The Economics of Oil

June 2, 2004

Suddenly oil is on everyone’s mind. It was inevitable – high oil prices always attract media and investor interest. Oil demand is up, supply is weak, fears are high, competition is low. Will high oil prices kill the economic goose that lays the golden stock market? Here’s our petroleum primer to help you separate the facts from the fiction.

<b>Why are oil prices high?</b>

Oil prices were quite low a few years ago, near $10 a barrel. After rebounding they slipped again with the global recession. The reason for the last bout of low prices were twofold: 1) when the economy is weak, the world needs less oil 2) OPEC was trying to coerce other countries, notably Russia, to join the organization by lowering prices to levels that hurt higher cost producers. 

Besides driving and commuting, oil is used to heat and power factories, and make plastics and chemicals used in manufacturing and packaging. The less a country produces, the less people at work, the less oil needed. As the supply of oil doesn’t swing as much as demand, prices fall – there is a mini oil glut.

Oil prices are high now largely because of a strong global recovery, particularly in China and the U.S. One reason for the economic boom here is massive fiscal and monetary stimulus – we jacked up the economy without jacking up oil production. 

GDP growth over the last year has been at historic highs, oil production growth hasn’t kept up largely because it can’t grow quickly. Artificially creating economic growth can sometimes create inflation for this very reason – the supply of oil and other commodities, as well as labor, real estate, etc., can’t keep up and prices rise to equalize the markets. 

<b>Are high oil prices a tax on the consumer like the media says?</b>

Not really. High oil prices are certainly not good for the economy, but for your typical individual’s budget, paying more money to drive the car and heat the house means less money to buy things that disposable income would normally go for - electronics, new cars, travel, clothes, etc. 

For every extra dollar spent on energy, one dollar is not spent elsewhere in the family budget. This hurts some businesses (GM, Sony, American Airlines, Nike) but helps others (ExxonMobil). Its not like the money just vanishes from the budget and isn’t spent, which is more akin to a tax. 

Tax cuts are stimulative for the very reason money appears in the household budget that was not there – new dollars to get spent. Tax increases remove money from the budget. Paying more for gas is not akin to a tax hike.

<b>But isn’t all this money going to the Middle East?</b>

More money goes to the Middle East when oil prices are high, but more money goes to U.S. and British oil companies as well, who sell their own production. The largest producer of oil in the world is the United States, and we consume more American oil then Saudi Oil each day. 

High oil prices help certain U.S. industries. When you buy the consumer discretionary items listed above much of your dollar goes abroad – in fact buying oil keeps more profits in the U.S. then many items consumers spend their money on. 

<b>Does OPEC make oil expensive to hurt the U.S. economy?</b>

The last time OPEC tried to use fuel as a weapon was the early ‘70s as protest of American foreign policy. Today OPEC has one goal – make as much money as possible. This goal is achieved by maintaining a price range for oil that produces the most profit for OPEC nations. If oil prices are too high, global consumption falls for two reasons: 1) economies can go into recession 2) people start conserving energy.

OPEC wants a strong U.S. economy – it means we buy more oil. OPEC likes to let prices run up just long enough to make a nice profit, then let them fall before we start selling our SUVs and buying hybrids. 

<b>What is OPEC anyway? How do they control prices?</b>

OPEC is the Organization of Petroleum Exporting Countries. Members include Saudi Arabia, Iran, Kuwait, Qatar, United Arab Emirates, and non-mid east countries like Nigeria and Venezuela. OPEC was founded in Baghdad in 1960.

OPEC is a cartel – a group that gets together and acts collectively for their own best interest – setting prices, rules, and production to maximize profits but also to drive competitors out of business and stifle competition.

OPEC was created so that the Middle East could have more power in the oil markets. Previously, American and British oil companies largely controlled Middle East oil. Eventually Middle East countries nationalized the oil companies and took control of their reserves and production. 

The misconception is that with OPEC setting prices there isn’t a free market for oil, which is why prices are high, but in free markets companies often get together and collude on ways to boost profits. In controlled market counties like the U.S. and Europe, governments no longer allows such anti-competitive behavior or price fixing, and do what they can to ensure companies compete with each other to benefit consumers. 

