The Economics of Oil
Cutting through the spin
Summary of a presentation by
Mark Zupan
Dean of the William E. Simon Graduate School of Business Administration at the University of Rochester, New York
Energy Independence?
"Energy independence” has served as a political rallying cry since the first Arab oil embargo in 1973. Presidents, senators and congressmen continue to call for an end to America’s dependence on foreign oil. But whether such a thing could really happen in an election cycle or a lifetime is another matter.
"The last six presidents going back to Nixon have said we will be more energy independent. None have succeeded,” Zupan said. “We’ve been growing more dependent, and I see no end in sight.”
In 1970, the United States imported one third of its oil. Today, it imports half of its oil, and domestic production remains stagnant. Yet the same old rhetoric of energy independence continues, but without any meaningful way to address the problem.
Given that most of the world’s oil reserves are in the Middle East, there is no easy solution. Even recent deep water finds in the Gulf of Mexico and development of the Arctic National Wildlife Reserve cannot solve the basic problem: The U.S. economy is powered on oil, and it consumes more than it can produce.
Lifeblood of the Economy
Oil is a unique commodity in the world economy. It makes motor vehicle transportation and commercial aviation possible; it heats homes; it allows goods to be distributed across the country, and it is the base for countless petroleum-based products.
"Oil serves as the lifeblood of the economy,” Zupan said. “Any constriction in the supply of such a commerce-lubricating good has a significant detrimental effect on the level of macroeconomic activity.”
Increases in oil prices correspond closely to downturns in the economy. The last four recessions all correlated with restrictions in the oil supply during the periods of 1973-74, 1979-1981, 1990-1991 and 2000-2001. When energy prices spike, the market slows down; when prices decrease, the market speeds up.
"The slowdown of 2001 had actually begun before the 9/11 terrorist attacks, and most economists attribute the recession more to the Riyadh Pact than to 9/11,” Zupan said.
In 1999, the three largest oil exporters to the United States, Saudi Arabia, Venezuela and Mexico, met in Riyadh and agreed to collectively reduce output by 1.5 to 2 million barrels per day (about 2-3 percent of world production).
The recent surge in the stock market correlates with a drop in energy prices caused by the release of oil reserves into the market, which created a stock market bubble, Zupan said.
The Interdependent World
The world is becoming more economically interdependent, especially when it comes to energy. Oil – whether it is produced in Saudi Arabia, Venezuela or Alaska – is sold on the world market. Russians and Canadians don’t horde their oil for themselves in the name of energy independence; they sell it on the world market – usually to the closest buyer.
The notion of energy independence runs contrary to the general trend of internationalization of trade. The U.S. government continues to reduce trade barriers through policies such as the North American Free Trade Agreement, the elimination of tariffs, and other free trade agreements. As a result, the percentage of the U.S. economy that comes from international trade is steadily rising.
Increased world trade is beneficial both economically and politically. "The theory is that people will become more amicable with more trade interaction,” Zupan said. “Through mutually beneficial exchange, a great deal of this increased interrelationship will be for the good as we find opportunities to establish personal ties that make war less likely.
"But there could also be contrary cases, where countries that have nefarious designs acquire the means to be more destructive, if they so choose, through expanded economic opportunities,” Zupan said. Many put forth this argument as reason to go to war with Iraq – in order to prevent Saddam Hussein from cashing in his oil resources to build his weapons arsenal. A similar argument is now being made with regard to Iran.
Economic interdependence also makes the domestic economy more susceptible to disruptions in distant and unstable regions of the globe, such as the Middle East, South America and Africa. In past years, strikes in Venezuela caused a drop in the approximately 1.5 million barrels of oil per day imported from that country; ethnic strife in Nigeria, the fifth largest supplier of oil to the United States, can disrupt the 570,000 barrels per day imported from that country.
A Wild Market
A 2-3 percent cut in world oil production can have significant impacts on gas prices and resulting negative repercussions on the U.S. economy.
Energy prices tend to fluctuate wildly, and in the short term consumers can’t adjust their consumption patterns quickly enough to avoid the pinch.
"Neither suppliers nor consumers are able to respond significantly in their behavior in the short run to an unexpected reduction in output, such as the one instigated by the Riyadh Pact,” Zupan said.
Changing energy consumption habits is difficult and costly. Buying a new car, a smaller house, retrofitting with energy-efficient appliances or changing commuting patterns requires significant investment and inconvenience.
"People are stuck in certain consumption patterns and can’t change much in the short run,” Zupan said.
Given more time, consumers and suppliers can adjust to upward movements in oil prices. Consumers can develop strategies for conservation such as driving smaller cars, moving closer to work, etc., and suppliers have the economic incentive to develop alternate sources of energy, such as fuel cells or solar power. On the other hand, downturns in oil prices can kill investments in alternative sources, which suddenly become economically unfeasible.
