Oil Prices and the U.S. Trade Deficit

This Economic Letter from the San Francisco Fed looks at the relationship between oil prices and the trade deficit:

Oil Prices and the U.S. Trade Deficit, by Michele Cavallo, Economic Letter, FRBSF: With the price of oil ... having nearly quadrupled over the last four years, it is little surprise that U.S. import prices have soared. One concern about these higher import prices relates to their implications for the U.S. trade balance... This Economic Letter explores the relation between the surge in oil prices and the trade deficit...

[It] first review[s] data on U.S. international trade... It then discusses a recent study that examines how the U.S. trade deficit might evolve in response to higher oil prices. Finally, it considers a model that can help explain why, surprisingly, the volume of U.S. petroleum imports has remained essentially constant, despite the remarkable increase in their cost and what that implies for the trade deficit.

Has the increase in oil prices affected the U.S. trade deficit?

Figure 1 plots monthly data from January 2002 to July 2006 for both the overall trade balance and the petroleum-related trade balance; the latter includes imports and exports of crude oil, fuel oil, liquefied petroleum gases, and other petroleum products.

It shows that the overall monthly trade deficit went from $30 billion to $68 billion, and the petroleum-related trade deficit went from $6 billion to $26 billion. These numbers imply that higher oil prices and the resulting higher cost of petroleum imports have accounted for over 50% of the deterioration in the overall U.S. trade deficit during this period. Indeed, looking at only the last two years, from August 2004 to July 2006, the data are more striking. The overall trade deficit grew from $54 billion to $68 billion and the petroleum-related trade deficit rose from $14 billion to $26 billion, indicating that the deterioration in the petroleum-related trade deficit accounts for 80% of the worsening in the overall trade deficit.

How will higher oil prices affect the U.S. trade deficit?

If oil prices persist at higher levels, what will happen to the U.S. trade deficit? Will it continue to deteriorate, or will it level off over time, or even revert to a balanced position? These questions are particularly pertinent because oil futures markets indicate that oil prices may well remain at their relatively high current levels for the foreseeable future.

To tackle these questions, Rebucci and Spatafora (2006) examine how an advanced oil-importing economy like the U.S. adjusts to a permanent increase in the price of oil. ...[T]hey find that, as the price of oil rises, the overall trade deficit increases noticeably... In their analysis, ... as oil imports become more expensive, households and businesses have fewer resources to spend on other goods and services, which leads to a contraction in domestic nonpetroleum demand for consumption and investment. ... In particular, lower domestic demand for nonpetroleum products leads to lower domestic demand for domestic tradables, which is compensated only in part by higher foreign demand coming from oil-exporting countries, which is generated by their higher oil revenues. ... As a result, a contraction in domestic nonpetroleum demand generates a lower overall demand for domestic tradables and, correspondingly, an excess of supply of these goods, leading therefore to a decline in their relative price. As domestic tradables become more competitive, export sales increase and the nonpetroleum trade balance improves. In turn, this improvement helps the overall trade deficit, so that, eventually, it returns to its baseline level.

How has this adjustment process played out in the U.S. so far? During the last two years, the nonpetroleum trade deficit has not improved but has actually remained constant, at $44 billion. This suggests that the adjustment process in the U.S. overall trade deficit is occurring quite slowly. How long, then, can the adjustment process take? The answer depends, in part, on the persistence of the oil price increase: The longer oil prices stay at high levels, the longer it will take for the trade deficit to adjust.

As Rebucci and Spatafora point out, the answer also depends on other factors, two of which I will highlight here. The first factor is the monetary policy responses of oil-importing countries. ... When higher oil prices start to raise not only headline inflation but also core inflation—that is, the price measure that excludes food and energy—the central bank usually tightens monetary policy to offset the inflationary pressure. The resulting increase in interest rates dampens domestic aggregate demand even further, leading to slower economic growth, a decline in the demand for imports, and a faster improvement in the overall trade deficit.

In theory, the increase in interest rates can also induce an offsetting effect on the trade deficit by appreciating the domestic currency. The currency appreciation, by making domestic goods relatively more expensive than imported goods, can lead to a decline in exports, an increase in imports, and a deterioration in the overall trade deficit. In reality, however, this effect is likely to be smaller than the one that works through the reduction in the demand for imports. In fact, empirical evidence shows that the degree of pass-through of exchange rate movements to domestic import prices is quite limited... As a result, the effect that works through the demand for imports is likely to dominate, so that an increase in the domestic interest rate leads to a faster improvement in the overall trade balance.

