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Lost at sea

If I look confused it's because I'm thinking
     —Samuel Goldwyn

If you're not confused, you're not paying attention
     —Tom Peters

Oil_prices_nytimesIt is crucial for those warning others about the dangers of peak oil to look at the effects of increasing oil prices (graph left) on economic growth. For some years to come, peak oil constraints will be manifest in the oil price, not in disruptive, recurring and systemic spot shortages—at least in the United States. What effects have oil price increases had on real U.S. GDP growth in the last 7 years? To be honest, nobody really knows—yet. We will all find out eventually.

There is no peak oil supply shock until world production of oil derived from fossil fuels production (crude + condensate + gas liquids) actually begins its irreversible decline sometime in the next decade. Until then, the correct answer to most peak oil inquiries is price, price, price as slow or no supply growth coupled with ever-higher energy costs creates more and more unsatisfied demand. Substitutes and efficiency measures (e.g. plug-in hybrids) will not save our bacon, despite what optimistic policy wonks and pandering presidential candidates say (NPR's Morning Edition, April 7, 2008).

Oil is not like iPhones. No studies link real GDP and iPhone price trends. Keith Sill, a senior economist1 with the Philadelphia Fed, tells us why oil prices are important in his The Macroeconomics of Oil Shocks.

Oil prices matter for the economy in several ways. Changes in oil prices directly affect transportation costs, heating bills, and the prices of goods made with petroleum products. Oil price spikes [shocks] induce greater uncertainty about the future, which may lead to firms’ and households’ delaying purchases and investments. Changes in oil prices also lead to reallocations of labor and capital between energy intensive sectors of the economy and those that are not energy-intensive. For these reasons and others, oil price increases may lead to significant slowdowns in economic growth...

With the release of the latest unemployment numbers, most observers are convinced that the United States is now in recession following the dramatic GDP growth slowdown (0.6%) in the 4th quarter of 2007. Most attribute the apparent recession to the credit crisis resulting from the collapse of the Housing Bubble. (See A Recipe For Disaster, ASPO-USA, March 26, 2008.)

Real_gross_domestic_product What about the role of the oil price in the economic slowdown? For economists, this remains an open, and perhaps unanswerable, question. Macroeconomic models can not explain the complex, non-linear historical relationship between oil prices and GDP, especially over the last 6 or 7 years, although researchers like the University of Michigan's Lutz Killian are trying to explain why Not All Oil Price Shocks Are Alike.

The big open question concerns the lack of a recession—up to now?—despite rising oil prices since 2002 (graph left from the BEA). It's worth noting that average GDP growth in the last 6 quarters is 2.18%, whereas growth in the 6 quarters previous to that period was 3.13%.

All this should be considered in light of the fact that what you don't know is often more important than what you do know.

No Oil Price Relief For Consumers

Current evidence2 points to a downturn in both U.S. GDP growth and oil consumption which has not been accompanied by a decrease in the oil price. This is the worst of all possible worlds for American consumers.

The EIA data now indicates that U.S. oil demand fell off 3.7% between December, 2007 and January, 2008. That's a huge drop off, far larger than the usual seasonal pattern (last year's decrease was 1.2%). The 4-week period ending March 28th shows a more modest 1.3% decrease compared to the previous year. Other preliminary data for the 1st quarter of 2008 suggests that "U.S oil consumption has declined in the first quarter by nearly 475,000 barrels a day as compared to last year" according to the Associated Press report Drop in US first-quarter oil use appears most since Sept. 11 terror attacks

Jan Stuart, economist at UBS Securities LLC in New York, said "Macro [economist] folks won't officially label the U.S. economic environment a recession for some time, but at first glance (first-quarter) oil data sure look bearish," in a report Thursday.

Preliminary data for February and March, subject to revision, show that pressures from record-high crude oil and products prices and the uneasy U.S. economy have continued to cut deeply into demand. [emphasis added]

This last statement in the AP story begs for explanation. How can U.S. demand be down nearly ½-a-million barrels a day in the 1st quarter while oil prices continue to rise? (This story is about oil market fundamentals, I will not be discussing dollar value or trading effects on the price.) The monthly average oil price series from economagic for NYMEX WTI shows a 10.7% jump to $105.56 in March over February. The price at this moment is $108.81, up this week on news that OPEC will not be raising production again—no surprise there!

