Research

Podcast: World economy heading for an oil slick?

Analysts are watching the global oil situation with a raised eyebrow as prices flirt with the $100 per barrel mark. The U.S. economy is bearing the brunt, because with a weakening dollar oil costs more, and because at 20 million barrels per day, America uses more oil than any other nation. With the U.S. accounting for 25 percent of gross domestic product globally, trouble for the U.S. economy could spell trouble for the world. According to Lee McPheters, director of the JPMorgan Chase Economic Outlook Center at the W. P. Carey School of Business, prices will drop when the risk factors that have been driving them skyward moderate. But short term the situation is "potentially difficult."

2007-11-07

Analysts are watching the global oil situation with a raised eyebrow as prices flirt with the $100 per barrel mark. The U.S. economy is bearing the brunt, because with a weakening dollar oil costs more, and because at 20 million barrels per day, America uses more oil than any other nation. With the U.S. accounting for 25 percent of gross domestic product globally, trouble for the U.S. economy could spell trouble for the world.

According to Lee McPheters, director of the JPMorgan Chase Economic Outlook Center at the W. P. Carey School of Business, prices will drop when the risk factors that have been driving them skyward moderate. But short term the situation is "potentially difficult."

Top Line Points:

• Historically, oil was primarily a U.S. product, and from 1865 up until now oil was a relatively inexpensive commodity.
• In the past there were few price-spike periods, such as the one that occurred during the Iran-Iraq war.
• According to McPheters, the rise in oil prices is attributable not just to exceptionally strong demand, but also to the weaker dollar and the political environment.
• The U.S. economy is bearing the brunt of high oil prices because the dollar is weaker, U.S. demand clocks in at 20 million barrels a day, and the American consumer tends to use a lot of gasoline.
• Forecasts predict that for the next 30 years or so oil will continue to represent 40 percent of our energy requirements.
• Profound changes in our sources of energy will not upset the rank order of energy sources in the U.S. — oil is number one, coal is number two, natural gas is number three — at least for the next 30 years.

Transcript:

Knowledge: With oil flirting with the $100 a barrel mark, corporate America, Wall Street, and consumers across the Country are facing even higher gas prices. The impact on the economies of the nation and the world could be serious. But is this a permanent state of affairs?

Here with the stats on the current oil crunch is Lee McPheters, professor of economics, senior associate dean and director of the JP Morgan Chase Economic Outlook Center at the W. P. Carey School of Business. Oil prices are obviously up, what are the factors that are causing this recent round of increases?

Lee McPheters: Well, of course economists would want to look at the price environment in the context of supply and demand, and when you look at supply and demand for oil in particular you're looking at a product that has been produced ever since about 1865 in the U.S. economy.

Oil was first discovered in Pennsylvania and was actually primarily a United States product for many, many years, and over that whole period from 1865 up until now oil, in fact for the most part, was a relatively inexpensive commodity with a couple of price spike periods that lasted for quite a while. One of them was the Iran-Iraq war period, the run-up to that and then the period after that, about 10 years from around the mid-70s to the mid-80s, and then oil was much lower priced for quite a while until after the 9/11 attack.

So when you look at oil you're really looking at a product that is a commodity and that is generally viewed as something that would ordinarily have a fairly stable price. So now when you look at supply and demand you see that the demand for oil worldwide is somewhere in the range of 80-85 million barrels per day. The U.S. is the major source of that at 20 million, and the main factor of that is different now from just a few years ago. On the demand side is that you have developing economies, particularly China and India, where demand is increasing very rapidly.

There's other parts of the world, especially Western Europe, where the demand for oil has actually fallen in recent years. Now on the supply side you have, of course, OPEC as one the major producing areas, and then you have all the rest, and all the rest consists of such countries as Russia, for example, which is now coming on very strong as one of the leading producers.

When you look at the rest of the oil producing nations other than Russia, you find very few that are really increasing supply. So what it comes down to is that you have strong demand, especially on the part of the emerging economies, you have countries that have normally been oil supplying countries for decades where their production is not up by much, and inventories over the past two to three years have steadily declined.

And, as a result, we now have a very fragile sort of environment with supply and demand where any kind of disruption at all, whether it's from the weather or political risk, tends to cause prices to gyrate very, very wildly. If you look at the most recent figures that we have and compare that to where people thought oil was going let's say even three months ago, to think we'd be over $90 a barrel right now is really, I think, surprising to most analysts but I wouldn't really attribute this in any way to exceptionally strong demand.

I think you have to look at other factors beyond that like: the weaker dollar, the political environment and basically there's really a war tax on oil right now, we have the same sort of situation now, Middle-East turmoil, that we had the last time oil was at such high prices.

Knowledge: As you mentioned, you know, a year ago over $90 seemed incomprehensible, now we're looking right in the face of $100 a barrel, it looks very possible that's going to happen. If it does and if it stays hovering around that area what will the effects be to the American economy as a whole and to the global economy as a whole?

McPheters: Well, first of all oil prices are expressed in dollars, so some countries where the dollar's actually weakening relative to their currency — I'm thinking here of the Euro in particular — in those countries the effect is not felt quite as seriously. And, of course, if you're an oil-producing country the rise in price of oil is by and large something that's favorable for you.

