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Oil Shocks, and What They Hold for the US Economy

by: Joseph Trevisani July 21, 2008    

Joseph Trevisani

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The United States financial system had a serious scare, the Europeans meandered through a dismal series of economic reports and oil closed almost $20 lower.  For all the cross currents last week it was the collapse in oil prices that holds the most promise for the American economy and the dollar.  The epicenter of this oil shock was not the Persian Gulf but Washington D.C. and in response the Dow Jones Industrial Average gained 3.6%, its strongest weekly rise in five years.

Political events gave oil traders and stock short sellers every reason to take profits. President Bush lifted the executive ban on offshore drilling on Monday and by Friday crude prices had completed their sharpest fall in percentage terms since late 2004.  Polls in the US show deep support for increasing the supply of domestic energy, drilling in offshore waters and Alaska.  But the Bush executive order was symbolic. It is a Congressional prohibition that blocks oil exploration offshore.

Oil traders are betting that this Congressional ban on drilling, which covers 85% of US continental waters, will not stand. The ban itself expires on September 30th and will have to be renewed by Co,ngressional vote.  If Congress does nothing the ban lapses. Technically the ban is an annual Congressional prohibition on appropriations for the Interior Department for processing offshore drilling leases. Congress has renewed the moratorium every year since 1981.

The Democrats who control Congress have vociferously opposed letting US oil companies increase production from offshore supplies. Harry Reid the Democratic leader of the Senate and Nancy Pelosi the Democratic Speaker of the House both refused to consider modifying or lifting the ban. But this is an election year and offshore drilling in some capacity is very popular:  73% of the population approves modification or removal of the ban.  Will Congress bend to the popular will? Will Barack Obama change his anti-drilling stance as he seeks middle and working class votes, precisely those voters most affected by high gasoline prices and the voters he needs to get elected?  

Crude oil prices fell 11% on the week. Oil traders seem to have a clear opinion on the likely direction of Congressional policy.

Federal Reserve Chairman Ben Bernanke has maintained that slowing growth will eventually reduce inflation. The greatest source of inflation has been skyrocketing energy prices. Core inflation has risen only 0.2% since last June from 2.2% to 2.4%, while headline inflation has nearly doubled to 5.0% from 2.7%. If there were ever a justification for basing rate policy on core rather than headline inflation, it was this week's fall in oil prices.

But executive action in the US was not the only factor weighing on oil prices. The mild tone from the US and the Iranian governments concerning the renewed negotiations over the Iranian nuclear program also helped, as did an unexpected rise in oil stocks. And a world wide economic slowdown, though in many countries not reaching recessionary levels, is also cutting energy usage. 

The combination of political and economic events was elementary reading for oil traders: take profits. But events could swiftly reverse the downward direction of oil prices. A military confrontation between Israel and Iran, more stringent sanctions on Iran for its nuclear program or any number of imagined or unimagined events could send oil back to its recent highs and beyond. If crude oil returns to its heights then traders will punish the dollar and this time the euro will probably not stop at 1.6040. The return of a nightmare is often scarier than the original manifestation. So it will be if oil returns to $145.

The US economy has three main problems: commodities prices (read oil), the housing market collapse, and the fear generated by financial failures. The housing decline, while translating into an enormous problem for the financial sector, has had a muted effect on the economy as a whole and on consumer spending. The financial fear is serious and as more institutions fall under suspicion it damages stocks but in reality it has, as yet, had minimal effect on the consumer except in its effect on consumer sentiment.    

Despite all these interlocking problems the US economy has not derailed. But it is directly affected by oil and gasoline prices. The Fed has provided 325 points of rate reductions in less than a year. The Federal government has delivered a large economic stimulus. The question now is have these moves prevented the bottom from falling out of the US economy or are their simulative effects simply taking more time than usual to promote a recovery? And despite all the recent criticism directed at Ben Bernanke for the weakness of the dollar it is that dollar which has spurred US exports providing a large measure of support for American productive firms. 

In July 2007 premium gas averaged $3.15 a gallon in the United States; at the beginning of 2007 it had been $2.50. Premium fuel is now $4.30 a gallon. Where would the US economy be without higher gasoline prices?   Of course higher gasoline prices and lower economic activity are not a simple trade off. One of the factors driving oil higher was the falling US dollar. The dollar weakened because of Fed rate policy, itself predicated on the housing and credit problems in the US. But the rise in oil prices and thus gasoline has far outstripped the fall in the dollar. And so the punishment inflicted on the US economy by energy prices was far greater than the reflection of the dollar decline. 

The betting last week was that if the excess in oil expense is removed then the Fed rate reductions will have a better chance of returning the US economy to prosperity. That was the defensive view in the stock market. It may soon become the opinion in the currency markets as well.

