*** Stephen Roach Oil roundtable ***
Global: The Great Oil Debate
Stephen Roach (New York)
May 28, 2004
It was a little over 30 years ago when the world was hit by the first oil shock — an OPEC embargo on the West that led to a quadrupling of the price of crude petroleum in late 1973 and early 1974. A second shock hit during the Iranian Revolution of 1979 that resulted in a near tripling of oil prices. Both of these shocks led to rapid inflation and severe recessions in the global economy. A less dramatic shock in 1990 prior to the Gulf War led to a similar outcome. Over this 30-year period, there has been a very tight relationship between the ups and downs of the oil and business cycles.
Today, with geopolitical risks mounting and energy markets once again sending ominous signals, oil has once again emerged as a macro wildcard. Despite our all-too-frequent experiences in having to cope with several oil shocks since the early 1970s, economists and policy makers remain sharply divided in assessing the impacts of these disruptive episodes. Arguably, today's "shock" is the by-product of strong global demand running into limited energy supply. The price increases that result from this interplay might have very different consequences than those arising out of the true supply shocks of yesteryear. Or will they? In the spirit of open and vigorous exchange that has long defined the culture of Morgan Stanley's global economics team, we recently debated several aspects of this rapidly developing macro risk factor. Highlights of the give-and-take follow:
Stephen Roach: Let's start with the obvious and important question as to whether the current run-up in oil prices even qualifies as a full-blown shock. The answer, in my view, hinges on context. On that basis, it's hard to call $40 a shock. A year ago, after the end of the first phase of the Iraq War, WTI-based oil quotes hit a low of about $25 per barrel. While the subsequent run-up of more than 60% can hardly be taken lightly, that's probably a misleading comparison. It makes more sense, in my view, to compare recent price fluctuations to a longer-term average, which more closely approximates equilibrium price expectations and oil consumption patterns. Relative to that benchmark, the current oil price of $41 represents "only" about a 40% increase from the average level of $29 that has prevailed since early 2000. Even if oil prices were to hold around current levels, it would be a stretch to call that a shock. Nevertheless, the recent run-up can hardly be construed as a constructive development for the world economy.
Stephen Li Jen: But the answer to your question also depends on the source of the escalation in oil prices. My guess is that about 80% of the recent price increase came from sharply improved global demand. If I am right that it is the global economy — especially China and the US — that is behind the latest surge in oil prices, then wouldn't that be a good thing? Should we really think of this particular oil shock as a negative?
Roach: So your advice is not to worry about the impacts of $40 oil.
Jen: I wouldn't go quite that far, but it really matters if price adjustments are dominated by forces driving supply or demand. I would also note that higher oil prices could also be seen as the functional equivalent of a monetary tightening. Consequently, a contained run-up in energy prices would allow the Fed to intentionally fall behind the curve, and thereby "minimize the risk to financial stability" as Fed Governor Bernanke would say. The yield curve would be steep, but stable.
More formally, perhaps we could include oil prices as one component of a broad Financial Conditions Index (FCI) for the US. On that basis, the FCI would be made up of the following: (1) interest rates; (2) exchange rates; (3) equity prices; (4) real-estate prices; and (5) oil prices.
With the confluence of quite diverse shocks currently impinging on the global economy, it is important to appreciate that there are trade-offs to all these shocks that we are contemplating. What is generally seen as a nuisance could quite conceivably be something positive.
Robert Feldman: In addition, the world — and the US in particular — is never going to get serious about energy-saving technology development until the price of oil gets very high. I honestly believe that the oil market is doing us a favor, with higher prices spurring research and ultimately reducing our dependence on fossil fuels.
Roach: All points well taken. In my view, the "true" shock probably comes with $50 oil. A sustained increase to that level for 3–6 months would represent a surge of more than 70% above the post-2000 average — on a par with full-blown oil shocks of the past. The recession call probably wouldn't be too far behind in that instance.
Of course, that's leaping well ahead in this story. A lot can happen between the oil price and the real economies it impacts. Just as central banks were key actors in shaping the macro repercussions of these two oil shocks, we suspect they could well hold the key to the world's response to the current increase in energy prices.
