The Economy -- The Energy Noncrisis

Dec. 21, 2004
Our latest dilemmas should have little effect on the economy.

In the last 20 years, energy crises, along with higher inflation and tighter monetary policy, have been a major contributing factor to recessions for several reasons. First, higher energy prices reduce real disposable income available for purchasing other goods and services. Second, the spillover effect raises core inflation. Third, higher inflation boosts interest rates and restricts credit. Fourth, consumer attitudes plunge. Fifth, shortages sometimes have occurred. The last few months have not been immune to these developments: Crude oil prices tripled, natural gas prices briefly quadrupled, and while there were no shortages at the pump, California suffered the indignity of rolling blackouts with threats of more to come. How much did this hurt the economy and how much will the economy improve when these situations are alleviated? The U.S. uses about 20 million bbl/day of petroleum products, or 7.3 billion bbl per year. Of that amount, one-third is now domestically produced. Hence a $10/bbl price increase raises the total amount spent on petroleum products by $73 billion, of which about $24 billion is offset by higher profits to domestic producers and suppliers. As a result, the net drain on domestic income for a $10/bbl price hike is about $50 billion. At its peak, crude oil prices rose from $10/bbl to over $30/bbl, but that is a misleading statistic because the $10/bbl price was far below equilibrium. In terms of assessing the economic impact, it would be more reasonable to say the general level of oil prices rose about $10/bbl, hence reducing GDP by roughly 0.5% in the second half of last year. Oil prices are expected to drop about $5/bbl later this year, which should boost real growth by about 0.25%. The changes in the other components of the energy "crisis" are similarly small on a macroeconomic basis. Natural gas prices, which averaged $2.30 per million BTU in 1999, briefly spiked at $10 but have fallen back to approximately $5. The analysis is different here because unlike crude oil prices, which are determined on world markets, natural gas prices are determined regionally. Hence the major impact of this increase has been to reduce exports and increase imports of natural-gas-based chemicals (largely ethylenes). Since import prices are about 50% more than 1999 domestic prices, that has boosted inflation by 0.2% and reduced demand accordingly. In addition, the doubling of natural-gas prices will decimate the agricultural sector. Since the price of nitrogenous fertilizers also has doubled, less fertilizer will be used, reducing yields and production. The result is likely to be a shortfall of about $5 billion in net farm income. Since net farm income has averaged less than $50 billion per year for the last four years, that is a major reduction for the farm sector. However, the macro effect, even considering the reduction in expenditures by farmers and the increase in food prices, would be no more than 0.2% of GDP. It now appears that the California energy-blackout situation will be resolved by raising prices to consumers as much as 50%. Before the recent price hikes, consumers spent about $130 billion on natural gas and electricity. Since California represents about 12% of the national economy, that would indicate an $8 billion decrease in real disposable income, less than 0.1% of GDP. However, one could argue that the impact on California will be much greater, reducing real disposable income by almost 1% in the state. However, over the last five years personal income in California has risen about 1% per year faster than the national average, so even if the full negative impact of the energy crisis is felt in the state, growth in California should still keep pace with the overall U.S. economy. Since many Californians will reduce their saving as well as their spending, the energy "crisis" is likely to shave only about 0.5% off real growth this year in that state. To summarize, the return of crude oil prices to normal levels should add about 0.25% to real growth this year, the increase in natural gas prices should reduce it less than 0.4%, and the higher cost of energy in California should shave it by no more than another 0.1%. Taking all these factors into account, the net impact of the energy situation should reduce real growth by less than 0.25% this year. Michael K. Evans is president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

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