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This article has 17 comments:

  •  
    Jul 21 08:24 AM
    make every contract in futures market for compulsory delivery and see where oil goes!!!
    Reply
  •  
    Jul 21 10:15 AM
    So, you really clarified things, thanks, but what is your idea for a solution? I would be very interested in hearing it since you seem to have a good grasp on things and you can explain it in plain english. Thanks.
    Reply
  •  
    Jul 21 11:20 AM
    Joe
    You seem to believe that offshore drilling is going to lower the price of gasoline at the pump. When American oil companies discover, develop and pump oil the oil belongs to the oil company, not to America or Americans. The oil company will negotiate the best deal it can find on the world market and sell the oil to the highest bidder. If the highest bidder is China the oil will be loaded into a tanker and shipped off to the folks in Chinghai. With 20 of the world's major oil fields in decline, the idea that offshore drilling is going to affect the price of gasoline is total nonsense.

    As far as drilling in the ANWAR the maximum capacity of the Trans Alaskan pipeline is 1.4 million barrels per day. How is the addition of 1.4 million barrels going to affect the worldwide price of crude? It won't.
    Reply
  •  
    Jul 21 11:33 AM
    Ditto gailwhitaker:

    The world is running out of oil.
    The world's economies still need oil to function.

    Therefore:

    The price of oil will rise in the long run.

    Unless:

    1) The laws of economics are repealed by God or man.

    2) The human race learns to use other sources of energy.
    Reply
  •  
    Jul 21 12:05 PM
    Joe,
    I think you are correct concerning the short and mid-term of oil. Longer term I don't see how oil will stay below $100.00

    BTW - Are you from Ossining NY?
    Reply
  •  
    Jul 21 12:07 PM
    My opinion is contrary to (apparently) everyone else. I think we should:

    (1) Impose an escalating gas tax. Pick a number 3 cents a gallon and increase it monthly until we are on par with Europe.

    (2) Use the income to generate green power (a la T Boone Pickens)

    (3) Accept the fact that this will hurt some people and companies immediately, but understand that ultimately, this will force our country into energy savings.

    (4) Do not drill in Anwar or off the coast. I do understand that we have a credit card' mentality. I.e. "I can't be out of money, I still have checks!". When you're in the desert, you don't have a bath with your last canteen of water. Doesn't it make sense to save our oil for when it really matters? What do we do in 20 years when Saudi Arabia, Russia and Mexico have depleted their supplies? Wouldn't it be kinda nice to be the creditor then, rather than the debtor?

    Thx jegan ;-)
    Reply
  •  
    Jul 21 01:10 PM
    Oil is the basic industrial commodity and will remain so for at least a generation. This is not a comment on the desirability of an oil based economy but a recognition of fact. It is the availability of cheap energy more than any other development that has enabled the industrial revolution and the rise in living standards, so we should be hesitant to consign oil to the past. It is the most potent transportable fuel known.

    The era of inexpensive oil does appear to be ending, though we should be cautious because many prior shortages (food, light metals) have been declared only to vanish as new technologies appear and evolve.

    Drilling for available oil also does not does not mean we should not pursue all alternative sources of energy. We should. Oil will be sold at the world market price, that is true. But the market price is determined by more than current supply and demand. The perception of future supply and demand, as we have seen this past year, can have an overriding impact. It is this perception of future supply that will be affected by current drilling. There is little doubt that oil is available and that at $100 and more a barrel it is profitable to extract. The idea that we should not drill because it will take five or ten years to see the product is not a serious objection. Doesn’t that objection also apply to every form of alternative energy? Should Toyota not have invested in hybrid technology ten years ago because it would not have been available immediately?

    I thank you all for your comments. I very much enjoy hearing from readers.

    For the question about Ossining N.Y. Yes I did grow up in that old river town.

    Joseph Trevisani
    Chief Market Analyst
    FX Solutions
    joet@fxsol.com
    Reply
  •  
    Jul 21 01:26 PM
    John Egan, I agree with you. Drilling for more oil will not decrease oil prices in the long run, but only contribute to a faster depletion of our own oil reserves. Taxing more heavilly would decrese consumption and force use of alternate energy, possibly force people to use more of the so called "greener energy" alternatives. Increasing the tax, gradualy would soften the blow, and give sufficient time for adjustment. Oh, and yes, all that excess tax, should be spent on infrastructure and road improovement, which would create more jobs locally, where we nee them...
    Reply
  •  
    Jul 21 05:20 PM
    1) Ummm, doesn't our government already tax gasoline? Then where are the alternative subsidies? Let me fill you in, these taxes were squandered and adding more tax to a gallon of fuel means more squandering. Put up the subsidy now for all energy options, alternative such as solar/wind/diodeisel AND traditional such as nuclear/coal/drilling. Phase 3 of green energy cannot exist until we add more of Phase 2. Reminds me of underpants knomes the enviro's are: "Phase 1, collect underpants, Phase 3 profits!"

