RateWatch #409 – The Price of Oil

May 29, 2004 by Dick Lepre

What's Happening

This week, one Fed member said that rates will be increased at "a measured pace" noting, "The pace of tightening will of necessity respond to evolving economic conditions, particularly the strength of the ongoing recovery in the labor market and developments on the inflation front". In plain English: the Fed will start increasing soon but will keep rates low if inflation remains in check. The priorities are: 1) GDP growth and 2) jobs.  Concern about the effect of Fed hikes on the
economy is overblown.  Talk has certainly hurt mortgage rates but once folks realize that rates are not going to soar then perhaps anxiety will subside.  This relief from the upward pressure of the secular bear market is not likely to occur for six months.

Oil and the Economy

So it is Memorial Day weekend and the nation's attention focuses, as it always is on this holiday, not on our war dead but on the price of gasoline.

Significant attention has been recently captured by rising oil prices. In is hard to not notice the price of gasoline when it is posted in 16" tall numbers on every other street corner.

Just as in 2000 when we had a comic staging where Al Gore had to "suggest" to Bill Clinton that he release oil from the Strategic Petroleum Reserve (SPR) to drive down the price of oil we are seeing politicians using oil prices for a political leverage.

Releasing oil from the SPR will have absolutely no lasting effect on the economy. The purpose of the SPR is not to stabilize the price of oil. The purpose is to provide an emergency reserve in the event of a discontinuity of importation of crude. The Oil Boycott of 1973 is an example of what the SPR is intended for.  A release of inventory from SPR would likely be offset by a decrease in
OPEC production.  The result would be no price stability and a loss of those strategic reserves.  The case is, to be fair, a bit more complex.  One might make a purely economic case that the SPR should be drawn down while oil prices are high and filled up while they are low.  The policy of the
present administration is that this is a strategic reserve and it should not be tapped absent an event similar to the oil boycott of 1973.

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 serious one. Higher oil energy prices have precipitated three of the past five 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 2001 recession was brief but
was caused, in no small measure, by 9/11 which had, in some perverse way, something to do with oil.

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, businesses 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

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 30 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 economy. It is notable that the public has such strong confidence in the Fed at the present time that we are not having "anticipatory inflation" brought on by fear of the I-Monster (inflation). For example, industry has become savvy enough to use hedging techniques to moderate the impact of higher open-market energy prices.
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. There were 1,166 oil rigs operating in the US on April 6. A year ago, there were 1,050. This is down substantially from the "rig count" of 2000.

More oil can be taken out of the ground in Mexico and the North Sea.  The short-term solution to the present problem is not tapping the SPR, it is extracting more oil. That is not something that has any political value - it just makes sense. In the long term, oil is not the solution to our energy needs.  What we need are high-tech solutions which are economical and have much less negative impact on the environment.

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:

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 both a political and 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. It also creates the responsibility of finding that 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?" On March 16, 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 which 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.

The making of electricity, whether from nuclear fuel or coal, involves the creation of 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.)

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

Nuclear reactors make energy from a controlled nuclear fission process.  What we should be spending a ton of money on is physics/engineering research for controlled nuclear fusion. For an insight as to what this is about see the International Thermonuclear Experimental Reactor web site at: http://www.iter.org/ ITER is a large-scale international (the European Union, the United States, Russia, Japan, South Korea, and China) project dedicated to spending a ton of money to build the next generation large-scale fusion reactor.  Nuclear fusion would use hydrogen as a fuel and create little waste product and little environmental impact.

Other Sources

Recognizing the necessity to become more oil-independent we should also be spending more money on developing solar power and looking to alternative methods (such as hydrogen) as energy storage media to power cars.

These decisions need to be based on technology and politics. Instead we see things such as ethanol (E95) which sound good on the surface but have some underlying problems: 1) ethanol has about 30% less energy per gallon than gasoline and 2) it takes energy to make ethanol both in the process of planting and cultivating corn and in refining it. 

Hybrid vehicles have gotten a lot of great press and are "hip" but the unfortunate fact is that they do not always get the mileage advertised.  Consumer Reports state that while hybrids get
close to EPA estimates on the highway the get less than 60 percent of EPA estimates on city streets.  Hybrids do get better mileage.  What they probably need is a revision to EPA standards to make the city mileage closer to reality and avoid the bad rap from disappointed motorists.

The Conclusion

The variable price of energy is still a  threat to the U.S. economy. The threat is probably not as large as perceived but, as we know, perception can fast become reality. 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. We are more dependent on imported oil then ever.

Some components of a solution are:

- buying more fuel-efficient vehicles rather that SUVs.  Wehave become enamored of the convenience of SUVs and are paying the price at the pump.

- We need to get over our "nuclophobia" and find ways to build safe reactors and methods of disposing of the waste.

- The physicist's dream of the production of large amounts of energy from controlled nuclear fusion is still just a dream but, fortunately, a dream that we are working on. A technically and economically feasible solution to the controlled fusion problem could solve almost all of our energy problems.

- We need to continue to developing energy-efficient building designs and materials and household appliances. Houses need to consume less energy on heating in the winter and cooling in the summer.

- Solar power continues to be explored as an alternative for the future.  At present solar is relatively expensive to install but if it becomes less expensive and fossil fuels are depleted and become more expensive it will become an economically viable alternative.

In the mean time, turn of the lights when you are out of the room and turn off your computer monitor when you are finished reading this.

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