OPEC controls prices by limiting production. The scheme works because global demand is so close to global supply that a group of countries that control less then half of world production can easily set prices by withholding supply. If demand were lower, OPEC would have little power because if they withheld supply, another non-OPEC producer would step up production. 

One positive side effect of OPEC is less volatility in the oil markets. OPEC generally cuts supply when prices fall to get prices higher, and increases supply when prices rise to send prices lower. This has the effects of smoothing out the wild swings in the world price for oil.

Giant oil companies have a love/hate relationship with OPEC. While behemoths like ExxonMobil don’t like it when OPEC drives oil prices down, they love it when OPEC cuts supply and raises world oil prices because Exxon can sell their oil at higher prices too and aren't bound by OPEC's production limitations. The main downside of OPEC for big oil is that large oil companies are often restricted from exploring for more oil in oil rich OPEC countries, and are having trouble replenishing their own reserves.

<b>Don’t environmental regulations and taxes increase oil prices?</b>

Not really. Most environmental regulations are aimed at the gas pump, not at the barrel. Gas is taxed heavily in most states, on top of a federal tax. This tax plus various environmental rules that dictate fuel blends and limit refinery capacity raise pump prices.

But higher pump prices means less gasoline consumed, which means less demand for a barrel of oil. That’s right; any inefficiency along the way that constrains consumption of gas actually lowers oil prices by cutting demand. The best example is if Europe and Japan eliminated their massive taxes on gas such that prices fell from $4 - $5 a gallon to the levels that we pay. Consumption would grow in these countries (we want SUVs too!) which would push global demand way over global supply. 

Bottom line, taxes and regulations increase pump prices which decreases demand for oil at the barrel.

<b>Will high oil prices sink the economy and the stock market?</b>

Probably not. $40 per barrel oil is not that high adjusting for a weak dollar and inflation. Remember that in other countries, oil prices have not climbed all that much. Our dollar has slipped in value which means that the same goods cost more. 

If the U.S. dollar fell 50% in value against the Yen, the price of a Sony TV would double (assuming Sony doesn’t hedge currency movements) yet Sony would still be making the same amount of Yen after converting our money to theirs -  even thought the U.S. price doubled. Saudi Arabia is making more dollars selling oil at $42 a barrel, but not that many more Riyals (their currency) and the U.S. dollars they keep do not buy as much on the world market as those they received a few years ago.

Higher oil prices will hurt certain industries like airlines, hotels, autos, chemicals, plastics, and many others. Companies in these industries will have to raise prices or profits will disappear. In the case of autos, if consumers feel high prices are here to stay they may buy more fuel efficient cars, which could hurt the U.S. auto industry. 

For higher oil prices to really sink the economic recovery and send us back into a recession oil prices would have to climb to maybe $55-$85 a barrel and stick there for some time. This is rather unlikely as higher prices should cut oil demand enough to stabilize prices and remove some of OPEC’s power. 

<b>Won’t high Oil prices raise inflation? Won’t this hurt bonds?</b>

Higher oil prices raises costs to businesses. Eventually those businesses will have to raise prices. This could start an inflationary spiral which will hurt bond investors. Significantly higher oil prices could sink the economy, which could actually lower interest rates (increasing bond prices). This is a complex relationship and is difficult to call; elevated oil prices could cause some inflation and hurt bonds, but truly high oil prices could sink the economy and help bonds. 


To drive oil prices significantly higher would requires one or more events taking place: 1) major problems in the Middle East (repeated and successful attacks on oil infrastructures 2) another major oil exporter joining OPEC, like Russia 3) further economic expansion by emerging markets like China with minimal increases in global supply of oil to match new demand. Oil consumption is tough to curb short term – there is little an economy can do if prices spike (unlike demand for orange juice, there are few substitutes), but gradual increases can be handled.

These are all unlikely scenarios and for now there is no immanent danger of an oil based recession or market meltdown. We’ve had our top category rating on energy and natural resource funds for most of the last two years, but have recently lowered the rating to reflect the fact that this oil and natural resource rally is getting long in the tooth. When everyone is sure that high oil prices here to stay, they often fall. Energy oriented funds were also highlighted in our hot funds for 2004 report five months ago.

We probably won’t see significantly cheaper oil (below $30 a barrel) for some time, but $42 a barrel oil is close to the high end. Oil will stay high enough for people in the oil business to make gobs of money, but not move high enough for people to consume significantly less.