Eric Chaney: That is a very intriguing and timely point to raise, Steve. A news dispatch recently crossed the wires regarding the ECB's potential response to rising oil prices. In particular, we are hearing interesting noises from the new Bundesbank President, Axel Weber. He seems to be in the camp of those who think that an oil price shock is deflationary rather than inflationary. This is consistent with the point I have made for some time — that higher oil prices are, in effect, a tax that crimps real disposable personal incomes. No doubt other ECB Board members are on the same page.
Joachim Fels: Eric, oil price shocks per se are neither inflationary nor deflationary. It all depends on the reaction of monetary policy. Higher oil prices could lead to deflation if central banks overreact by hiking rates too much. Conversely, higher oil prices could lead to inflation if the authorities sit on their hands or even cut rates while inflation expectations creep up. The sad reality in the euro area is that so far, oil price hikes have always fed into higher core inflation and wages after some time. The last time this happened was after the oil price increase of 1999 to 2000, which led to a combination of weaker-than-expected growth and higher-than-expected inflation for several years. And I think this time around, the outcome is also likely to be stagflationary.
Chaney: That's the monetary approach, Joachim. But there may be more to the story than that. Another angle, based on labor economics and empirical macro analysis is that a permanent rise in energy prices would fuel inflation only if wages were indexed. However, since European wages are not indexed any more, lasting inflation is not a serious risk. Note that if nominal wages are rigid — and at today's low rate of wage inflation they most certainly are — then the rise in energy prices will cut real wages. Thus, both wages and profits would be cut in the short term by higher oil prices. To me, this looks like a double-edged shock, hitting both supply and demand.
Monetary policy is definitely not the appropriate tool to respond to this dislocation. I even think it would be a very serious mistake to raise rates in order to curb inflationary expectations that are unlikely to rise. Stagflation is unavoidable in the short term and reacting to it would only compound the supply shock. Moreover, the policy blunder could be magnified by a monetary tightening that would raise the cost of capital. That would inhibit the investment in energy-saving technologies that supply shock would otherwise encourage.
Fels: Interesting theory, Eric. But doesn't it really boil down to a tautology because you simply assume that wages won't react and hence there can be no inflation? It is important to note that the empirical work on wage indexation (or the lack thereof) you mention stems from an era when central banks aggressively acted to quell wage inflation. But we're now debating what would happen if they didn't act. The experience with the (relative) stagflation of the last three years following the oil price run-up of 1999 to 2000 makes me skeptical that the link between oil prices, wages and inflation has really been broken. If central banks follow accommodative monetary policies in the face of an oil price shock, I fear it's back to the 1970s.
Roach: But Eric, the oil market is made up of producers and consumers. Don't oil shocks merely shift the mix of income and wealth away from consumers toward producers, thereby having little net impact on the world economy?
Chaney: Fair point, Steve. In fact, the demand shock should be at least partially offset by stronger demand from oil producing countries. If the rise in oil prices is permanent, then it can be interpreted as a transfer of wealth, creating opposite wealth effects — and demand impacts — for producers and consumers, as you suggest. Consequently, in the end, it's the supply-side shock that really matters. Once the dust settles, the change in the relative price of energy will change the technology of energy consumption through conservation. That's the only possible answer to the supply-side shock.
Jen: I am not familiar with the experience with oil price shocks in Euroland, but in the US, it is generally believed that these shocks (most of them were supply-driven) should not be met with an overly tight monetary response. Fed Governor Ben Bernanke has made this argument most emphatically.
Roach: To be fair, Stephen, I would take issue with your assessment of the Fed policy response back in the 1970s. OPEC-I was met by a very limited move as you suggest. The result was a period of sharply negative real short-term interest rates — the likes of which we had never seen before. Arthur Burns felt the Fed was limited in what it could and should do to counter "exogenous" inflation. Hence, he had his staff (which included me) create core CPIs to show he was right. When the shock spread elsewhere into the price structure, he realized the mistake. The extraordinary monetary stimulus of the mid-seventies was duplicated by a similar Fed blunder later in the decade when OPEC-II came along. Our inflation performance wasn't very pretty during that period either. Paul Volcker understood the problem and dealt with inflation in the only way a central bank can — by finding the level of real interest rates that bites. By the way, today's real funds rate is more negative than at any point since the late 1970s. The Greenspan Fed is at risk of falling into a Burnsian sinkhole.