"Short run pains are a sure fire way to ensure long run solutions. High prices have a way of motivating conservation and finding other sources of supply,” Zupan said. “On the other hand, low prices can discourage alternative sources of energy.”
Supply and Demand
One of the most basic principles of economics: Raise the price of a good, and consumers will purchase less of it. In other words, if the price goes up, the quantity consumed goes down. If the price goes down, demand increases.
There are many different degrees of this rule. Demand for certain products, like cigarettes, is relatively unresponsive to price increases. The government could impose a stringent “sin tax” on cigarettes, causing the price of a pack to double, but demand would remain relatively stable in the short term.
Economists say demand for cigarettes is “inelastic.” On a graph, a perfectly inelastic demand curve is vertical.
On the other extreme, some products are hypersensitive to price changes. For example, raising the cost of a newspaper from 50 cents to 60 cents might anger people and cause them to cancel their subscription, or get their news from the Internet.
Economists call this type of market highly elastic. A perfectly elastic demand curve is horizontal – raise the price 1 cent, and all demand stops.
"This is a bad type of market to be in if you are a supplier. This is a perfectly competitive market,” Zupan said.
Demand for oil, like cigarettes, is inelastic in the short run. Consumers are slow to react to changes in energy costs. The price of gas at the pump could double, but people would continue filling their tanks because they have to continue driving to work, taking their children to school, etc.
In real numbers, the short-run demand elasticity for oil is about .2 percent. So for each 1 percent increase in price, demand goes down by only .2 percent.
In the long run, markets have more opportunity to respond and greater elasticity. Following the 1979 revolution in Iran and the subsequent Iran-Iraq war, the price of oil went from $11 to $35 per barrel. By 1985, world oil consumption had fallen from a 1979 high of 51 million barrels per day to less than 45 million – “particularly impressive since the long-run trend had been a 3 percent annual rate of increase in consumption,” Zupan said.
In response to the higher prices, production by non-OPEC countries increased significantly, from 15 million barrels per day in 1977 to 24 million barrels in 1985.
Like demand, supply of some products is more responsive to price changes than others. And like the demand for oil, the supply of oil is also inelastic, or price insensitive in the short run.
In real numbers, supply elasticity for oil is about .1 percent: For each 1 percent increase in price, the quantity of supply goes up only .1 percent – “pretty tiny,” Zupan said.
Understanding supply elasticity is not merely academic; it has real world applications. For example, when the British Petroleum pipeline in Alaska shut down temporarily in 2006, resulting in the removal of about 460,000 barrels from the oil market, economists were able to estimate the price increase that would result from reduced supply.
Traditionally, suppliers have had the greatest impact on oil markets. But recent trends display a greater influence on the demand side. China has gone from net exporter of crude oil (about 500,000 barrels per day) to a net importer (1.3 million barrels per day) over the past decade. As a result of this new demand, world production capacity is nearly maxed out.
"It’s doubtful whether supply will be able to keep pace on demand. Prices recently would suggest reason for pessimism,” Zupan said.
"We’re dependent on both demand and supply. Both sides – supply and demand – contribute to these wild gyrations in energy markets.”
Market Power
The Organization of the Petroleum Exporting Countries (OPEC), a cartel consisting of 11 countries, can influence world oil prices by restricting or loosening supply
"Supply gets a little trickier when you have one supplier or one subset of suppliers who have the ability to control prices,” Zupan said.
Manipulating prices by restricting supply impacts the U.S. economy negatively. But opening up supply also has negative consequences. For example, in 1985 and 1986, Saudi Arabia increased its oil production to the point that the price dropped to $10 per barrel. Since it costs about $15 to extract oil from North Sea, many suppliers outside the Middle East withdrew from the market. The oil glut in the mid-1980s had severe repercussions in the Gulf Coast economy, where producers couldn’t profit from such low prices.
Depressed oil prices had other impacts on demand and market behavior in the U.S. “The $18-20 per barrel price of oil that prevailed from 1987 to 1999, with the exception of the first Gulf War against Iraq (1990-1991), is a major reason why so many car buyers in this country purchased gas-guzzling SUVs during the 1990s,” Zupan said.
Oil cartels can still have a negative impact on the U.S. economy, but Zupan said their impact has diminished in recent years. It is very difficult for cartel members to maintain agreement over pricing, output and allowable market shares. In addition, higher prices encourage other suppliers to enter the market, thus undermining the cartel’s power.
"Saudi Arabia does have the ability to slow its own production, but the overall impact of OPEC has diminished over time due to other producers, like Russia, coming on the market, so the percentage accounted for by one supplier has gone down,” Zupan said.
"Without government support, supplier cartels designed to jack up market prices tend to collapse. Let’s say a group of suppliers agrees to cut back production 50 percent and jack up prices, but each supplier has an incentive to cheat for the purpose of benefiting their own bottom line.”
