The Bigger the Oil Price Shock, the Harder We'll Fall

Martin Feldstein is worried that if oil prices go up again and depress economic activity, a falling saving rate won't to bail us out this time:

America will fall harder if oil prices rise, by Martin Feldstein, Commentary, Financial Times: The price of imported oil in the US doubled between summer 2003 and summer 2005, reducing consumers’ purchasing power by more than 1 per cent of gross domestic product. Nevertheless, the economic slowdown that was widely expected never occurred. Consumers kept spending and businesses kept investing. ... The continued strong growth contrasts sharply with the economic weakness that occurred after almost every previous significant rise in the oil price. How do we explain this remarkable difference? And what are the implications for the likely response to a future rise in oil prices?

The key to the economy’s strength in 2004 and 2005 was that household saving declined dramatically while the price of oil rose. ... This shift ...in the annual rate of saving far outstripped the fall in income caused by the higher cost of oil. This fall in saving allowed households to raise consumption spending on non-oil goods and services while paying for the higher cost of imported oil. The primary cause of this dramatic shift was the fall in interest rates and the resulting rise in mortgage refinancing. Homeowners who refinanced their mortgages took out cash and reduced their monthly payments at the same time. Much of the cash obtained by refinancing was spent on consumer durables, home improvements and the like. The lower monthly payments permitted a higher level of sustained spending on all non-durable categories. ...

The faster increase in consumer spending caused businesses to invest more and raised the rate of growth of GDP. Faster GDP growth caused an accelerated rise in employment and a fall in the rate of unemployment. Mortgage interest rates were falling because the Federal Reserve’s fear of deflation had caused it to lower the short-term federal funds rate ... to the extremely low level of 1.0 per cent in 2003 and to leave it there in the first half of 2004 before beginning a very gradual process of rate increases. ... The lower mortgage rates induced refinancing and the subsequent gradual rise in rates induced additional refinancing by homeowners who wanted to borrow before rates rose further.

The powerful effect of mortgage refinancing on consumer spending was a very happy coincidence for the American economy at a time when oil prices were depressing consumers’ real incomes. If oil prices were to rise again in 2006 or 2007, the adverse effect on consumers’ real incomes would not be offset by increased mortgage refinancing. Mortgage refinancing has now peaked and is declining. The Federal Reserve is raising interest rates again to counter the inflationary pressures that remain from the rise in energy costs. And individuals no longer have the large amounts of household equity against which to borrow.

A rise in the oil price could happen again at any time. There is little spare capacity in global oil production and oil demand is rising rapidly in China and other Asian countries. A shock that reduced the production or shipping of oil could drive its price sharply higher. Speculative forces could compound this problem. The US was lucky after 2003 to escape the contractionary effect of an oil price rise even without an explicit change in monetary or fiscal policy. It would not be so lucky if a big oil price increase happened again now.

I don't always agree with Feldstein, but I do here.

Comments

[calmo]

The general theme I track but at this point:
Homeowners who refinanced their mortgages took out cash and reduced their monthly payments at the same time.

I remember that only 2/3 of the country are home owners. The large increase in the cost of oil for the 1 in 3 renters was not shouldered in this fashion. Hard to imagine that all of them dumped their savings into Exon.
It is hard to imagine that they do not assume losses from decisions to rent houses that their counterparts bought. One could select any commodity and make a similar remark and toss it off as 'that's the way the cookie crumbles: some winners and some losers'.
What seems different about this selection is the number of losers and the size of the loss. Apparently that ratio or that loss, has to expand before there is social unrest.
Last thing: I think that social unrest can be managed by manipulating the price of oil. Not that I know anything about the actual pricing mechanism, but that few, not many, control the resource. In response to weakening domestic US demand, prices will fall to protect/maintain/cushion consumption levels. The price gouging will milk, not obliterate, their symbiotic client. [I have such faith --but not much for the housing debacle.]
Well-Milked-R-Us.

[M1EK]

The housing bubble will eventually affect rents - either they won't rise for quite a while or will even drop. This happened locally (Austin) to a lesser degree during the dot-bomb - the rent on the condo we rent out dropped from $1200/month to $1100 a couple of years ago, and we're only back up to $1150 this year. That's where renters are going to get their savings - since the people holding on to 'investment housing' will face the choice between selling at a loss or holding and accepting what they probably see as temporary rental losses (which are treated quite favorably by the tax code compared to losing money on the sale of an investment home).

[Joe Rotger]

The question is: why are the Chinese still buying oil?

Internally and externally they're facing a slowdown. Shanghai’s real estate prices seem to be crumbling and the world out there is surely slowing down with higher short term rates.

So why are they still buying commodities?

I'll try an explanation.

Since the Chinese are one of the largest creditors to the US and holders of USDs, and this state of affairs worsens with each quarterly US current account deficit widening, the Chinese are compelled to diversify out of USDs; if not, they risk to lose 100's of billions.

But, if they buy other currencies, they devalue the USD in relation to those currencies.

They further risk the Chinese export price advantage, which would suffer if the USD/Yuan peg is disengaged.

IMO, China is buying commodities, production resources and such, to allow them to meet their diversification objective, while, at the same time, the PBoC is able to hold the USD/Yuan peg.