    2) Taxing gas upwards like the EU means the government subsidizes a lot more mass transit in short order. Shouldn't we be subsidizing energy sources, not more mass transit? I love being an American because I can drive my car wherever I want. Do I now have to wait for the American government to build me a train? So now we want to be like Europe a great socialistic paradise eh? Wonderful! Bring all our military home and let that great socialist paradise defend itself!

    3) The USA's leadership needs a financial crisis to dry up the money or you could say bad government created the financial crisis which will rectify bad government the hard way or the not-so-hard way. Liquidity created very big globalization pipe dreams of our government, with the USA wishing to sit on top to tax the global citizen. Our free market entrepenuars created the Internet and gave it to the world to get information about a better way to live... Globalization on this level and with this approach created blowback and massive wealth transfer, with 297 M out of 300 M U.S. citizens the short end of the stick (minus a cheaper plasma or ipod, great thanks). All energy must be our motto and then investment further innovation. Any empire needs energy (romans had slaves) we have mainly oil, meaning we are becoming slaves to Russia, GCC, Iran etc.

    4) The author is incorrect stating that other then consumer sentiment, there was no other fallout from the credit crisis, in other words a banking crisis. Credit lubing helped the Central and iBanks stay afloat, but in the downsteam, regional banks are getting creamed, jobs are being decimated and consumer credit tightened. Overvalued housing is deflating and will deflate to affordability based on median household income, so what happened to Joe's six packs ATM? Hard to pay the inflationary price on commodities and deal with us returning to the Save and Invest economy, now isn't it?

    We have an inverted yield curve. How does the free market increasing the long-terms rates effect the consumer, does rising long-term rates make it easier to obtain a loan or service the debt or harder? Is that the "no fallout besides consumer sentiment?" you meant?

    Consumer spending has increased! Yeah, on non-discretionary items such as energy and food. How do these higher priced consumables allow the nation as a whole to redeploy capital? That point I believe you do mention to a degree. Non-discretionary spending is going off a cliff and that was with the bailout package for consumers! That means a whole lot of enterprises going out of business.
    Reply
  •  
    Jul 21 06:46 PM
    I have read a number of reports where US oil demand is off 5%, annualized, since last year. If so, that translates to about 1 million barrels per day.

    ! million barrels per day is all we EVER expect to get from ANWAR.

    So... what has happened to the price of oil over the last year? Over the last month?

    While I am NOT opposed to drilling in ANWR or offshore, I think this is all political hype, proferred by the Republicans to stick it to the Democrats, except that the oil companies REALLY would like to drill in ANWR (they really don't give a damn about offshore) because it would extend the life of the Alaskan Pipeline and DRAMATICALLY increase the profitability of Alaskan oil.

    As for McCain's position on "letting the states decide", anybody who has followed this issue knows that left up to the states, there will NEVER be any new areas opened up since most of the protected offshore oil is off the coast of California.

    Again, this is all political hype.
    Reply
  •  
    Jul 21 09:00 PM
    to drill or not to drill. eventually we will drill whether it is now or later....but for sure the discussions are now simply political hype.

    however, i would not use an argument about how little benefit drilling for oil in alaska or offshore will bring because the same can be said of any of the alternate energy solutions proposed. we have to do everything possible (search for oil, nuclear, conservation, solar, wind, etc) to prevent an energy shortfall which will disproportionally effect the poor of the world.

    i believe eventually an obvious energy pathway will emerge. greenhouse gas emitting solutions are doomed, but any fool can recognize that it will take more than your lifetime to discover, manufacture, and install whatever the final solution(s) entails.
    Reply
  •  
    Jul 22 09:27 AM
    Sigh. Crude oil makes more products than just gasoline, and some of them do NOT have viable alternatives on the horizon. Particularly petrochemicals, jet fuel, heavy fuel for trains/big rigs/cargo ships.

    You don't tap your LAST domestic resources just to get cheaper pump prices. There are things that are going to be MUCH more important in terms of using that oil. Yes, we'll have to use it at some point, the question is when, and how-so? Once you use it, its gone. So waste it all on $4 gas now, and what will it look like when we are at 100% imports and a barrel of oil is $1000, just for the heavy uses?

