11-04-2000

ECONOMY: Over a Barrel

In the next few months, there is one man, more than any other, who will
determine whether the current surge in oil prices becomes a threat to the
longest era of prosperity in American history.


It isn't the president of the Organization of the Petroleum Exporting
Countries (who happens to be the energy minister of Venezuela). OPEC has
regained some


momentary control over its members' output, but the group hasn't been an
effective cartel for years and isn't seen by most people as the bogeyman
it used to be.


Nor is it Bill Clinton or whoever follows him into office in January.
George W. Bush and Al Gore differ on how to respond to the oil price
run-up, but both men's plans would have only a minor impact, and only in
the long term. Clinton's response-drawing down the Strategic Petroleum
Reserve in a "swap" that will return more oil a year from
now-has had only a tiny effect, if any at all.


It isn't even Alan Greenspan, the chairman of the Federal Reserve Board
who, many intelligent people believe, can leap tall buildings in a single
bound. Considering how people hang on his every word and gesture, it is
surprising that one of Greenspan's most consistent messages hasn't gotten
through: that the Fed is less powerful than it used to be, and much less
powerful than most people think.


If you've guessed that this mystery man is the chief executive of a major
oil company, you're close. Mergers such as those that created Exxon Mobil
Corp. and BP Amoco, and may soon create Chevron-Texaco, have indeed
concentrated market power in the industry, but not enough to give the
biggest oil companies the power to set prices. Hamstrung by price-fixing
laws (unlike OPEC) and by shareholders who demand short-run profits over
long-term payback, oil company executives are almost incapable of doing
anything that would contribute to a long-term price increase or supply
shortage. Despite oil companies' record earnings in the past couple of
quarters, history shows that the oil giants haven't been able to refrain
from a surge of production that increases supply and eventually drives
down prices.


Even the king of Saudi Arabia, in command of a quarter of the world's oil
reserves, doesn't have a free hand. King Fahd is just as beholden to his
customers as are the oil companies. At the request of the Clinton
Administration, Saudi Arabia has already agreed to boost production by
500,000 barrels a day to help head off an economic slowdown in the
developed world.


The lesson here is that, in a globalized world economy, power is diffuse
and often checked by the interdependence of producers and consumers. Most
oil-exporting nations have more reason than ever to try to moderate oil
prices simply because more of their wealth is tied up in the world's stock
markets. There is one man, however, who doesn't have to worry about
shareholders or customers. He is the last person that the next American
President is going to want holding the cards-Saddam Hussein.


A Troubling Scenario


Since the United Nations' easing of the Gulf War sanctions, Iraq has been
exporting 2.5 million barrels of crude oil a day, more than any giant oil
company and more than all but a handful of countries. Yet Iraq's
government has been regularly threatening since March to reduce or
eliminate its exports toward the end of this year. Its motives seem to be
mixed-in part, they are designed to goose the price of oil by sowing some
uncertainty, and in part they are meant to pressure the West to further
ease U.N. restrictions on how Iraq can use its oil revenue. More recently,
Saddam has tied the threats to the outbreak of violence between Israelis
and Palestinians. Those threats are not just words, either. Saddam moved a
force of five divisions to western Iraq, not far from his border with
Jordan, and as close to Israel as he can get.


If Saddam were to make good on his threats and to combine his move with
another unexpected political or economic event, the world economy could
pay a high price. And other surprises are not so far-fetched. Several Arab
nations have threatened to withhold oil to punish Europe and the United
States for their support of Israel. In addition, two weeks ago, the oil
minister of Iran, the world's third-largest oil exporter, threatened to
cut off oil supplies unless Israel withdraws troops from Palestinian
areas.


A full-blown war in the Middle East could disrupt oil shipping
dramatically. Other supply disruptions that might be minor at other times
could loom large now that supplies are tight. Oil markets trembled two
weeks ago, for example, when oil workers in Venezuela threatened a
walkout. Beyond the oil markets, some combination of other events could
compound the effects of a sudden price rise. A collapse in technology
stock prices could force a cutback in consumer spending just when people
have to tighten their belts to afford more-costly gasoline and heating
oil. Faced with a stock market crash, would the Fed be able to respond the
same way it did in 1987, when it injected huge amounts of money into the
economy by lowering interest rates? Combined with high oil prices, such a
move could trigger serious inflation.


