Tuesday, January 22, 2008

Energy and the Economy

We're currently being provided with an uncomfortable reminder that the economy trumps all other issues, when it's doing badly. Energy has been a big part of this story, at least in terms of perception. However, in part because weak refining margins have sheltered consumers from the full impact of $90 oil, and because natural gas has temporarily uncoupled from oil prices, on average Americans still pay less for energy than we did during most of the 1960s, 1970s and into the 1980s. Of course, that's cold comfort for those who have seen their fuel outlays double in the last four years. The important question now is how energy will affect a weakening economy, and vice versa. In lieu of a comprehensive answer that would tie up a team of economists for weeks, here are a few thoughts on the subject.

Energy and the economy are deeply intertwined. Economic growth pushes up energy demand, though at a much slower rate than in the past. Energy prices rise in turn, and that stimulates supply, albeit with a significant lag. In this cycle we've seen the impact of supply constraints from infrastructure, resource nationalism, and the availability of equipment and experienced technical staff. Now throw in the rapid economic transformation of China, India and the rest of Asia, along with the undetermined effects of unprecedented levels of financial speculation in oil. Prices haven't self-corrected as we might have expected, and the result has been dramatic energy price inflation of a type very different from the energy crisis of the 1970s. The financial flows this has created are enormous: a billion dollars per day, from the US alone.

So what happens next? That depends on how much influence the US market has on an increasingly globalized energy market. Even with the economy still growing, we've seen total US oil consumption has plateau for three years, now, and our imports of oil and petroleum products have been essentially flat since 2005. We're responsible for less than 15% of the 5 million barrel per day spurt of demand since 2003 that has used up most of the world's spare production capacity. If our consumption fell this year, that might not affect oil prices much, unless the US economic slowdown triggered a global economic contraction. Consider China, where rapidly increasing oil consumption has been led by domestic consumers, who are insulated from world oil price changes by regulated petroleum product prices, and by export industries that supply developed countries, including the US. Because China uses much more energy per unit of GDP than we do, a slowdown there would have a more dramatic impact on oil prices.

But if $90 oil represents a significant drag on the US economy, how much would oil prices have to fall in order to stimulate economic growth? That's hard to say, because during most of the run-up from $30 per barrel to $70 or so, our economy appeared to be immune to the consequences of higher oil prices. Right now analysts and markets seem most concerned about consumers, for whom the increase in gasoline prices since last January has added an average of about $65 per month in cost per household. Reversing that would require getting oil back to the mid-$50s, barring a big increase in refining margins, as refiners cut back on output that is losing them money.

How might oil revert to $50 per barrel this year? We can rule out the influence of alternative energy, in the short run. Biofuels output can't grow fast enough to make that kind of dent in demand. I also doubt we can convince OPEC to open their taps wide; they are unlikely to see that as being in their best interest, unless they thought it was the only option for preventing a global collapse that would shrink their revenues even more. That leaves speculation and demand. There's no consensus on how much of the current oil price is attributable to speculation. As the yields on other asset classes drop, are speculators more or less likely to invest in oil commodities? And how many of them will need to liquidate commodity holdings to cover losses on other positions? Even if the contribution of speculation dropped by $10 per barrel, we're still only talking about roughly $20 per month per household.

That leaves demand, though this is an example of the worm eating its tail. Demand growth is widely viewed as the biggest contributor to the increase in oil prices since 2003, so a global drop in oil demand of a couple of million barrels per day would probably deflate oil prices sharply. But in the short term, we can't create that big a fall in demand through higher efficiency alone. The scenario that comes closest to being able to deliver that looks similar to what we experienced in the Asian Economic Crisis of the late 1990s, when the combination of falling regional demand and rising global production cut oil prices in half. However, the global economy has become much more inter-dependent in the last ten years, and this kind of cure would almost certainly be worse than the disease.

Although oil prices have contributed to the current crisis, they didn't cause it. While oil prices will likely fall, if the US goes into recession and the global economy contracts, that by itself won't do much to restore the economy to sound health. Oil looks like a lagging, rather than leading indicator, here, and we need to turn elsewhere to solve the financial mess that has resulted from the popping of the US housing bubble and the debt problem that has created. Later this week I'll take a look at what this might mean for alternative energy.

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