If there
are crude oil supply disruptions, refinery
shutdowns, transportation bottlenecks and the
like, the price of refined oil products (gasoline,
jet fuel, heating oil, kerosene, and so forth)
invariably increases.
The rise in these
prices is a shock to oil importing economies,
resulting in higher inflation pressure, and the
risk of an economic
slowdown and recession
in countries that are large importers of oil to
the extent of even causing a global recession.
The transmission of an oil price shock
goes through a number of channels. As gasoline
(and home heating oil) prices go up, consumers are
forced to spend a larger portion of their income
on these basic necessities. Yes, they can drive
less, buy more efficient cars, insulate their
homes better, but these take time. Oil price
increases do not change energy consumption over
night but change consumption habits with time.
Oil price increases also affect the price
of taxis, air transportation, mass transit and
more. Thus, at least in the short run, oil
products eat up a larger percentage of consumers’
disposable income, resulting in lower expenditures
on other goods and services and thus in a general
economic slowdown.
At the same time,
higher energy product prices increase the energy
cost of almost all businesses, including the
transportation of goods. Businesses, in turn,
increase their prices to consumers and to their
business clients, resulting in prices going up
more generally and economy wide inflation picking
up, which again reduces the disposable income of
consumers and causes a further economic slowdown.
Higher inflation invariably also results in higher
interest rates and is another reason for an
economic slowdown.
The danger with
inflation is that it increases inflationary
expectations and if these expectations become
anchored, then the inflationary spiral becomes
more pronounced, dangerous and more costly to
address by central banks.
Inflation is
transmitted across borders to other countries
through higher export prices, which in turn have
feedback effects. The generalized slowdown in
economic activity also reduces international
capital flows and the flows of workers’
remittances, further exacerbating a global
economic slowdown.
While everything so far
points to a global economic slowdown, there could
be at least one source of stimuli. The transfer of
capital to oil-exporting countries through higher
oil prices and revenues allows them to increase
their imports. But realistically, this does not
result in a one-for-one increase in imports as a
number of these countries have limited absorptive
capacity and thus also add to their savings; this
is especially the case for Kuwait, Qatar, the
United Arab Emirates and to a lesser degree for
Saudi Arabia.
Historically, it would
appear that the impact on economic activity is
more significant if oil price increases are
accompanied by generalized commodity price
inflation.
Research by a number of
prominent economists seems to confirm that the
impact of oil prices on economic activity depends
on the source of the price change, on oil price
volatility, and on the price level (gradual
increase in oil prices can be better accommodated
than sharp increases); nor is the price impact
symmetrical for a price increase and a price
decrease (see below).
It is also important
to re-state the fact that the short- and long-term
response to energy price shocks is different. As
energy prices go up, it takes time to adapt and
economize on energy use. If home insulation is
improved and more energy efficient cars are
bought, then a decline in energy prices will not
take us back to where we were before adopting more
energy-efficient ways, and thus the response to
energy price increases and decreases is not
symmetrical.
While big jumps in oil prices
have in most cases induced recessions in the
United States and elsewhere, the impact has become
somewhat muted in the more recent years. Namely, a
given percentage change in crude oil prices today
leads to a lower percentage change in economic
growth than it did 10 years ago, an even lower
percentage change than 20 years ago and much lower
than in 1960.
A number of prominent
economists claim that the reasons for this muted
effect of oil price shocks is first and foremost
that energy is today a smaller percentage of the
total cost of most businesses and thus an increase
in its price has a less pronounced effect. Another
reasons is the liberalization of all markets,
especially increased labor market flexibility in
the United States and elsewhere, making adjustment
to shocks less costly.
The ability to
substitute natural gas and other energy inputs for
oil may be another reason, especially in the most
recent years, given the rising importance of shale
gas and its relative price disassociation with
oil. Other economists also claim that more
thoughtful macroeconomic policy and the better
implementation of monetary policy have allowed the
US to ameliorate the impact of oil price shocks.
Will there be future price shocks? Yes,
you can bet on it. Will they be less or more
pronounced? Our guess is much more pronounced as
new discoveries (or additions to global reserves)
have slowed while gross domestic product, and thus
oil consumption, seems to just keep on going up
rapidly in a number of emerging markets,
especially China.
The oil market is likely
to become tighter and tighter, with less and less
spare oil production capacity around the world; at
the same time, the likelihood of conflicts in the
Persian Gulf region is higher than at any time
since World War II - the perfect mix for bigger
oil price shocks.
But of course there are
steps that energy importers can take now - energy
conservation, alternative energy production,
larger strategic oil reserves and the like - to
blunt the impact of future disruptions in oil
supplies and price shocks.
Most
importantly, the US can do more to bring peace and
economic cooperation to the Persian Gulf and more
generally to the Middle East. This should include
democratic and political reforms in its client
states in the Persian Gulf, reduced military
expenditures, enhanced oil and gas development in
the region and genuine reforms to benefit the
people of the region.
As we hope to see in
future articles, it is these longer-term policies
that will ameliorate the global energy outlook and
reduce the likelihood of serious price shocks as
we transition to a renewable energy world.
NEXT: Whose oil?
Hossein Askari is Professor of
Business and International Affairs at the George
Washington University.
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