    I think we can get off the gasoline crack-pipe. But we'll still need oil for these other things, and I'm afraid that too much short-sightedness on this issue will exhaust these resources without regard for the declining future supply.
    Reply
  •  
    Jul 22 01:13 PM
    Hi!
    Could you, please, think about this?
    Most of those who speak about oil prices forget that there is really no matter of demand-supply issue. Move back a little bit and think what happened with stocks. No need to go further than last few years.
    There was a big boost in loans, especially mortgages and many people live above their possibilities. Companies and other market players all need to keep that direction if they want to stay competitive. Means all economy is based on spending more and more and that makes the most of the profits of companies.
    On the other hand you have market players or we can say traders who "make" the market by pumping in the money.
    And so...last few years stocks climbed to the tops of the tops. Normal thing is to correct the prices and then traders who earned millions (billions) go away and they put the money in commodities.
    Don't be fooled, because they (market makers, investors and other participants) "make" the information and they have very sophisticated ways to present them to all of us, through media, politicians and some scientists.
    Now what? Now when stocks have fallen and they made huge profits, they sell the commodities and search for new place to invest. Possibly into stocks which are much cheaper today than 2007 but also into some new "casualties"... like water supply, food (already did), real estates etc.
    At the end just 1 note:
    Please read Siegfried's Tischler, university professor of geology, articles and things connected to his statements:
    Oil is not fossil fuel!!!
    Sound strange and stupid when you read it for the 1st time...BUT!!!
    The official theory is old and not ever changed because oil companies and other "big players" want you to believe that. But researches made in past 20 years showed the other source(s) of the oil and it is not so rare as we thought.
    The truth is that We just need to pay for our ignorance and not using our brains just using and refining data that we got presented and not the data we got by our research or invention.
    On the other hand, "big players' " greed for billions of our hardly earned US$ wants us to stay in such condition.
    I am glad if "helped" at least 1 person to look the things from the other perspective. Thanks!
    Reply
  •  
    Jul 22 04:31 PM
    "Oil is not fossil fuel!"

    Ah yes, the abiogenic theory of oil creation. You do realize that the vast majority of industry geologists greatly dispute this theory, and they're the one's getting paid to find the oil. And yet they drilled the Siljan Ring on Gold's prognosis that there would be loads of abiogenic oil there.

    They got 8 barrels of unusable sludge. Abiogenic origin theory looks good on paper, but its almost certainly not true, and certainly not accepted in the mainstream. Its a great way of convincing yourself that oil is somehow magically not finite; that our planet just conveniently churns it out from the mantle like clockwork. And yet we accept that many of our other resources, of which we have not peaked in exploitation of, we still consider finite but vast...
    Reply
  •  
    Jul 23 04:19 AM
    Of course , you are right, because every truth has 2 sides.
    If you say "..industry geologists greatly dispute this theory, and they're the one's getting paid to find the oil." you just need to ask yourself why is it so.
    Who says they did not find the oil?
    First, drilling and exploration is very expensive process which means it can be payed only by big companies. And nowadays they earn more than ever. Why would they drill and deliver more oil to the market? Why??
    Isn't it more reasonable to deliver e.g. 1 million barrels for 130US$ per barrel rather than 10 million for 13US$ per barrel? This is a simple projection and am not taking the expenses and costs of everything else, of course. In such way with low cost and on long term they can deliver expensive oil to us and have us "on a leech".
    This is also good moment for nuclear lobbies and their interests are considerable at the moment. Despite people are talking nuclear and oil lobbies are competitive, don't be fooled, they are playing the game together and as energy consumption rises there is plenty of room for all of them.
    The real answer to them would be turn to saving energy mode, "green energy" and new sources of energy that could be used. Am not saying it is short term and easy and not expensive , but probably the only way...because on the other hand we have troubles with climate and global changes like global warming etc., already.
    Some of the methods were found but carefully hidden from the public, because as it was said: "who has the energy rules the states and who has food rules the people".
    Reply
  •  
    Jul 23 09:23 AM
    Sorry but that doesn't make any sense. We've seen that when groups try to artificially constrain supply, they eventually get tempted by profit to over-produce, as was seen in OPEC. The American fields are all in decline, so they must seek new sources just to stay up with current production. So if the abiogenic theory was somehow true, and oil was actually plentiful, then why hasn't someone, like the Russians, exploited it? Why can't the US maintain at least flat year-on-year production? Certainly there is profit-motive to stay at least flat. The idea that its all a big conspiracy is hard to swallow, especially when all of the abiogenic research is out there to look at.

    But as for going away from fuels like oil and coal, towards greener sources, we're in complete agreement that it should be done.
    Reply
  •  
    Jul 23 10:31 PM
    There is no gaurante drilling for more oil will bring down the price of oil, however it is a gaurante that if we don't drill for more oil the price of oil is going to go a lot higher .To believe otherwise is unintelligible and stupid .
    Reply
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