When you come to the U.S. economy we're really bearing the brunt of these high oil prices in that of course oil is much higher priced to us, the dollar is weaker, we're one of the primary... the largest single demand component for oil at that 20 million barrel a day figure, and the American consumer tends to use a lot of gasoline.

So, what we're looking at I think as oil prices tend to go up into these ranges that we've not really seen before is, in the short term, we're probably going to have to grin and bear it. I really don't think that we are going to see the consumer stop driving.

The figures that we have on mileage driven show that those numbers are not in any sense skyrocketing but consumers are continuing to drive. Consumers are going to have to make some choices because of course there's a relationship between oil prices and gasoline prices at the pump.

Typically we think of the consumer budget as somewhere around I would say about five percent of the consumer budget goes for gasoline and related energy, and as this part goes up you have many elements of the economy — people I would say below median income where even a five percent to 10 percent increase in gas prices is really felt.

But overall probably what we're going to see is that high oil prices are eventually going to work their way through the industrial structure in such a way that we tend to see higher price pressures and we're probably going to have weaker economic growth.

So all of these things combine, I think, to be bad for the economy. In the longer run there's probably going to be adjustments that are made, because when you have high gasoline prices, when you have high oil prices, people that use those products either as consumers or commercially; they're going to try to make adjustments and try to move away from the higher priced energy source.

Knowledge: And what about the global economy?

McPheters: Well, I think globally we are at risk with a weak U.S. economy, the reason being that the U.S. accounts for somewhere in the range of 25 percent of gross domestic product globally. In other words, the world output is accounted for by the U.S. About one out of every four dollars the world outputs is accounted for by the U.S.

So if the U.S. economy gets weak, as they say; if the U.S. sneezes the world catches a cold. And I think we have a potentially difficult situation here in the short run, and I think that most analysts are really watching oil with a raised eyebrow, because as I said before; no one really expected that we'd be seeing oil prices anywhere near these levels.

Knowledge: Will these higher gas prices finally push the American consumer or American industry to start looking for or demanding new sources of energy, and just how realistic is that - that we'll have something that will replace oil, or at least be a strong competitor to oil within say; the next 20 or 30 years?

McPheters: Well, economists would look at any kind of commodity price rise — oil would be an excellent example — they would look at a commodity price rise and they would say something on the order of "price cures price". And what they're trying to indicate there is that higher prices stimulate — on the one hand — conservation, they stimulate decision making by consumers and business to try to find lower cost alternatives.

On the other side; high prices influence supply because the producers of oil now have an incentive to undertake more exploration, to perhaps apply more technology and the result is that eventually there is somewhat of a return to a more normal price range for the particular product.

So, when you look at the options for oil, certainly something like windmills has become much more popular, but based on the data that I've seen for example on windmill, one windmill produces the equivalent of about 35 barrels of oil per day, and this is an economy that needs 20 million barrels of oil a day, so you would need a lot of windmills for that.

In the future, most of the forecasts that are coming out of the major public and national and global agencies suggest that oil is still going to be — for the next 30 years or so — 40 percent of our energy requirements. And while it's certainly wise to look at alternative sources of energy, you really can't count on wind or hydroelectric or even biomass to have much of an impact; it's probably going to be much less than 10 percent of our total energy supplies even 30 years from now.

Knowledge: And still, the United States and large parts of the world, are still spooked by nuclear power.

McPheters: That, I think, has enormous potential, but again, it is extremely long-term. Perhaps over the next 20-30 years that will be a factor, but when you just look at the role of oil in our society, our economy, even profound changes in our sources of energy are still going to leave you with the ranking we have right now — that is, oil is number one, coal is number two, natural gas is number three. And those three sources of energy right now account for over 90 percent of the energy we use. It's probably going to be the same way 20 years from now.

Knowledge: So, where do you see oil prices being in the next year, next three years?

McPheters: Well, I think that if we could really estimate the influence of the middle-east political situation accurately, that we would probably come up with a figure somewhere approaching $20-$30 per barrel just based on political risk, uncertainty, and when and if we ever see that situation calm down I think that that will be accompanied by a rapid reduction in oil prices.

That's what we've seen historically and there's every reason to believe that it's gong to be that way in the future. If you look at the long term, again you get an opportunity for businesses to adjust, for consumers to adjust, they buy cars that get better mileage, a business finds different ways to produce goods and services that don't use so much energy.

So over the longer term, these factors will work. In the short term I would think that the best we can hope for is a return to where we were; and it was only about a year and a half ago, really, that we were at $50 a barrel and at that time people thought oil was high priced. I think that within the next two to three years we'll probably be back in that range; $50-$60 a barrel. And I think we're going to have to live with that $50-$60 a barrel until we see a much more calm and benign situation in the Middle East.

Knowledge: I sometimes wonder if even some of these oil producers realize there's only so much that they can push it before even they have to start pulling back on how much they can charge for this.

McPheters: You know, historically it has always been that way. It goes up, and then all of a sudden it just doesn't go anymore. There's kind of a ceiling. We're at that ceiling now. If you take out the inflation effects and all of that, put it in 2006 dollars, oil kind of hit the peak around 1981 or '82 at close to $70 a barrel. And we're up there and a little bit past that now.

So people tend to think that there's a limit to what you can do because, after all, the demand right now is really not much stronger than it was three years ago. There's really not much difference there. So the big question now is what's causing this, and you've just got to look at all the political turmoil. Every time something happens in the Middle East the price spikes again.

Economics Faculty