The standard explanation for rising prices over the last several years is the global demand shock brought about by soaring consumption levels in the developing economies, including both the oil exporters (e.g. Russia, Saudi Arabia) and the Asian economies (e.g. China, India). Since rising oil prices have occurred in a context of global GDP growth, including the United States, they have been seen as a sign of health, not a drag on economies. Dr. James Hamilton explained the situation back in 2005 in his Economic consequences of the high price of oil.

By contrast, global oil production has increased steadily during the current episode [in 2004].3 The run-up has been caused this time not by a shortage of supply but rather by booming world demand (see What's up with oil prices?). The strong world economic growth that produced this demand overall must be regarded as good economic news, not bad. And although we have again seen West Texas intermediate [WTI] nearly double from $28 in September 2003 to $54 today [in 2005], this time the increase required a year and a half rather than just three months.

Both the gradualness of the price move and the circumstances attending it have left consumers and firms substantially less nervous about the current economic situation than they were in August of 1990, with none of the postponing of spending decisions that characterizes most economic downturns. U.S. car and light truck sales are only down 1% for the first five months of 2005 compared with the first five months of 2004, hardly enough to bring the auto sector to its knees, let alone the rest of the economy with it.

Consumer_spending None of the factors mitigating the effects of oil price increases that Hamilton cites in June, 2005 are true now in April, 2008. The average monthly oil price has gone up 42.3% over the past 9 months, an increase that can hardly be called gradual. This looks a lot like an "oil price shock."

Consumer confidence is dropping like a stone, the consumer spending growth rate (graph left) has taken a sharp downturn, and the anecdotal evidence reveals that consumers are postponing spending decisions, according to the Wall Street Journal's Personal Spending Up Mere 0.1%, But Inflation Pressures Are Muted (March 29, 2008). Hamilton recently commented on the continuing downturn in auto sales at his weblog Econbrowser. Consumer spending growth appears to have slowed after the post-hurricane oil price increases in the 3rd quarter of 2005.

It is clear that high oil prices during a recession can not be a a good thing. What is not clear is whether prices will stabilize at their current level for a while during the downturn or continue to rise. Now that the current situation is somewhat clear, let us turn to the question of macroeconomic effects of high oil prices.

Lost at Sea

It is hard to tease out how much of the current downturn is due to higher oil prices as opposed to the rest of the mess we face. For some time now, observers like A. Gary Shilling have predicted that consumer spending was about to crash after the housing collapse due to alarming trends in savings rates and debt service payments.

So it is difficult to argue now that the oil price has been the prime mover in the not-yet-official U.S. recession. We're cast adrift, lost at sea, on this crucial issue.

Past recessions have often been preceded by oil price shocks, however, and Hamilton states that "both theory and evidence [are] consistent with the interpretation that [the oil price/recession] effect results from the disruption of the pattern of spending by consumers and firms on items whose utilization is sensitive to energy prices and supplies." See Questioning Peak Oil Economic Assumptions for a discussion of the relationship between oil prices and recessions (ASPO-USA, November 28, 2007).

Sill Net Oil Price_Increase Based on Hamilton's work, Keith Sill (op. cit.) presents an accessible model of the effects on GDP growth of net oil price increases resulting from exogenous oil shocks. An oil price shock is exogenous when it originates outside the U.S. economy e.g. the price shock resulting from the supply disruption caused by the Iran-Iraq war in October, 1980. Such a shock is not a feedback from the needs of the growing economy itself, as Hamilton posited back in 2005 when he noted that oil price hikes had not caused a recession in the United States.

Sill_output_response Net oil price increases (1st graph left) reflect price movements in a given period—the previous 36 months in Sill's example—which serve as a "good proxy" for exogenous changes in oil prices and have a "more stable relationship with real output (GDP) growth." The net oil price increase is zero if a given month's average price is lower than some prior month in the 3-year series. Otherwise, the net oil price increase is the percentage increase from the previous highest month's price.

