Friday, May 14, 2004
Rising Oil Prices
The price of crude per barrel crossed $41 in New York today. There seems to be a consensus that rising demand in China (alongwith the usual OPEC supply games) is probably what is driving prices higher. Of course, trouble in Iraq has meant that the neo-con dream of oil at $20 post-Iraq will remain just that. I dont think the situation is going to get any better as India's (and other major emerging economies') demand for oil surge over the next couple of years. And given what rising oil prices does to inflation, perhaps it is time to pay attention to those who call for Manhattan Project-type investments to develop alternative sources of energy.
Paul Krugman writes in the New York Times that an oil-driven recession might not be all that far-fetched.
The International Energy Agency estimates the world's spare oil production capacity at about 2.5 million barrels per day, almost all of it in the Persian Gulf region. It also predicts that global oil demand in 2004 will be, on average, 2 million barrels per day higher than in 2003. Now imagine what will happen if there are more successful insurgent attacks on Iraqi pipelines, or, perish the thought, instability in Saudi Arabia. In fact, even without a supply disruption, it's hard to see where the oil will come from to meet the growing demand.
But wait: basic economics says that markets deal handily with excesses of demand over supply. Prices rise, producers have an incentive to produce more while consumers have an incentive to consume less, and the market comes back into balance. Won't that happen with oil? Yes, it will. The question is how long it will take, and how high prices will go in the meantime.
To see the problem, think about gasoline. Sustained high gasoline prices lead to more fuel-efficient cars: by 1990 the average American vehicle got 40 percent more miles per gallon than in 1973. But replacing old cars with new takes years. In their initial response to a shortfall in the gasoline supply, people must save gas by driving less, something they do only in the face of very, very high prices. So very, very high prices are what we'll get.
Each $10 per barrel increase in crude prices is like a $70 billion tax increase on American consumers, levied through inflation. The spurt in producer prices last month was a taste of what will happen if prices stay high. By the way, after the 1979 Iranian revolution world prices went to about $60 per barrel in today's prices.
Could an oil shock actually lead to 1970's-style stagflation — a combination of inflation and rising unemployment? Well, there are several comfort factors, reasons we're less vulnerable now than a generation ago. Despite the rise of the S.U.V., the U.S. consumes only about half as much oil per dollar of real G.D.P. as it did in 1973. Also, in the 1970's the economy was already primed for inflation: given the prevalence of cost-of-living adjustments in labor contracts and the experience of past inflation, oil price increases rapidly fed into a wage-price spiral. That's less likely to happen today.
Meanwhile in India, everyone's favourite political buffoon (and member of the winning coalition), Laloo Prasad Yadav, was asked whether oil prices in India (which had been held down during the elections by about Rs 3-4 per litre) would be allowed to rise in response to global price rises now that the elections were over. He replied that he would ensure the use of subsidies to either hold prices at current levels or reduce it still further. That's very reassuring. I can only hope the more sensible folks in the Congress party will prevail over the populists.
Paul Krugman writes in the New York Times that an oil-driven recession might not be all that far-fetched.
The International Energy Agency estimates the world's spare oil production capacity at about 2.5 million barrels per day, almost all of it in the Persian Gulf region. It also predicts that global oil demand in 2004 will be, on average, 2 million barrels per day higher than in 2003. Now imagine what will happen if there are more successful insurgent attacks on Iraqi pipelines, or, perish the thought, instability in Saudi Arabia. In fact, even without a supply disruption, it's hard to see where the oil will come from to meet the growing demand.
But wait: basic economics says that markets deal handily with excesses of demand over supply. Prices rise, producers have an incentive to produce more while consumers have an incentive to consume less, and the market comes back into balance. Won't that happen with oil? Yes, it will. The question is how long it will take, and how high prices will go in the meantime.
To see the problem, think about gasoline. Sustained high gasoline prices lead to more fuel-efficient cars: by 1990 the average American vehicle got 40 percent more miles per gallon than in 1973. But replacing old cars with new takes years. In their initial response to a shortfall in the gasoline supply, people must save gas by driving less, something they do only in the face of very, very high prices. So very, very high prices are what we'll get.
Each $10 per barrel increase in crude prices is like a $70 billion tax increase on American consumers, levied through inflation. The spurt in producer prices last month was a taste of what will happen if prices stay high. By the way, after the 1979 Iranian revolution world prices went to about $60 per barrel in today's prices.
Could an oil shock actually lead to 1970's-style stagflation — a combination of inflation and rising unemployment? Well, there are several comfort factors, reasons we're less vulnerable now than a generation ago. Despite the rise of the S.U.V., the U.S. consumes only about half as much oil per dollar of real G.D.P. as it did in 1973. Also, in the 1970's the economy was already primed for inflation: given the prevalence of cost-of-living adjustments in labor contracts and the experience of past inflation, oil price increases rapidly fed into a wage-price spiral. That's less likely to happen today.
Meanwhile in India, everyone's favourite political buffoon (and member of the winning coalition), Laloo Prasad Yadav, was asked whether oil prices in India (which had been held down during the elections by about Rs 3-4 per litre) would be allowed to rise in response to global price rises now that the elections were over. He replied that he would ensure the use of subsidies to either hold prices at current levels or reduce it still further. That's very reassuring. I can only hope the more sensible folks in the Congress party will prevail over the populists.