When the government attempts to tinker with energy markets, other problems can occur. For example, the Russian government subsidizes heating costs in the city of Moscow. Consequently, Moscow, a city of about 10 million, burns up more energy than all of France, a country of 64 million.
"This is not just because of the cold Russian winters,” Zupan said. "Energy prices in Moscow are kept artificially low, and therefore people have little incentive to conserve energy. Buildings are inefficient. People control their thermostat by opening the window. … When you keep the lid on prices to consumers, it can be counterproductive.”
Similarly, in response to the first Arab oil embargo, the U.S. government resorted to rationing and price controls, which only further exacerbated the problem.
Market Failure
Energy markets tend to break down when it comes to the environment – for example, when an oil exploration company drills for oil and dumps the contaminated mud into the ocean without bearing the “external costs” of that action.
"On the supply side, if you don’t bear all of the costs, you have an incentive to overproduce,” Zupan said. “On the demand side, people will over-consume because they don’t fully bear the costs of consuming crude oil.”
Taxation on consumption can be used as a means to recoup external costs, but tinkering with energy markets presents its own set of problems. “Using taxes to account for costs associated with oil that are not reflected in price is a slippery slope. It is too easy for politicians to rely on this source of revenue for other pet projects completely unrelated to rectifying any previously unaccounted for costs of oil consumption. It’s always tempting to dip into the cookie jar,” Zupan said.
A new externality associated with oil consumption is the cost of national defense. “We are dependent on oil supplies from the Mideast, and we have to have a larger army to police conflicts that emerge. But the cost of gasoline at the pump does not reflect the cost the military,” Zupan said.
If global warming is considered an externality of energy consumption, creating policy to deal with it presents an even more difficult problem: Global warming is a long-run risk issue on a time scale far beyond economic time in either the short run or the long run.
"Internalizing the costs of greenhouse gas emissions will put demands on the economy. But there are long-run benefits to the planet that can’t be ignored,” Zupan said. “To the extent that most of the studies point to the tie between global warming and greenhouse gas emissions, the benefits of promoting that internalization will be worth the costs.”
Spinning Solutions
President Bush and a host of senators and congressmen tout development in Alaska’s Arctic National Wildlife Refuge as a means toward achieving energy independence. Recent discovery of the "Jack II” deep-water oil field in the Gulf of Mexico has also raised hopes.
When analyzing such claims, Zupan said it is always important to consider “marginal supply” – whatever incremental amount of supply added to the world market that will impact prices. Before 1973, the U.S. had control of marginal supply. OPEC could try to increase prices by reducing supply, but then the U.S. could match whatever supply OPEC cut, thus keeping domestic prices stable.
The U.S. no longer controls marginal supply, and will probably never regain it even with development of ANWR and Jack II. “Even if we reduced foreign dependence by 10 percent, we would still be affected by a million barrel per day cutback from somewhere else in the world. On the margins we are still affected by what happens in Nigeria; what happens in Iraq; what happens in Venezuela. The world is interconnected.”
Zupan said Americans should relinquish any illusions or nostalgia that they can control world energy markets. “It’s this belief that we can inflate ourselves like King Canute and command the way,” he said. “If you look at the sheer magnitude of energy demand, the idea that we can isolate ourselves from the rest of the world just doesn’t wash.”
Watching the Indicators
Zupan offered several economic principles for policy makers and the media to watch:
- Don’t forget to adjust for inflation. In economic terms, calculate the “real” prices rather than quoting the “nominal” prices. For example, $1.30 per gallon gas prices in 1981 were the equivalent of $2.76 in 2003, factoring in inflation.
- Always consider long run and short run. Policy makers and the media tend to overreact to the short run, which is contrary to long-run interest.
“Journalists have to report what’s new today. Policy makers have to explain to their constituents what’s going on. This reflects human psychology and behavioral economics; namely, we tend to feel that any market-based economic gain is merited, while economic losses are not,” Zupan said.
- Price spikes have a sunny side: “Short run pains are a sure fire way to ensure long run solutions. High prices have a way of motivating conservation and other finding other sources of supply,” Zupan said.
- Incentives matter more in the long run. “Given time, consumers and suppliers adjust much more significantly to any sort-term upward spikes of oil prices,” he said.
- Don’t forget to account for social costs and “external costs” associated with oil consumption. Gas prices at the pump usually don’t cover the costs of pollution, congestion or the military.
- Tinkering with energy markets creates its own set of problems. “In the grand scheme of things, market forces tend to be more powerful [than any government policy] in dealing with energy problems,” Zupan said. “Markets produce the efficient amount of any good so long as, among other things, all the costs associated with the good’s production are reflected in its price. Whether this is indeed the case with oil is an open question.”
Written and reported by Bruce Murray.
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