
however, oil prices go higher, as inflation goes down; and by 2003, oil
prices skyrocket, with only a minimal effect on inflation. Here, again,
there are various exogenous factors to consider—mainly better
macroeconomic management and the influx of goods from China, which have
kept prices low. But this does not negate the underlying fact—that
higher oil prices have not generated inflation, at least not to the
level expected (and feared) by observers.

This reality produces the following question: could it be that firms
are taking the hit? It is possible that firms would try to absorb
energy costs in order to maintain demand for their goods. If this were
true, we would expect firms that need a lot of energy to suffer more
than firms that need less energy for their outputs. There is some
evidence for this hypothesis, though the verdict is ultimately mixed:
as Figure 3 shows, utilities and transportation—two energy intensive
industries, had mixed results in 2004 with the former turning a profit
while the latter suffering losses. From the rest (excluding Agriculture
and Mining), there appears some trend, albeit weak, linking higher
energy intensity and lower profits. At the same time, the numbers
involved (energy costs at around 5-10% of total intermediate costs, and
generally high profits) for most industries suggest that we cannot rely
on this explanation—that firms are taking the hit—for understanding why
oil prices are not having a large effect on the economy.

Perhaps the clearest view on this question comes from a more basic
statistic: how much do firms spend on energy? Figure 4 shows gross
output in the United States for the years 2000-2004 (gross output is
labor and capital expenses, which make up GDP, as well as firm
expenditures on energy, materials and services). The left axis plots
gross output while the right axis shows total energy costs. What is
impressive is that energy costs make up such a small portion of total
costs (or total output). Even with high prices in 2004, energy costs
make up about $450bn or 4.5% of total input costs. More than anything
else, this should underscore why large changes in energy expenditures
are not placing as high a strain on the economy, even though the fact
that prices have risen more orderly than in the past may help explain
why the adjustment has been less painful.

Granted, economic performance is but one aspect of the current energy
crisis; it may not even be the most important. Granted too, that these
numbers rest on a macro-level analysis and may conceal many problems,
not least that of that families trying to pay their energy bills.
Granted also that there are many international dimensions (even
imbalances) to consider that may be salvaging economies from recession.
But there is still some truth in here—that economies can grow in spite
of high energy prices should make us rethink energy security and the
calamities we tend to associate with rising oil costs. It may also give
us some reassurance about our ability to make the transition from
hydrocarbons to other energy sources as painless as possible. And that
is good news for the long term.

References:
Figure 1 data come from the Economic Report of the President (February
2006); Figure 2 data come from FRED—the Federal Reserve Economic Data;
Figure 3 and 4 data come from the US Department of Commerce, Bureau of
Economic Analysis, while the WTI spot prices for figure 3 are from the
Energy Information Administration. All numbers / years are latest
available.

~~~~~~~~~~~~~~~ Editorial Notes ~~~~~~~~~~~~~~~~~~~

Andrew
McKillop deserves some recognition for predicting early on that high
oil prices will drive economic growth – up to a point. Here’s some
excerpts from some of McKillop’s articles published on Energy Bulletin:

Increasing
oil and gas prices, up to levels around $75/bbl or barrel-equivalent
($10-13/million BTU) will certainly be called ‘extreme’, but will not
in fact choke off world energy demand.
The likely net impact of price rises to $75/bbl, if interest rates
in the OECD countries are not ‘vigorously’ increased to double-digit
base rates, will be increased world oil demand due to continued and
strong economic growth. This ‘perverse’ impact of higher prices will
therefore tend to reduce the time available for negotiating and
planning energy and economic transition.

Only at genuinely ‘extreme’ oil prices, well above
US$100-per-barrel, will the pro-growth impact of increasing real
resource prices be aborted by inflationary and recessionary impacts on
the world economy.

This will come too late to offer any chances of organized and
efficient economic and energy restructuring, especially in the OECD
economies and societies, which are the most oil-dependent due to their
high or extreme average per capita rates of oil demand.

( 22 September 2004) and

Higher
oil prices increase world economic growth by raising ‘real resource’
prices, through what we can call ‘the revenue effect.’ The pro-growth
impact of oil does not stop there, because fast increasing values of
world merchandise trade due to higher ‘real resource’ prices directly
leads to fast growth of world liquidity … the quantity of money in
circulation. The trend for world liquidity is close-linked to oil price
changes (both up and down), but in the current context there is also
growing world liquidity due to fast industrialization of, and growth of
exports from China, India and other countries. This directly translates
to additional growth of the value and volume of world trade. World
trade is now growing at its fastest rate for over 15 years, which again
is concrete, cast iron proof of fast economic growth.

(21 September 2004)
-AF

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