Oil Markets and Their Impact on the US Economy Research Paper

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Oil Market & U.S. Economy

In June 2008, when the price of oil had crossed $120 per barrel, the predictions for the impacts on the U.S. economy were dire. Whereas just months previous, prices were expected to top out at $100 before returning to a more reasonable equilibrium point (Schoen, 2007), now the potential of $200 barrel oil came to pass, bringing with it economic catastrophe (Biderman, 2008). The short version is that demand for oil in the United States is relatively price inelastic. Therefore, as the price of oil increases, the amount of money that American businesses and consumers spend on oil increases. This reduces the amount of money available for consumer spending and industrial infrastructure investment. Ultimately, this harms the economy by concentrating capital flows to the petroleum industry. The capital eventually flows out of the country to the petroleum-producing regions.

This paper will delve into the subject in greater detail. First, the patterns of demand will be analyzed. Then the relationship between world oil supply and U.S. consumption will be examined. From there, the impact of high and low oil prices on the U.S. economy will be determined. Lastly, this paper will outline the benefits to the U.S. economy of low oil prices.

US Oil Demand

In 2007, the U.S. consumed 20.7 million barrels of oil per day. Of this, the largest component by far was transportation, at 14.26 million barrels, or 68.9% of all consumption. The other major use was industrial, at 5.06 million barrels per day, or 24.4% of consumption. The remaining markets accounted for 1.37 million barrels per day, or 6.6% of total consumption (Energy Information Administration, 2007).

Price elasticity of demand for oil is low. In the late 70s, price elasticity was estimated to be between -0.21 and -0.34 (Hughes, et al., 2006). This indicates a significant willingness on the part of consumers to reduce oil consumption in the face of rising prices. This is supported by the rise in compact cars over the same period, indicating that the increased oil prices had an impact on car purchase decisions. In another period of similarly high oil prices, 2001-2006, the price elasticity of demand was determined to be between -0.034 and -0.077 (Ibid). This indicates a significant shift in the short-term elasticity of oil demand. Consumers during that period did not curtail their oil usage, even in the face of high prices. There was some indication that the oil price spike in early 2008 did result in declining sales of SUVs and other large vehicles, and an increase in sales of hybrids and compacts, however. The difference is that the oil price level at which consumer behavior began to shift is significantly higher now.

There are many reasons for the shift in short-term elasticity. Of significant importance is the physical structure of our living environment. Americans today driver further distances in their commutes, and our communities have become overwhelmingly car-centric. It is difficult if not impossible, outside of a handful of major cities, to function in the United States without a car. It is worth noting that during 2001-2006, the SUV was the automobile of choice for millions of Americans, the opposite of the late 1970s trend towards smaller cars.

One of the reasons for this difference is that Americans have become so accustomed to high gas prices that those prices, and their increases, no longer play as significant a role in the decision-making process. In the late 70s, American consumers were coming off of the embargo, and experiencing Jimmy Carter's price controls. A decade earlier, gas prices were stable and there was no consideration of a possible shortage. In short, the high prices were still a shock to many; today they are not a shock but just another cost of living.

Relationship between World Supply and U.S. Consumption

The late 1970s situation as just described was a clear example of U.S. consumption decreasing in response to a perceived decline in global supply, as this decline was reflected in higher prices. The more recent price fluctuations, however, are not viewed as being related to global supply. The prevailing chatter is that commodities speculators, fueled by 10% margin requirements and in need of the next bubble, have contributed to the volatility of fuel prices in recent years. Yet now, more than in the 1970s, there are real supply issues. Peak oil is widely believed to have come and gone (Deffeyes, 2003). Emerging nations such as China and India are rapidly increasing consumption, causing a reduction in world supply (Mouawad & Werdigier, 2007). Current production levels are 24.845 million barrels per day from OPEC (OPEC, 2008) and 50.7 million barrels per day from non-OPEC countries (OPEC, 2009) for a total of 75.545 million barrels per day. The current U.S. demand for oil is estimated to be 18.99 million barrels per day (Doggett, 2009).

An examination of oil supply charts and U.S. oil consumption charts (EIA Annual Energy Review, 2007) show that there is a strong correlation between the amount of oil produced in the world and U.S. consumption. Both graphs show a steady, upward curving increase through the 1960s. This is followed by a couple of peaks in the 1970s. After a sharp decline in the late 1970s/early 1980s, both production and U.S. consumption increase steadily through the present. There is a major difference, however, in the percentage of world consumption, as the U.S. has dropped from an estimated 50% of world consumption in 1960 to 24% today (Ibid).

The strong correlation between the production of crude oil and U.S. oil consumption leads to one of two possible conclusions. One is that production follows U.S. demand. The more the U.S. needs, the more is produced. The other conclusion is that increased production keeps prices low, therefore encouraging more consumption. The diffusion of suburban sprawl, large automobiles and long-distance transportations all contribute to demand, but they are facilitated by rational economic decisions. Americans ship goods across the country by truck because it is affordable to do so. Americans commute long distances to work for the same reason. If production had not increased, the tight supply would have caused prices to increase, thereby resulting in lower consumption. Indeed, even today we see that OPEC has cut production by 4.2 million barrels per day in order to increase the price of oil. OPEC uses the price of oil to influence consumer decision making. When Americans turned to smaller cars as a result of the oil crisis, OPEC dramatically increased production. Thus, it remains undetermined whether low prices have driven U.S. demand or if U.S. demand drives production, but there is a strong correlation between oil supply and U.S. demand.

Impact of High/Low Prices on U.S. Economy

The low elasticity of demand for oil means that when oil prices rise, the amount of money available for other goods and services declines. Few consumers are willing to curtail their oil consumption if prices increase, so they simply are forced to make cuts in either spending or in saving elsewhere. Businesses are faced with a similar decision, except that they have the luxury of passing at least some of the increase onto consumers. This results in further reduction of money in the economy on account of inflation.

Historically, the United States economy has been able to grow despite increases to gas prices as a result of productivity improvements (McNamara, 2006). However, this has become less the case in recent years. Because of the low elasticity, increases in gas prices act in a similar manner to taxes. They simply take money out of the economy. The International Monetary Fund estimated in 2000 that for every $5 per barrel increase in the price of oil, the U.S. economy contracts $17 billion or 0.2% of GDP (IMF, 2000). During the oil price shock of 2001, U.S. GDP fell 0.17% (Azzouz, 2006).

Low prices have the opposite effect. With low fuel prices, the amount of money available for consumption and savings increases. Low fuel prices also spur economic investment. Low prices also encourage greater fuel consumption. Companies make choices that are more transport-dependent. Demand for residences in far-flung suburbs increases, driving new home growth. However, there are trade-offs. For example, a prolonged slump in oil prices would reduce oil supply growth, hampering economic growth in the long-run (CERA, 2009).

Benefits of Cheap Oil in the U.S.

There are many benefits to cheap oil in the United States. These include increased money for consumers, lower cost structure for business, a reduction in the transfer of wealth, and lower inflation (Majidi, 2006). Remember that transportation makes up 68% of all oil usage. Part of this will be for businesses, but the majority goes to fuel consumer consumption. The price of crude oil accounts for 58% of the price at the pump, so the price of crude on the market is not perfectly correlated with gasoline prices, but there is a fairly strong correlation. When oil prices are low, so too will be gasoline prices. When consumers have more…[continue]

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