Sill uses a statistical analysis (a regression) and an impulse response function to measure the "dynamic effect of an exogenous oil shock on real GDP growth." Here's the main result:

Figure 6 [2nd graph above left] shows that an increase in the net price of oil leads to a drop in real output growth that gradually increases over time until it reaches a maximum four quarters after the shock hits. After that, the growth rate of real output gradually recovers, so that after about three years, the effect of the oil shock has largely worn off and real output growth is back on its trend path (in the figure, the trend growth rate of real output has been removed). The impulse response function indicates that a 10 percent increase in the price of oil results in real output growth falling 0.55 percent at its maximum impact. This translates into about a 1.4 percent permanent reduction in the level of real output. Even a modest external increase in the net price of oil has a significant impact on real output, according to our analysis. [emphasis added]

To evaluate this result, let's look at net oil price increases over the last 2 and ½ years. Only positive (non-zero) results are shown. A quarterly net increase is the average of the months in that quarter.

Quarter Net Oil Price Increase
2005 III 5.30%
2006 II 2.70%
2006 III 1.63%
2007 III 2.46%
2007 IV 5.83%
9/07 - 11/07 8.33%
2008 I 3.83%

Discussion: There haven't been any oil price shocks exceeding 10%. Rather, we've had a series of mini-shocks. The three-month period 9/07-11/07 does not fall within a single quarter, but shows the largest increase (8.33%) occurred last fall. That's a hefty new oil price rise.

House_prices The standard view (e.g. Hamilton, 2005, op. cit.) is that increases since 2002 had little effect—compare with the real GDP numbers in the BEA graph—because the oil price was riding atop the economic growth wave. The GDP numbers bear this out until quarter IV of 2005. GDP growth is erratic and down on average thereafter, but this is coincident with the collapse of the Housing Bubble (graph left). No oil price signal is detectable.

What about net oil price increases that have occurred in the last 6-7 months? If Sill's model has any validity in 2008, the 9/07-11/07 price shock (8.33%) would have effects on real GDP 4 quarters or so after the increase. This drag effect on real output would occur in the latter part of this year just when the economy will be trying to emerge from the current slowdown according to the standard view.

For the recent price hikes to count as a real "oil price shock" for economists, the event would have to be exogenous to the U.S. economy. At first glance, this appears to be the case in so far as U.S. GDP growth has slowed considerably during the recent period and oil consumption is down (see the EIA numbers above.) This view may be correct, but is complicated by the price effects on oil consumption and any positive feedbacks to the U.S. economy following from increased oil consumption elsewhere—these feedbacks come primarily from China and other Asian economies who export goods to the U.S.

The bottom line is that we still do not know what effects all these ever-more painful oil price increases are having on the U.S. economy, as reported in Fuel prices aren't done setting records (Houston Chronicle, April 9, 2008). We are still lost at sea.

We have beat the oil price & real GDP issue to death without coming to any firm conclusion. It seems obvious that Americans can not absorb these net oil price increases over and over again, especially in a slumping economy, without incurring some very substantial losses sooner or later. Because the U.S. imports about 66% of its oil, price increases operate as a tax on consumers. Peak oil remains primarily a price phenomenon for now, but it's hard to sort out the effects because the messed up U.S. economy has multiple failures. The effects of oil price escalation on real U.S. GDP growth will be revealed over time, and it is hard to avoid the conclusion that the eventual outcome will not be salutary for American consumers.

Contact the author at [the original article]

Notes

1. Sill took the time to speak with me while I was preparing this column. My thanks to him.
2. I say "consumers" because that is the commonly accepted term. As far as I'm concerned, the downfall of our civilization began when American citizens were commonly labeled "consumers" in the 1970s.
3. Obviously, Hamilton wrote this in 2005 before he and the rest of us became aware that world oil production was entering a 3-year plateau (EIA data).

Editorial Notes: Related from Jeff Vail: Timing: The Credit Crunch & Peak Oil (April 8)

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