Oil Prices and the U.S. Economy: Demand, Supply, and Impact

Introduction

In June 2008, when the price of oil had crossed $120 per barrel, predictions for the impact on the U.S. economy were dire. Whereas just months earlier prices had been expected to top out at $100 before returning to a more reasonable equilibrium point (Schoen, 2007), the potential of $200-per-barrel oil suddenly came into view, bringing with it the prospect of 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 as well. This reduces the amount of money available for consumer spending and industrial infrastructure investment. Ultimately, this harms the economy by concentrating capital flows toward the petroleum industry, with that capital eventually flowing out of the country to petroleum-producing regions.

This paper delves into the subject in greater detail. First, the patterns of demand are analyzed. Then the relationship between world oil supply and U.S. consumption is examined. From there, the impact of high and low oil prices on the U.S. economy is assessed. Lastly, the paper outlines the specific benefits to the U.S. economy of low oil prices.

U.S. Oil Demand

In 2007, the United States consumed 20.7 million barrels of oil per day. Of this total, the largest component by far was transportation, at 14.26 million barrels per day, 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).

The price elasticity of demand for oil is low. In the late 1970s, 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 — a pattern supported by the rise in compact car sales during the same period, indicating that higher oil prices had a measurable impact on car purchase decisions. In a later 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 represents a significant shift in short-term elasticity: consumers during that period did not substantially curtail their oil usage, even in the face of elevated prices. There was some indication that the oil price spike in early 2008 did result in declining sales of SUVs and other large vehicles alongside an increase in sales of hybrids and compacts; however, the price level at which consumer behavior began to shift is now significantly higher than in earlier decades.

There are many reasons for this shift in short-term elasticity. Of particular importance is the physical structure of the American living environment. Americans today drive further distances in their commutes, and 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 toward smaller cars.

One reason for this difference is that Americans have become so accustomed to relatively high gas prices that those prices, and their incremental increases, no longer play as significant a role in decision-making. In the late 1970s, American consumers were coming off of the embargo and experiencing price controls. A decade earlier, gas prices had been stable and there was no consideration of a possible shortage. In short, the high prices of the 1970s were still a shock to many; today they are no longer a shock but simply another cost of living.

Relationship Between World Supply and U.S. Consumption

The late-1970s situation described above was a clear example of U.S. consumption decreasing in response to a perceived decline in global supply, as that decline was reflected in higher prices. The more recent price fluctuations, however, are not widely viewed as being driven by global supply constraints. A prevailing explanation is that commodities speculators — fueled by low margin requirements and in search of the next asset bubble — contributed to the volatility of fuel prices in recent years. Yet today, more than in the 1970s, there are real supply concerns. 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 available world supply (Mouawad & Werdigier, 2007). Current production levels stand at 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 approximately 75.545 million barrels per day. U.S. demand for oil is estimated at 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) reveals a strong correlation between the amount of oil produced in the world and U.S. consumption. Both data sets show a steady, upward-curving increase through the 1960s, followed by a couple of peaks in the 1970s. After a sharp decline in the late 1970s and early 1980s, both production and U.S. consumption increase steadily through the present. There is, however, a major difference in the percentage of world consumption: the U.S. has dropped from an estimated 50% of world consumption in 1960 to approximately 24% today (Ibid).

This strong correlation between world crude oil production 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 is that increased production keeps prices low, thereby encouraging more consumption. The diffusion of suburban sprawl, large automobiles, and long-distance transportation 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 for the same reason. If production had not increased, tighter supply would have caused prices to rise, resulting in lower consumption. Indeed, OPEC has at times cut production by 4.2 million barrels per day in order to support the price of oil, demonstrating that it actively uses price as a lever to influence consumer decision-making. When Americans turned to smaller cars as a result of the oil crisis, OPEC dramatically increased production. Thus, whether low prices have driven U.S. demand or U.S. demand has driven production remains undetermined, but the correlation between oil supply and U.S. demand is strong.

Works Cited

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