How much tightening the central bank does may depend on how well-anchored the public's inflation expectations are... For example, in the U.S., inflation expectations appear to be pretty well-anchored... Rebucci and Spatafora conclude that this factor might have helped delay the adjustment of trade deficits in the U.S. The speed of the adjustment can also be affected by how strongly the central bank responds to any increase in inflation expectations and core inflation.

The second factor is the extent to which oil-exporting countries spend or save their additional revenues from higher oil prices. In fact, oil-exporting countries have been quite cautious about increasing their spending in response to the windfall generated by larger oil revenues. One consequence of the resulting increase in saving by these economies has been a larger global supply of funds, helping to keep global interest rates at lower levels. Rebucci and Spatafora suggest that unusually low global interest rates might have limited the contraction in demand, thereby facilitating the persistence of trade deficits. Obstfeld and Rogoff (1995) argue that this factor was also at work after the oil-price increase of the early 1970s; at that time, oil-exporting countries were unable to raise their spending in line with the increase in oil revenues. As spending in oil-exporting countries rose by less than it fell in oil-importing countries, the amount of global saving increased and helped push global interest rates down.

Why have U.S. oil imports not declined as oil prices have increased?

In the U.S., one additional factor that has hindered the adjustment of the trade deficit is that the volume of oil imports has remained essentially constant. As shown in Figure 2, two measures of oil imports—the quantity of crude oil imports and the amount of real petroleum-related imports—have not declined in response to the oil price increases that began in 2002. As a result, increases in both nominal expenditures for petroleum imports and the petroleum-related trade deficit have tracked increases in petroleum import prices quite closely. Though this finding may seem surprising, Atkeson and Kehoe (1999) note that this pattern is fairly well known among energy economists, who have observed that, in the short run, the use of energy resources, such as oil, is fairly unresponsive to price movements.

Atkeson and Kehoe construct a model that captures this feature of the data. The mechanism underlying their model helps explain why oil imports have not declined and why the U.S. trade deficit has not adjusted as oil prices have soared.

In their model oil enters as an energy input, which is combined with the stock of existing capital goods to produce consumption goods. These capital goods are designed to use energy in fixed proportions; in other words, they require a fixed complement of energy to operate. Therefore, firms cannot adjust their energy consumption in response to higher energy prices in the short run.

In the long run, however, matters are quite different. With persistently higher energy prices, businesses tend to invest in new types of capital goods that use lower proportions of energy. As a result, energy use ultimately is quite responsive to higher energy prices, as more energy-efficient capital goods replace less energy-efficient ones over time.

Conclusions

Oil prices have almost quadrupled since the beginning of 2002. For an oil-importing country like the U.S., this has substantially increased the cost of petroleum imports. International trade data suggest that this increase has exacerbated the deterioration of the U.S. trade deficit, especially since the second half of 2004. One factor can explain this evolution: The real volume of U.S. petroleum imports has remained essentially constant. One explanation for why the demand for petroleum imports has not declined in response to higher prices comes from a model in which firms are fairly limited in their ability to adjust their use of energy sources, such as oil, in the short term.

Of course, the mechanism underlying this model may imply that it could take a while for the U.S. trade deficit to adjust in response to persistently higher oil prices, as businesses need time to install new, less energy-intensive equipment. However, one positive and important implication is that eventually the U.S. economy will become more energy-efficient, which, in turn, would help contain the cost of oil imports and increase the economy's flexibility in absorbing future oil price increases.

---

References

Atkeson, Andrew, and Patrick J. Kehoe. 1999. "Models of Energy Use: Putty-Putty versus Putty-Clay." American Economic Review 89(4) (September), pp. 1028-1043.

Obstfeld, Maurice, and Kenneth S. Rogoff. 1995. Foundations of International Macroeconomics. Cambridge, MA: MIT Press.

Rebucci, Alessandro, and Nikola Spatafora. 2006.  "Oil Prices and Global Imbalances." In IMF World Economic Outlook (April 2006), pp. 71-96. Washington, DC: International Monetary Fund.

Comments

[calmo]

Fome the end of the Conclusion in that report However, one positive and important implication is that eventually the U.S. economy will become more energy-efficient, which, in turn, would help contain the cost of oil imports and increase the economy's flexibility in absorbing future oil price increases.
Eventually.
My goodness.
And eventually, scholars at the FRBSF will make a remark about the political (in)action that makes some of us think that "eventually" means after the Republicans have left office.
Why do I smell the same taintedness, the political wash as it were, on scholarly work here as with the piece on Black Unemployment and Immigration? Where is the work to support this 'eventually' statement?