Another double whammy could be the impact of higher oil prices on the U.S.
trade deficit, which has almost tripled in three years. The trade deficit
was already expected to cut U.S. economic growth next year by 25 percent
to 30 percent. Imported oil could dramatically increase that deficit. This
raises the possibility of a sudden devaluation of the dollar, something
that would raise prices on all those imported goods of which Americans
have become so fond.


Based on his past behavior, Saddam would seem to be the largest short-term
threat. Yet he has hardly been mentioned in the presidential race, and
when he has, he is referred to as a kind of abstract, long-term challenge.
This belies an important development: The recent surge in oil prices has
probably given the Iraqi leader more leverage than he's had at any time
since the end of the Gulf War.


Iraq's production represents 3 percent to 4 percent of worldwide crude oil
demand, but this vastly understates the effect of a sudden cutoff. The
combination of strong worldwide demand from the healthy global economy,
stretched production capacity, and tight inventories for oil at the
beginning of the winter heating season means that "we are just one
event away from a real crisis," said Philip Verleger, a respected oil
economist who advises major oil companies. "Iraq or some other sudden
cutoff in supply could be that event," he said.


That's especially true if Saddam chooses the right moment, and acts in
concert with one or more other events that are rattling the markets.
"At that point, I think, you're talking about a price shock that
could knock 1 percentage point off" the world growth rate-roughly 40
percent of global growth next year, Verleger said. That is about half the
effect of the oil price shock of 1973, which ushered in a generation of
declining living standards.


Not to Worry


Informed opinion, however, counters that the underlying economic situation
of 2000 is so much different from that of the 1970s that Saddam's threats,
although real, should not send people into panic. The basic facts, in this
view, are:


* Even though oil has more than tripled in price since the spring of 1999,
the bottom price of $10 a barrel was artificially low because the
temporary contraction of Asia's major economies lowered demand. At most,
prices have doubled from their average levels in the 1990s. This is half
the fourfold increase that occurred between 1973 and 1975. Factoring in
inflation, $34-a-barrel oil today is 40 percent less than $34-a-barrel oil
in the 1970s.


* America's high-tech economy is less dependent on energy. Oil consumption
accounted for 4 percent of U.S. economic output in 1973, 6 percent in
1979, and 2 percent during the Gulf War in 1990 (the last time expensive
oil hurt the United States). Today, oil represents just 1.9 percent of
output. (See chart on p. 3480.)


* We aren't running out of oil. Proven worldwide oil reserves in 1970
totaled 560 billion barrels; after a decade of strong economic growth
around the world, reserves are now almost double that. Higher prices serve
as an incentive to find more oil. Cambridge Energy Research Associates
predicts that the reserves will grow an additional 30 percent by
2010.


* Other developments further soften the impact of a crude-oil price jump.
Natural gas (which has also risen in price) is more available for home
heating and for industry. Unlike in 1973, there are now futures and
options markets to allow oil refiners and users to help hedge the risk of
a price increase. This discourages the hoarding that economists say was
the real cause of the gas shortages of the 1970s. And computer technology
has enabled companies to find, extract, refine, and distribute oil faster
and more cheaply.


Because of all these developments, the economic profession has so far
collectively shrugged at the oil price spike. But a closer look at the
1970s, or at the unprecedented prosperity of the 1990s, shows that
economists can't fully explain why things were so bad then (and are so
good now.) Economists today still don't fully understand important aspects
of the 1970s and 1980s-why, for example, productivity growth was so
stubbornly slow, year in and year out, in both decades. Likewise, they
aren't sure why consumer spending is now outpacing income growth. Lately,
it is common to ascribe both the bad productivity gains then and the huge
gains now entirely to technological factors, but this is a completely
unproven theory-an educated guess, in other words.


One thing, at least, has become clearer in the past 25 years. Oil
prices-or, more precisely, oil price shocks-played a crucial role in the
past three U.S. recessions, going back to 1973. To some experts, this is
reassuring news because recent oil price increases are much smaller than
those that preceded the recessions of 1973 and 1979.


