EconSouth (Fourth Quarter 2004)
Eduardo J.J. Ganapolsky is a research economist and assistant policy adviser in the regional section of the Atlanta Feds research department.
As I start to write this column, I am feeling worried. My computer and office lights are on, and today is cold in Atlanta, so the heat is on. You might wonder why I note these facts when I am writing about oil. Well, the need for oil is everywhere. Because I am consuming more electricity, the power company needs more oil to increase production. Therefore, I am helping to keep demand for oil high.
Actually, I am not that powerful, but markets work more or less in that way: Increasing demand without a comparable increase in supply invariably results in higher prices, such as those the world is experiencing now for oil.
A bit of history
Nevertheless, determining the impact of an oil shock on the economy requires taking into account not only the magnitude of the price increase, which is considerable, but other questions (and answers) as well:
Factors driving the oil market
To understand the volatility of supply, it is important to recognize that most of the worlds oil supply is highly concentrated in OPEC countries and countries that were formerly part of the Soviet Union. Thus, the bulk of productionaround 53 percentcomes from areas with significant political and institutional uncertainty. Oil concentration is even more pronounced if we consider proven oil reserves: OPEC accounts for 77 percent of the worlds total.
In analyzing how supply responds to demand in the short run, we must take into account the spare production capacity and the level of available inventories. Presently less than 1 percent of spare production capacity exists worldwidea historical low. Oil inventories have been recovering since the last quarter of 2003 among members of the Organisation for Economic Co-operation and Development (OECD), a group of 30 countries committed to market economies. These stocks are in the middle range of their five-year year holdings, representing 82 days of oil consumption. Capacity and inventories point toward a very inelastic short-run oil supply; therefore, oil prices will be very responsive to any change in demand.
Peering into the future
On the demand side, consumption is also highly concentrated; almost 60 percent of oil is consumed by OECD countries. But this pattern is changing over time. Global growth drives oil consumption, so oil intensitythe ratio of a countrys oil consumption to its gross domestic productis a vital factor to consider when thinking about the evolution of oil demand. Two opposing forces play a role. Oil intensity has been falling all over the world in recent decades (believe it or not, even after the arrival of thirsty SUVs). Across countries, though, non-OECD countries are much more oil intensive than OECD members are, and in the coming years these non-OECD countries will drive the worlds economic growth. Thus, we should expect a sustained growth in oil demand.
How about shifting toward substitutes for petroleum? The coal and natural gas markets are currently quite tight as well. But, from a long-run perspective, proven reserves of these fuel sources are much higher than they are for oil60 years of natural gas reserves and 200 years of coal reserves worldwide.
Say goodbye to cheap oil
Obviously, the impact of higher oil prices will be different across the world: Oil-exporting countries will gain at the expense of oil-importing countries, especially the fast-growing, oil-intensive Asian economies (for instance, China, India, the Philippines, and Thailand). The United States is also an oil-importing country, and this fact makes further reduction of U.S. oil intensity a priority.
For my part, Im turning off my computer and going to the gym (on my bike, of course).