Oil shock: Taking the long view

Sep 19, 2005 02:00 AM

by Peter Fox-Penner and Gary Taylor

With the heartbreaking toll of Hurricane Katrina and the surrounding media fury, it is easy to forget that there was an oil shock under way long before the storm surge hit the levees of New Orleans. The problem is, no one was taking it seriously.
With Katrina's damage there are now real worries about an energy crisis in the United States; but they primarily involve near-term shortages of oil and gas while we try to restore our energy infrastructure in the Gulf of Mexico region. However, we still aren't facing up to the long-term issue that a lingering period of high prices will be a long-term drag on our national economy.

Prior to Katrina, the conventional wisdom said that the rise in oil prices from about $ 40 to $ 60 per barrel wasn't enough to tip the United States into a recession. In this respect, the present oil shock was going to be different than the shock of 1979, when 18 months of prices about as high as they are today (in real terms) sent interest rates to a peak of 20 % and stagflation plunged the country into a steep recession.
High gas prices are certainly putting a painful squeeze on low- and moderate-income families, but several key differences between the US economy of 2005 and 1979 point to reduced near-term impacts. The United States uses barely half the oil per unit of gross national product today as it did in 1979. And we aren't likely to see the counterproductive overreactions we saw in 1979 -- extensive gas and oil price controls and sky-high interest rates.

These factors are all important positives. The problem is that there are many other aspects of our energy marketplace and economy that are negative compared to 1979. These factors greatly increase the prospect of an economic downturn sparked not by high interest rates and inflation, but by reduced consumer spending and decreasing asset values.
Going into the 1979 shock, the prime rate was in the 6-9 % range, just a bit higher than today. However, today's federal deficit is twice the size it was in 1979 and forecast to rise. Consumers are carrying record amounts of personal debt and saving nothing. Median household incomes were still growing in the 1970s -- today they are stagnant. And now we have a real estate value bubble in some regions that Federal Reserve Chairman Alan Greenspan believes must burst sooner or later, further reducing family wealth.

The net effect of all this is that there is very little room for manoeuvring in either personal consumption budgets or government spending. We have no rainy-day money to spend on higher gas bills. The money is going to have to come out of consumption or even deeper public or private borrowing, both of which will prove especially costly in today's economy.
We may be much less dependent on oil per unit of GNP, but this masks a higher dependence for our transport needs. Petroleum still provides 95 % of our transport fuels, and auto fuel efficiency is essentially unchanged since 1980. With continued urban sprawl and our highly mobile lifestyles, total vehicle-miles travelled by Americans have increased more than 80 % since 1979. Small wonder that our national gasoline bill is likely to be 30 % higher than 1979 levels in real terms.

If this isn't enough, there is a second energy price shock hitting our economy. Winter delivery natural gas is trading at more than $ 12 per-mm-Btu, the highest ever. As with gasoline, these prices will directly hit the pocketbooks of homeowners and businesses that heat with gas. Natural gas prices will also affect the broader economy via their impact on petrochemical and electricity prices.
Ironically, natural gas and power deregulation and the shift in our power generation mix means that gas price increases will have the same sort of rapid transmission into the economy that wage agreements and cost-of-living adjustments did for oil prices in 1979.

The conventional wisdom is now that Katrina's damage may have been severe enough to crimp the US economy for a number of months, but notover the long term. This may be so, but the impacts of this oil shock will last a lot longer than it takes to restore a semblance of normalcy to the ravaged Mississippi delta.
Any case for complacency over the effects of high oil prices is over for good.

Fox-Penner is principal and chairman of The Brattle Group, an economic consulting firm, and is an international expert on energy policy. Taylor is an energy expert at The Brattle Group. The views expressed in this article are their own and not those of The Brattle Group or its clients.

Source: The Brattle Group
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