Recent research, however, supports the idea that high oil prices had much
deeper and longer-lasting effects than initially thought-some of them tied
to the unpredictable responses of consumers and businesses to the
unfamiliar world of an oil price shock. The national mood seems to have
played a role, too-a factor that economists cannot quantify. The pessimism
that was pervasive in the 1970s helps explain why the economy was so slow
to recover, just as the rampant optimism today might explain why consumers
seem to be ignoring sluggish wage growth and ever-mounting piles of
personal debt.


Consumers today also seem to be shrugging off higher energy prices, just
as they seem to be ignoring the stock market's doldrums. Analysts feared
earlier this year that $2-a-gallon gasoline would hurt the economy by
keeping vacationers at home this summer, but consumption was almost the
same as it was the year before, when gas prices were closer to $1 a
gallon. Summertime spending, as a result, did not slump, and the economy
grew healthily in the third quarter of 2000. "I'm somewhat puzzled
that there hasn't been more of an impact on consumption," said Guy
Caruso, a longtime U.S. government energy economist who moved recently to
the Center for Strategic and International Studies. "I would have
thought we'd see it by now."


This is good news if it continues, because it means that higher costs for
driving cars and heating homes won't lead consumers to cut back their
free-spending ways. Consumer spending, after all, accounts for two-thirds
of economic growth. "Oil price shocks ... can lead to a recession
because (they) take money out of people's pockets," said Charles
Schultze, who wrote the standard history of the 1973 crisis before he
confronted its longer-term effects, while serving in the Carter White
House. This time around, he said, "people don't seem to be feeling
it" so far.


Consumer Overconfidence


The flip side of this consumer confidence, however, is that demand for
energy has fallen less than expected as a result of higher prices.
Refineries, operating at 95 percent to 96 percent of capacity, have been
running flat-out since the summer to keep up with consumer demand that is
undaunted by higher prices. This strong demand is crucial, because history
shows that oil crises occur not only when there are restrictions on
supply, but also at moments when demand is unrelentingly strong. That was
the case in 1973, when the U.S. economy was roaring along and cheap oil
had made fuel efficiency an afterthought for most Americans.


It is paradoxical, but the longer this strong demand lasts, the more
likely that a disruption in supplies would occur that could lead to much
higher prices and a slowdown in the U.S. economy. In this way, the
seemingly unshakable optimism of consumers could contribute to an event
that shakes that very confidence.


Implicit in the yawns with which most economists greet higher oil prices
is the conviction that consumers would not suddenly lose confidence. But
this attitude is intuitive, rather than scientific, based on eight years
of good times. Polls still indicate that many consumers harbor grave
doubts about their economic security. Economists simply don't know what it
would take to uncover these doubts, and whether it would happen gradually
or in a tidal wave.


Economists also aren't sure how and why oil price shocks are as damaging
as they seem to be. According to the basic rules of market economics, oil
price rises are not any worse than oil price drops-eventually, the economy
adjusts, reallocating resources to less-energy-intensive industries, and
the overall level of employment doesn't fall. Although most people might
think that oil price increases permanently kill jobs, a great deal of the
confidence that most economists have right now about the United States
handling a modest oil price jump is based on this faith that the economy
will adjust.


But recent research indicates that oil price shocks do cost jobs.
Economists Steven J. Davis and John Haltiwanger found that oil price
increases are much more damaging to manufacturing jobs, even in the long
run, than similarly sized price decreases. In a paper for the National
Bureau of Economic Research, a nonpartisan think tank, the two found that
oil price shocks eliminated many more jobs than expected. The two
economists also found that oil price increases force more people to change
jobs than decreases do.


James D. Hamilton, an economics professor at the University of California
(San Diego), found that oil price increases have a much more unpredictable
impact on economic growth than decreases do-and thus it is harder to know
just how bad the effects of the current price jump will be. Hamilton says
that oil price shocks can shake consumer confidence enough to keep people
from buying a car or a home.