[yartrebo]

Energy is a highly inelastic good at current prices. Increasing the price only slightly decreases demand, even in the long term.

Slow increases in price probably have the least effect on demand, as people don't get shocked into conservation they way they would in a price spike (like the 1970s).

[calmo]

This sounds good: Firms eventually buy more energy efficient machinery. Especially in China where fuel consumption is highly skewed to Firms and not Softies like us who visit the pump often. Aren't we Softies taking the lion's share of the fuel consumption? Hasn't there been an abysmal response from the government in the face of pump prices (the $100 rebate was indicative, no?)

This statement arouses my suspicions about the accounting : During the last two years, the nonpetroleum trade deficit has not improved but has actually remained constant, at $44 billion If true, this means that our financing industry has made significant gains in foreign countries. More likely, it is only partly true and goods with mixed origins (domestic and foreign components) are booked in a biased way.

[Movie Guy]

Michele Cavallo, Federal Reserve Bank of San Francisco - "Of course, the mechanism underlying this model may imply that it could take a while for the U.S. trade deficit to adjust in response to persistently higher oil prices, as businesses need time to install new, less energy-intensive equipment."

Not much reality with this statement.

If Michele Cavallo would leave her cubicle and actually visit some U.S. manufacturing facilities, she would know that the majority of energy savings measures for equipment have already been put in place. Long ago. I mean very long ago.

I wouldn't be surprised to hear others say that manufacturers should switch over from 660, 440, and 220 voltage equipment and motors to 110-120 volt equipment and motors. Of course, the absolute opposite is the best course of action.

Now, if one wants to talk about different fuel sources, that's a different story. But most of those viable changes have already been implemented based on available fuel sources.

[calmo]

I gave this a thought too MG, that instead of tieing into the grid they could use solar or soybeans or nanotube generators (Ok, I make this up people) and that would create miracles in terms of energy conservation and lower costs of production. But what is the current cost of energy as a percent of total production costs? Not significant enough for the writers to identify. Worse. They allude to this mechanism knowing that to identify/measure it would show that it is insignificant.
Are the domestic auto companies closing plants instead of implementing state of the art energy sources to remain competitive?
The "eventually" line is inconsistent with the wider general environment of falling production of Goods. Either these people know this and conceal it from their readers, (have political interests whose views need to be supported) or they are incompetent despite those years in grad school (not bloody likely).
I am not a happy camper.

[spencer]

From 1990 to 2000 the trend growth of real oil imports was 6%. Since 2000 oil imports have been flat. The original flattening out of real oil imports was an inventory adjustment. But the flat oil imports after that original correction is in very sharp contrast to
the 6% trend of the 1990s.

So by only focusing on the post 2002 period the study can come to some very misleading conclusions.

Moreover, imports are the marginal souce of oil.
Given that the long run trend is for domestic oil production to decline, just holding domestic consumption flat would still generate a need to expand imports. For the US to actually reduce oil imports either we have to expand domestic output -- an almost improbable posibility -- or actually cut domestic demand.

[anne]

Spencer:

Again I am slow this morning, but please clarify and slightly develop your seemingly important comment.

[spencer]

Over the long run us oil production is falling at a 2%-3% rate.

Normally domestic demand grows at a 1% to 3% rate.

Consequently, real imports as the marginal supply grow at a 4% to 6% rate.

The 2002 -06 period of flat real oil imports is very unusual.

In the early 1980s because of high real prices and the severe recession real oil imports fell sharply. But
this ended in 1984 and since then they have grown very rapidly.

Using 2006 prices the real price of oil peaked at $100 in 1980,so at the current $60 oil price the real price is about where it was in 1983 when US oil imports started bottoming. The early 1980s drop in oil imports appears to be due as much or more to recession as conservation.

If real prices fall over the next few years as they did in the 1980s, almost certainly we will go back to the 1990s trend of real oil imports rising.

If real prices stay high demand growth will slow significantly and maybe the decline in domestic prodution will moderate, but do not count on it.

[anne]

Spencer:

Perfectly explained, and a typically important observation of yours.

[calmo]

How large a player was China in the 80s and is it likely that oil prices will fall given their increased and increasing share of crude oil which seems to be growing at a much slower rate than world demand?
'Appreciate that view spencer The early 1980s drop in oil imports appears to be due as much or more to recession as conservation.

[Ernest ODell]

I was just wondering if the recent drop in oil and gasoline prices to "supply and demand" or if this was some sort of political conspiracy by politicians.

I've seen gas prices drop in Blanco, Texas at the BP Amoco station (Blanco Ice House - http://www.blancoicehouse.com) to $2.09/gal.

