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How High Oil Prices Will Permanently Cap Economic Growth

Bloomberg, 24 September 2012

For most of the last century, cheap oil powered global economic growth. But in the last decade, the price of oil has quadrupled, and that shift will permanently shackle the growth potential of the world’s economies.

The countries guzzling the most oil are taking the biggest hits to potential economic growth. That’s sobering news for the U.S., which consumes almost a fifth of the oil used in the world every day. Not long ago, when oil was $20 a barrel, the U.S. was the locomotive of global economic growth; the federal government was running budget surpluses; the jobless rate at the beginning of the last decade was at a 40-year low. Now, growth is stalled, the deficit is more than $1 trillion and almost 13 million Americans are unemployed.

And the U.S. isn’t the only country getting squeezed. From Europe to Japan, governments are struggling to restore growth. But the economic remedies being used are doing more harm than good, based as they are on a fundamental belief that economic growth can return to its former strength. Central bankers and policy makers have failed to fully recognize the suffocating impact of $100-a-barrel oil.

Running huge budget deficits and keeping borrowing costs at record lows are only compounding current problems. These policies cannot be long-term substitutes for cheap oil because an economy can’t grow if it can no longer afford to burn the fuel on which it runs. The end of growth means governments will need to radically change how economies are managed. Fiscal and monetary policies need to be recalibrated to account for slower potential growth rates.

Energy Source

Oil provides more than a third of the energy we use on the planet every day, more than any other energy source. And you can draw a straight line between oil consumption and gross-domestic-product growth. The more oil we burn, the faster the global economy grows. On average over the last four decades, a 1 percent bump in world oil consumption has led to a 2 percent increase in global GDP. That means if GDP increased 4 percent a year — as it often did before the 2008 recession — oil consumption was increasing by 2 percent a year.

At $20 a barrel, increasing annual oil consumption by 2 percent seems reasonable enough. At $100 a barrel, it becomes easier to see how a 2 percent increase in fuel consumption is enough to make an economy collapse.

Fortunately, the reverse is also true. When our economies stop growing, less oil is needed. For example, after the big decline in 2008, global oil demand actually fell for the first time since 1983. That’s why the best cure for high oil prices is high oil prices. When prices rise to a level that causes an economic crash, lower prices inevitably follow. Over the last four decades, each time oil prices have spiked, the global economy has entered a recession.

Consider the first oil shock, after the Yom Kippur War in 1973, when the Organization of Petroleum Exporting Countries’Arab members turned off the taps on roughly 8 percent of the world’s oil supply by cutting shipments to the U.S. and other Israeli allies. Crude prices spiked, and by 1974, real GDP in the U.S. had shrunk by 2.5 percent.

The second OPEC oil shock happened during Iran’s revolution and the subsequent war with Iraq. Disruptions to Iranian production during the revolution sent crude prices higher, pushing the North American economy into a recession for the first half of 1980. A few months later, Iran’s war with Iraq shut off 6 percent of world oil production, sending North America into a double-dip recession that began in the spring of 1981.

Kuwait Invasion

When Saddam Hussein invaded Kuwait a decade later, oil prices doubled to $40 a barrel, an unheard-of level at the time. The first Gulf War disrupted almost 10 percent of the world’s oil supply, sending major oil-consuming countries into a recession in the fall of 1990.

Guess what oil prices were doing in 2008, when the world fell into the deepest recession since the 1930s? From trading around $30 a barrel in 2004, oil prices marched steadily higher before hitting a peak of $147 a barrel in the summer of 2008. Unlike past oil price shocks, this time there wasn’t even a supply disruption to blame. The spigot was wide open. The problem was, we could no longer afford to buy what was flowing through it.

There are many ways an oil shock can hurt an economy. When prices spike, most of us have little choice but to open our wallets. Paying more for oil means we have less cash to spend on food, shelter, furniture, clothes, travel and pretty much anything else. Expensive oil, coupled with the average American’s refusal to drive less, leaves a lot less money for the rest of the economy.

Worse, when oil prices go up, so does inflation. And when inflation goes up, central banks respond by raising interest rates to keep prices in check. From 2004 to 2006, U.S. energy inflation ran at 35 percent, according to the Consumer Price Index. In turn, overall inflation, as measured by the CPI, accelerated from 1 percent to almost 6 percent. What happened next was a fivefold bump in interest rates that devastated the massively leveraged U.S. housing market. Higher rates popped the speculative housing bubble, which brought down the global economy.

Unfortunately, this pattern of oil-driven inflation is with us again. And world food prices are being affected. According to the food-price index tracked by the United Nations Food and Agriculture Organization, the cost of food rose almost 40 percent from 2009 to the beginning of 2012. And since 2002, the FAO’s food-price index, which measures a basket of five commodity groups (meat, dairy, cereals, oils and fats, and sugar), is up about 150 percent.

Food Prices

A double whammy of rising oil and food prices means inflation will be here sooner than anyone would like to think.

Rising inflation rates in China and India are a clear signal that those economies are growing at an unsustainable pace. China has made GDP growth of more than 8 percent a priority but needs to recalibrate its thinking to recognize the damping effects of high oil prices. Growth might not stall entirely, but clocking double-digit gains is no longer feasible, at least without triggering a calamitous increase in inflation. If China and India, the new engines of global economic growth, are forced to adopt anti-inflationary monetary policies, the ripple effects for resource-based economies such as Canada,Australia and Brazil will be felt in a hurry.

Triple-digit oil prices will end the lofty economic hopes of India and China, which are looking to achieve the same sort of sustained growth that North America and Europe enjoyed in the postwar era. There is an unavoidable obstacle that puts such ambitions out of reach: Today’s oil isn’t flowing from the same places it did yesterday. More importantly, it’s not flowing at the same cost.

Conventional oil production, the easy-to-get-at stuff from the Middle East or west Texas, hasn’t increased in more than five years. And that’s with record crude prices giving explorers all the incentive in the world to drill. According to theInternational Energy Agency, conventional production has already peaked and is set to decline steadily over the next few decades.

That doesn’t mean there won’t be any more oil. New reserves are being found all the time in new places. What the decline in conventional production does mean, though, is that future economic growth will be fueled by expensive oil from nonconventional sources such as the tar sands, offshore wells in the deep waters of the world’s oceans and even oil shales, which come with environmental costs that range from carbon-dioxide emissions to potential groundwater contamination.

And even if new supplies are found, what matters to the economy is the cost of getting that supply flowing. It’s not enough for the global energy industry simply to find new caches of oil; the crude must be affordable. Triple-digit prices make it profitable to tap ever-more-expensive sources of oil, but the prices needed to pull this crude out of the ground will throw our economies right back into a recession.

The energy industry’s task is not simply to find oil, but also to find stuff we can afford to burn. And that’s where the industry is failing. Each new barrel we pull out of the ground is costing us more than the last. The resources may be there for the taking, but our economies are already telling us we can’t afford the cost.

Today, the world burns about 90 million barrels of oil a day. If our economies are no longer growing, maybe we won’t need any more than that. We might even need less. Maybe the oil trapped in the tar sands or under the Arctic Ocean can stay where nature put it.