Economic theory assumes that "perfect competition" will lead oil
companies and gasoline stations to compete for customers, and that such
competition will eventually lower prices. But this theory doesn't
adequately explain how slowly prices have dropped after oil shocks,
according to economists Julio Rotemberg of Harvard University and Michael
Woodford of Princeton University. "Imperfect competition,"
otherwise known as collusion or price-fixing, makes up the difference,
they argue. If they are correct, today's high gas prices may last longer
than some economists predict.


Davis and Haltiwanger attribute much more of the economic problems of the
1970s and 1980s to oil prices than classical economics would predict. They
blame more of the unemployment problems of that era on oil than on other
factors, including changes in monetary policy by the Fed. But Robert
Barsky, at the University of Michigan, finds the opposite-that Fed policy
resulted in the stagnant growth and high inflation known as stagflation.
In fact, says Barsky, the Fed, in part, caused high oil prices by keeping
interest rates too high.


The point is that a quarter-century later, economists remain divided over
the role that oil price rises played in the bad times of the 1970s and
early 1980s. This lack of agreement about what happened in the `70s and
`80s means that it's hard to predict how the current situation will play
out.


Bush and Gore


Of all the lessons taught by the oil price shocks of the 1970s, the most
sobering may be the limited power of government to do anything to help.
The two major options available for any President are neatly represented
today by Bush and Gore. Bush, the former Texas oilman, would suspend
environmental restrictions on oil production on Alaska's North Slope, and
reduce other regulations and taxes for oil producers. Gore, the
environmentalist author of Earth in the Balance, would embark on a new
government-led effort to promote energy conservation.


Both approaches were tried in the 1970s, and both failed to have much of
an impact on oil prices. Bush's supply-side strategy, meant to expand
domestic production and reduce imports, could hardly go further than the
deregulation tried in the Reagan years. But, as Pietro Nivola of the
Brookings Institution argues, this is entirely wrongheaded.


"Energy security is myth," said Nivola, who studies government
regulation. "Unless the United States is actually threatened with a
major supply shortage, it makes no sense to think that the answer to high
prices is to promote domestic production." Nivola said this strategy
only transfers profits from foreign producers to domestic producers.
"We're never going to have the same [low] cost of production as Saudi
Arabia," he said, and it is foolish to base U.S. energy policy on the
assumption that American oil should underprice imports.


Moreover, in a global economy, higher domestic production doesn't even
mean higher domestic supply. Compounding the well-known heating oil
shortages in the Northeast this year is the fact that higher prices in
Europe are leading some refiners to export their production there. And
higher prices in oil-dependent Japan mean that much of the production that
Bush would add in Alaska would be shipped to Asia. Any benefit could also
be years in coming, since it takes time to get new capacity onstream.
Boosting drilling and production won't help deal with an immediate oil
price shock.


Government-led conservation efforts also have a poor track record.
President Carter's televised appeal for Americans to turn down their
thermostats illustrates the shortcomings of this strategy. Aside from
provoking resentment, Carter's plea failed as a national policy because
the only thing that was going to force Americans to conserve was the harsh
reality of sky-high heating costs. Government-directed
conservation-whether it is voluntary, such as the Carter thermostat
appeal, or mandated, such as car fuel-economy standards-distorts the
normal mechanism for conservation, which must be driven by high prices.
Americans bought fuel-efficient cars when they wanted them, not when
Congress said they should want them.


Government also has a poor record in using subsidies and tax incentives to
promote conservation. Carter's billion-dollar program to promote synthetic
fuels from oil shale and coal was a costly folly, based on the predictions
that oil prices would keep rising and that new technologies would emerge
to make processing these new fuels economical. But both predictions were
wrong. Market realities also overwhelmed tax incentives to promote
energy-efficient lighting and solar power-cheap electricity in the
mid-1980s helped kill off many of these programs.


And government has always done a dismal job predicting which technologies
will succeed. At this moment, the expensive, government-funded effort to
produce a practical all-electric car appears to be a failure. Partly, this
is because of special interests. Electric utilities pushed the idea of a
plug-in car loaded with huge batteries, despite its impracticality. And no
company has developed batteries that can hold a charge long enough for
today's extended commutes. Ultimately, though, government is no match for
private enterprise in bringing about great innovations. Two Japanese car
companies have introduced "hybrid" cars that generate their own
electricity, essentially refining the much-maligned internal combustion
engine. DaimlerChrysler announced two weeks ago that eventually 15 percent
of the pickups it sells will be hybrids.


