RateWatch #326 - Oil
October 19, 2002
By Dick Lepre

What's Happening

Equity buying hammered Treasuries this week and has led to higher mortgage rates. Rates have been low but the market is due for a correction - higher rates.

Oil and the Economy

President Bush has authorization from Congress to do whatever it is that he has in mind regarding Iraq. Several weeks ago I questioned whether the US indeed has the ability at any time in the near future to invade Iraq. The underlying issue is the same one that existed at the start of The Gulf War - oil.

Avoiding the political side of this - what is the effect on the economy of the price increase in oil?

The most obvious correlation is a drastic one. Higher oil energy prices have precipitated three of the past four recessions (1973-75, 1980, 1990-91). At the time of the other recession (1981-82) oil prices were falling but had been high and, thus, contributory.

The connection between high energy prices and recession is obvious. If folks have to spend a few hundred dollars more on gasoline and electricity they will have that much less to spend on other "stuff." In addition, business are hard-hit by higher energy prices. High energy prices "impact the bottom line" and as corporate profits are threatened so is the Dow. A hit to the Dow can translate into a hit to wealth and the ensuing anti-matter wealth effect can serve to further reduce consumer spending.

To quantify the effect: a sustained increase of $10 per barrel in the price of crude reduces real GDP growth by approximately 3/4 of a percentage point in the year following the increase.

There is more going on than just this. In 1975 the economy used 1400 BTUs of petroleum to produce a dollar's worth of GDP. Now, it takes less than 700 BTUs to produce one dollar's worth of GDP today. The U.S. is more energy-efficient than it was 25 years ago. More importantly, the nature of work has changed. The movement away from energy consuming, goods-producing jobs to service-producing jobs has lessened the impact of energy price increases on the U.S. economy.

A cold winter in the Northeast will translate into highly publicized heating oil price hikes. A lot of buildings in the media conscious Boston-New York- D.C. corridor still use heating oil and this has always been a political issue. No politician in the Northeast can go wrong by bitching about the high price of oil.

It would be decidedly unwise for OPEC to press crude prices higher because the world economy would be threatened. Higher oil prices will have a substantially deleterious effect on Europe. Nasty political posturing could result in diminished production, price increases and recession.

But in the U.S. the effect of oil prices on the economy may not be as drastic as it once was. Consider this: in 1980 oil accounted for 6% of all of the personal expenditures for Americans. Even with the present high energy prices oil accounts for 2.7% of the present personal expenditures of Americans. Things contributory are: Hondas replacing Pontiacs, energy efficiency and, to some extent, the continued movement of the population to warmer climes. Unfortunately, OPEC has not been the prototype for rational, predictable behavior.

The present economics of oil demands more production. The fact is this: in most parts of the world, oil can be taken out of the ground at a cost of under $15/bbl. More oil can be taken out of the ground in Mexico and the North Sea. In the long run there is still large untapped capacity in China.

Historical data on oil prices may be seen at: http://www.oilnergy.com/1onymex.htm

A good starting point for data on the energy industry is: http://oilonline.com/index.html

Missed Opportunities?

Looking at the present oil price picture, the high prices can easily be blamed on curtailed OPEC production. Somewhere here the U.S. failed to exert sufficient leverage on Saudi Arabia to keep supply up. The seemingly endless problems in the Middle East have not served to enhance our clout with the folks with the oil. To the Arab world, the U.S. is not an ally - at best, we are a customer. This is a politico-economic failure.

The other issue that has bothered me for at least 25 years in the unwillingness of the U.S. to back nuclear energy. As someone with a degree in physics I find this irksome. If we had pursued the technology of pressurized water reactors we would have, I would think, safe methods of producing massive amounts of electricity. The Achilles heel of the nuclear industry was and still is - waste disposal. France, which found itself in an ugly spot as a result of the 1973 "oil shock" opted for massive nuclear power plant building. Politicians found that no one wanted the waste buried in the ground. Instead they did just what we are doing here in the US. It was "stockpiled" until a solution could be found for its detoxification. While this is hardly an elegant solution it is a sort
of "well, do you have a better idea?" concept. Stockpiling radioactive waste expresses a confidence in the ability to find a technical solution.

In the 1970's concerned citizens and scientists searched for an answer to the questions: "Just how safe should nuclear reactors be?" and "Just how safe are they?" In 1979 the movie "The China Syndrome" was released. On March 28, 1979 an accident occurred at the Three Mile Island nuclear plant in Pennsylvania. Things have never been the same. One thing that hurt scientists and engineers about this accident was that they had previously devoted almost all of their efforts in regards to safety to hardware - having the right equipment. TMI blatantly demonstrated that poor training and operator error were even more dangerous. As Shakespeare put it: "The fault, dear Brutus, is not in the stars but in ourselves." At TMI the control room, for instance, had more than 600 alarm lights. Each one of them, by itself, added to safety because it reported that something was wrong. In a serious accident the effect was chaos. So many alarms went off that operators could not easily grasp what was happening.

For an excellent description of what went wrong see:

Seven years later the accident at Chernobyl occurred. While this reactor was of a design that American engineers consider flawed, the real problem was a series of operator errors.

Scientists and engineers had failed to explain to the public the dangers of nuclear power and people were suspicious. The media decided that Jane Fonda was the correct person to explain things nuclear.

Whether you're making electricity using nuclear fuel or making electricity using coal you will create noxious byproducts. When all is factored, it hardly seems the case that nuclear energy is a monster compared to, say, coal. In the case of nuclear power the noxious byproduct can be put in drums and set aside for later detoxification. In the case of coal-fired plans it is simply blown into the air.

As an aside, note that no commercial nuclear reactor is capable of blowing up like a nuclear weapon. Reactor danger stems from the intense pressure that can be built up so that the result is a chemical explosion of steam and pieces of metal which damage the containment vessel and allow radioactive materials to be released into the atmosphere. The propensity to locate nuclear power plants at non-remote locations for economic purposes (the energy lost in transmitting power over large distances is less if the plant is located near consumers) seems ill advised.

For an encyclopedia of information about radioactive waste see: http://www.radwaste.org/

The Conclusion

The variable price of energy is still one of the greatest threats to the U.S. economy. Until the United States can develop a large measure of energy independence our economy will always be at the risk of suffering a major shock if our supply of crude oil is interrupted. We have not learned
from the lessons of the 1970's.

In addition, a new dimension has been realized,  those dollars spent of Saudi oil funded 9/11.  It would be better if we did not need their damned oil.

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