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Economically Speaking

Energy and the U.S. economy: An uneasy alliance

picture of an oil refineryOil and natural gas are needed to run the U.S. and global economies, but sometimes the alliance is not an easy one. If energy prices go up too quickly or too high, the prices for goods throughout the economy can start to creep up at an accelerated rate, creating high inflation and slowing growth. Understanding the sometimes rapid jumps in energy prices requires an understanding of supply shocks.

Basic principles at work
The model of supply and demand is one of the fundamental concepts taught early in economics classes. To help students learn these important principles, the scenario of supply and demand is first set in an unchanging world, where the supply and demand curves do not move. Students come to understand how the equilibrium price and quantity are achieved at the intersection of the stationary supply curve with the stationary demand curve. But what happens when you look at the real world? Those curves do move, and one of the fastest changes to those curves is a negative supply shock.

Related Links
Activity for high school students
Activity for high school and middle school students

As Chart 1 shows, the supply curve and demand curve intersect to create an equilibrium price and an equilibrium quantity for consumers and suppliers. In a negative supply shock, the supply curve shifts to the left rapidly, as the chart's dotted line indicates. This action produces both a reduction in the quantity sold and an increase in the price. A similar situation occurred after the hurricane season of 2005.

Storms' effects on stark display
As Hurricanes Katrina and Rita came through the petroleum-rich Gulf of Mexico and the surrounding coastal areas, nearly all energy production, refining, and importation were shut down. Some of these activities shut down temporarily to prepare for the storms, but a large percentage remained closed after Katrina and then Rita because of severe damage to oil and natural gas platforms and pipelines carrying the products back to the shore. One of the largest ports for U.S. oil and gasoline importation was shut down for four days, meaning even more supply was cut off.

Chart 1: A Supply Shock
Chart 1: Supply side
Source: Wall Street Journal
Chart 2: Gasoline Prices
Chart 2: Gasoline Prices
Source: Wall Street Journal

Chart 2 shows the effect of this quick drop in supply—the supply shock—on prices. Energy prices jumped rapidly after each of these hurricanes made landfall and destroyed a significant range of energy infrastructure. The jump was more dramatic after Hurricane Katrina because it also knocked out power for days to two pipelines feeding refined products, such as gasoline, to the U.S. East Coast. The new supply arriving to those areas was nearly zero, making the leftward shift of the supply curve even more severe and pushing up prices even further.

With these disasters, the largest part of the shock was largely resolved within a few weeks. The offshore port returned to operation, and other countries sent more gasoline and oil to the United States to take advantage of higher prices and, thus, higher profits. Also, more offshore production began to return, and many of the refineries started to resume production. This restored production helped push the supply curve back closer to its original location and bring prices back down with it.

Concepts to take away from the storms
So what lessons can be learned from the aftermath of the Gulf Coast storms? Perhaps most dramatically and importantly, the storms highlighted the United States' vulnerability to increased energy prices when supply is restricted. Activities shown in the related links can help your students understand this uneasy alliance between energy and the U.S. economy.

By Sarah Dougherty, economic analyst, Atlanta Fed, and Sara Messina, community relations coordinator, Jacksonville Branch