I've seen it lower in other parts of the country and was wondering what's going on?

[JohnDewey]

Ernest O'Dell: "I was just wondering if the recent drop in oil and gasoline prices to "supply and demand" or if this was some sort of political conspiracy by politicians."

Well, a few liberals - who probably have never worked or invested in the energy industry - have suggested this may be the case. But it's not true.

Gasoline prices rose one year ago because two hurricanes knocked out Gulf coast refining capacity and offshore oil production. Those prices should have dropped by early 2006 as repairs were completed. But federal government action inhibited the immediate decline in gasoline prices.

A May 2006 article from Wharton, my alma mater, points to the impact of switching from the additive MTBE to corn-based enthanol, as mandated by the 2005 Energy Act:

"Unlike MTBE-blended gasoline, ethanol cannot be transported by pipelines. Instead, it has to be mixed in at terminals and then transported by trains or trucks. Many refineries were not prepared for this switch, and disruptions to the supply chain occurred."

http://tinyurl.com/epqy5

The Wharton article also notes that prices rose in the second quarter as refineries made the switch from winter blends to summer blends, which cost more to produce.

Consider these questions, Mr. O'Dell: How could an industry as broad as the energy industry possibly manipulate world oil and gasoline prices? They cannot. But even if someone found a way, wouldn't a disgruntled employee somewhere provide proof to the New York Times of such collusion?

Oil companies are realizing record profits and rewarding their executives with record bonuses. Do you think those executives would risk jail time, severe fines, and loss of their high incomes? just to help a few Republican candidates? Of course not. Oil company profits rise and fall due to world supply and demand, regardless of who controls Congress.

[Movie Guy]

John,

I believe you should do a little more research. I believe that the pipeline movement issue has been resolved.

[JohnDewey]

Movie guy,

Can you explain a little more? I quoted the May-06 explanation from the Wharton site, which was provided by David Wyess, Chief Economist at Standard's and Poors.

What's important is not whether the pipeline movement issue has now been resolved, but whether it had been resolved back in April and May.

Here's a partial transcript from a May-06 CBS 60 Minutes show:

"You can’t transport ethanol in oil pipelines, because oil-pipelines aren’t water-tight. That’s no problem if some water gets into the gas pipeline, because oil and water don’t mix. The water can be easily separated out at the end of the pipeline. But, ethanol and water do mix, and that’s bad for the ethanol and vehicles that would use water-contaminated ethanol fuel."

Movie guy, if you have reason to believe statements by both S&P economist Wyess and 60 Minutes are no longer correct, please do a little more research yourself and let us know. I have no reason to doubt these sources I've provided, and thus no reason to do more research.

[Movie Guy]

John,

Yeah, I got crossed up on my post as I was busy working on a real world project. What I meant to refer to - the Gulf Coast refineries and feed flows through Colonial and Plantation pipelines. Almost all of them are back to full operating capability, but it didn't appear to matter (as a critical point) as they have not been running at/near full capacity during most months in 2006.

If one goes back and studies the PADD data available at EIA Dept of Energy, the rate of utilization for many PADD refineries have been running lower than I expected throughout 2006. I did a post on this over at Brad Setser's a couple of months ago. The rate of utilization wasn't near peak.

As to your point about ethanol, I'm not convinced that the pipelines are leaking water into them. I've read the same type of articles, but I don't buy it from an engineering or environmental perspective.

Pipelines sweat. That's where I believe most of the condensation comes from. Unless, of course, water was pumped from the bottom of temporary holding tanks at the refineries.

Aside from having a high water absorbtion chemical quality, ethanol acts much like a solvent. And ethanol in a multifuel pipeline will scrub down the pipeline as the pumps and separation pig push the ethanol through the pipeline. Ethanol is corrosive. It is for this reason that E85 vehicle have a few modifications including stainless steel fuel tanks.

What really happens when ethanol absorbs water is that its octane rating drops off quite a bit, and it doesn't much water content to make that happen.

If water was the only concern with pipeline transport, it should be noted that Pure Energy Corporation has developed an additive system to prevent water absorption with ethanol-diesel. Perhaps the corp. has done the same for gasoline ethanol.

In Brazil, dedicated pipelines are being considered or financed for use to transport outbound ethanol to ports for export.

[Ernest ODell]

I wanted to say thanks to John Dewey for his cogent reply to my query. Your answer establishes my argument against the same liberals who would hurl the charge of conspiracy by the Petro Industry.

Ernest O'Dell
Blanco, TX