After solving the USD issue, the PBoC still faces helping out his burdened debtor, the US government; the PBoC’s is too far into its loans (which are too big) to ignore assisting its troubled debtor…

[anne]

http://select.nytimes.com/2006/02/03/business/03norris.html

February 3, 2006

High Profits, Sluggish Investments
By FLOYD NORRIS

AS oil company earnings soar, there is talk of excess profits and a new windfall profits tax. The real issue, though, is not how much the oil companies are making, but what they are doing with the money. In too many cases, they seem to have only a limited interest in investing it in projects that might help prevent or ameliorate a new energy crisis.

Exxon Mobil, the world's most valuable company, reported this week that it earned $36 billion in 2005. But it was only able to find ways to invest less than half that amount. Instead, Exxon Mobil's chief executive, Rex W. Tillerson, bragged that it had distributed $23.2 billion to shareholders, "an increase of 56 percent, or $8.3 billion, from 2004."

Those numbers minimize the distributions, since they count only some share repurchases, ignoring others that the company figures offset shares issued when executives exercise options. Include them, and the figure last year was $25.4 billion.

Exxon Mobil had so much cash because oil prices surged last year, as they did the year before and the year before that. But the company remains suspicious that such glad tidings may be temporary, and so it invests sparingly.

"The way we look at projects has been very, very consistent over many, many years," an Exxon spokesman, Mark D. Boudreaux, told me, adding that "snapshot economics" were a bad thing.

One determinant of whether an investment is wise is the price of oil that would be needed for it to be profitable. The lower the price a company expects, the fewer investments will pass muster.

It appears that Exxon's price forecast has not risen much in recent years, even though market prices have soared....

[anne]

http://www.nytimes.com/2006/02/03/politics/03energy.html?ex=1296622800&en=e2b8d5791a4280b5&ei=5090&partner=rssuserland&emc=rss

February 3, 2006

In Energy Work, One Hand Giveth and the Other Taketh
By MATTHEW L. WALD

WASHINGTON — President Bush supports the development of ethanol, wind power and other forms of renewable energy. So does Congress. But their goals differ in ways that compete for research dollars and are costing some government researchers their jobs.

About one research dollar in every five appropriated by Congress for the development of renewable energy sources is for a specific project inserted directly into the budget on behalf of a member of the House or Senate, and directed to a contractor or a university in the lawmaker's state or district. When ordered to pay for such pet projects, known as earmarks, the Energy Department reduces spending on similar projects at its own laboratories.

As a result, scores of staff members at the department's National Renewable Energy Laboratory, in Golden, Colo., and at contractors that the lab supports are losing their jobs. Some people on Capitol Hill acknowledge that layoffs, which are to begin in a few days, seem strange, coming after Mr. Bush's proposal in his State of the Union address on Tuesday that the government spend 22 percent more on renewable energy....

[Joe Rotger]

Anne wrote:

"One determinant of whether an investment is wise is the price of oil that would be needed for it to be profitable. The lower the price a company expects, the fewer investments will pass muster.

It appears that Exxon's price forecast has not risen much in recent years, even though market prices have soared...."

Anne,

Exploration is a very expensive proposition. If memory serves me right, just drilling a prospective offshore well in Nova Scotia cost +- $30 million USD. And, it's a hit and miss situation; for the particular rig I remember, it was a miss...

If oil fields are getting scarce, then exploration costs are rising exponentially.
So, entry costs are high.

Then, where do they spend their exploration money?
Venezuela, Russia, Saudi Arabia, Iraq, Iran, Nigeria, Argentina, Ecuador…
Should I continue?
The risks are very high.

Then, it all takes time.
A refinery, several years, and people have to be in pain to accept a refinery’s polluting intrusion close to their hometown.

So, the petrodollar investment bottleneck is evident.

If, on the other hand, the oil co keeps on pumping their existing fields, it's very profitable indeed...

Historically, after each oil shock, consumers adjust and demand falls, bringing prices down, and unbearable pain for those who over invested.

I guess (the oil) people learn from their past mistakes. The Arabs are not lending private banks this time around, maybe buying long term US bonds…

Or, maybe they’ve outgrown the USD phase and they’re diversifying away into other investments, such as commodities; gold, platinum, zinc, sugar…

Or, oil execs are recognizing that in such a tough world individual shareholders may do better.
(Oil execs do hold shares too...)

More of the same liquidity glut...

[anne]

The energy bill passed this summer, gave a $20 billion subsidy to energy companies for exploration and development. Foreign energy companies are busily exploring and developing, interestingly enough. Oh, I rather enjoy my energy company holdings and would have no qualms were the companies to increase investment :)

[kharris]

Joe R.

You seem to be thinking of China as a trading desk, rather than as a country with an expanding economy. China is still buying commodities because it is still a functioning economy. If China is buying more commodities, it is because China is a growing economy. Loading up on copper futures, when you need copper, may be as simple as wanting to lock in a cap on your cost of copper while you provide electric service to more and more citizens.

China may very well have some minor influence, in a tactical sense, in preventing bad things happening to US financial markets. Even China, though, can't hope to alter outcomes in such a strong way as to change the return on its portfolio of Treasuries over the period it would take to divest itself of a major portion of its portfolio. Short of that, any new purchase just increases China's exposure to risk from the US market.