The meaningful gains from conservation will be generated only in the
marketplace, and only if high energy prices persist long enough for
consumers to demand efficiency. A crash effort by a President Gore to
force conservation is no more likely to succeed than another lecture on
frugality.


Strategic Reserves


The one new policy option now available to U.S. Presidents and the leaders
of other developed countries is the use of strategic oil stockpiles.
Phillip Verleger says that governments now store 1.2 billion barrels of
oil, with about half of that in the U.S. Strategic Petroleum Reserve. The
U.S. reserve was created as a response to the embargo of 1973 and is
supposed to be tapped only when there is a significant cutoff in supplies.
Verleger is one of a small group that has long urged that the reserve be
used to respond to drastic price increases, even when there is no
shortage. He argues that never using the reserve is akin to putting money
in a bank and never lending it out. Even central banks such as the Fed, he
said, regularly lend out the gold they keep in their vaults. In times of
high gold prices, jewelers sign "swap" agreements, whereby they
promise to replenish the reserves with a larger volume of gold at a later
date. Central banks, he said, earn 2 percent to 3 percent profit on such
exchanges and help to moderate the price of gold.


Verleger laid out his proposal for an oil swap last March, in a paper for
the Institute for International Economics, and President Clinton took him
up on it a few weeks ago. That decision, however, was not without
controversy. As was detailed in The Wall Street Journal, Treasury
Secretary Larry Summers strenuously opposed the move-until Al Gore
proposed it on the campaign trail. Within a few days, the Administration
changed course and approved a swap of 30 million barrels.


Summers and others on his side initially argued that using the reserve to
manipulate oil prices was a mistake, because it would send markets the
message that any price increase would be met with government intervention.
That would tempt policy-makers to use the reserve too often, and then it
would be depleted when a real emergency came. In the end, said one
economist who participated in the decision, the White House decided that
the size of the swap was so small as to be "meaningless." As he
put it, "We could see that this was a tool that would have very
limited usefulness."


Even with those lowered expectations, the swap has been a disappointment.
In its haste to act quickly, the Energy Department used what it now
acknowledges were lax bidding requirements. As a result, a third of the
oil was awarded to three unknown trading companies, two of which were
one-man operations with no experience in oil deals. Those two bidders
couldn't complete the deals on time, and their portions had to be rebid.
The confusion associated with this delay has undermined confidence in the
whole idea, which is predicated on fast and smooth release of oil into the
marketplace.


And there were other problems. As was revealed in a Senate hearing on Oct.
18, the lack of spare refining capacity in the United States has meant
that little of the oil will make it to consumers very soon. In fact,
Energy Department officials confirmed that the main effect of the swap may
be to "back out" or displace oil that would have been imported,
and thus the action won't really affect prices much at all. Finally, the
vaunted payoff for the swap-more oil a year from now-


wasn't as much as many expected. In bidding to swap 30 million barrels now
for more later, the winning bidders offered to repay a total of 31.5
million barrels in 2001, only 5 percent above what was taken out, a number
that will shrink when the winning bids by the two fly-by-night oil traders
are reoffered to oil companies that can actually deliver.


As a result of all this, a top Energy Department official told a Senate
panel that the Administration was not expecting to repeat its oil
swap.


Here's a thought for the next occupant of the White House: Over the past
30 years, the only Presidents to be re-elected were those fortunate to
serve in times of low oil prices.


The odds are that the current oil price surge won't get much worse and
won't seriously harm the U.S. economy, but this view has its limitations.
Economists still can't fully explain why the shocks of the 1970s were as
bad as they turned out to be; they can't account for unpredictable shifts
in consumer sentiment that could be crucial; and they can't predict how
several independent actions-including a supply cutoff by Saddam-could
combine to compound a crisis. With timing and luck, Saddam or some other
force in the world could trigger a new oil crisis with long-term effects
for the United States and the world economy. And there won't be much that
the White House, or economists, can do about it.


John Maggs

National Journal