Dick Berner: You're taking us back to a difficult period, Steve. Joachim is right that whether energy shocks are inflationary depends on central banks. Ultimately, monetary policy determines whether or not price shocks affect inflation expectations. If expectations tilt up, the price shocks will change behavior. Consumers and business will be tempted to buy now, rather than wait, as they assume that prices will go higher. And expectations of higher inflation will affect the wage-bargaining process. COLAs (Cost of Living Adjustments) are less prevalent today than three decades ago, and labor markets are much more flexible. But expectations are still the fulcrum for leveraging shocks into inflation. Steve is right that the Fed under Chairman Burns (and then under G. William Miller) allowed inflation expectations to fester in the 1970s; as Fed staffers at the time, both Steve and I witnessed this blunder first hand.
I would go one step further: Bad policies in the 1960s laid the foundations for our awful inflation and economic performance in the 1970s. Fiscal policy was highly stimulative in wartime, and monetary policy failed to respond. I have a lot of sympathy for the idea that this economic setting contributed to the oil producers' ability to jack up prices, rather than the other way around.
Roach: But Dick, there are those who argue that energy is but one input into the national production function. All an oil shock does is change the relative price of factor inputs, forcing technological changes that eventually create energy efficiencies. Aren't we then better off as a result?
Berner: Higher energy prices involve more than a simple change in the price of energy relative to everything else, however. As the world's most important commodity, increased energy costs affect a broad array of consumers and industries. Transportation, materials and other costs will rise. How much gets passed through to underlying inflation depends on the cyclical context: If the economy is hot and near full employment oil shocks will be more inflationary than if they hit a weak economy with plenty of slack. In that regard, Eric is also right: Even with accommodative monetary policy it is not clear that the energy shock will produce more than a one-off adjustment to the price level, especially if the fundamentals are disinflationary. The trick is separating price-level effects from inflation.
I also worry that a big-enough supply shock would at least temporarily reduce productivity, producing a stagflation-like outcome. Such an outcome could also result in policy mistakes: Remember in the 1970s, the Fed's big mistake — which, as staff members, Steve and I warned against — was overestimating trend productivity growth.
Feldman: We also have to think about the health of the financial system. Yes, the banking crises of Herrstadt, Franklin National (Penn Central), and other secondary episodes were important in the early 1970s, but the entire financial system was not threatened by these failures. People may have thought so at the time, but these were small problems relative to the LDC debt crises of the 1980s, the S&L crisis in the US, and Japan's problems over the last decade.
The point is that the transmission mechanism from monetary excess to inflation in the face of an oil shock is affected by the state of the financial system. In terms of the monetarist framework (MV=PY), a bad financial system can destabilize V (velocity), and so an oil crisis that would normally transmit high M (money stock) into high P (prices) cannot do so.
Eric's point, with which I am quite sympathetic, relates to the effect of new sources of supply on the other transmission mechanism, the link from wages to prices. In the "good" old days of Herrstadt and Penn Central, labor would look at the central bank, bargain with management, and try to recoup expected price increases in nominal wages. Now, workers and management are both looking at China and Eastern Europe, and holding wages down, regardless of what the central banks do.
Thus, both the financial system weakness and the new structure of global trade have reduced the role of central banks in determining inflation — at least until financial system weakness is over, and China and/or Eastern Europe are fully integrated into the global economy. I will not hold my breath.
Chaney: I would add that the internal dynamics of labor markets has dramatically changed compared to the 1970s. Look at the share of flexible jobs and the dramatic decline of unionization rates all across the OECD. It seems to me that the supply-side revolution may be a long-term by-product of the slowdown in productivity growth that coincided with OPEC I. Mental superstructures eventually matter, to borrow from the rhetoric of the 1970s.
Also, Robby's point on the structural change triggered by the integration of China and India into the global economy is equally critical. If for any (geo)political reason, China changed course and moved back to isolationism, then inflation would become a serious threat. Pricing power would come back with a vengeance, profit margins would widen, and soon after wages would follow. Then, I would humbly ask Joachim to lend me some of his "inflation hawk" feathers. But we aren't there, are we?
Roach: No two shocks are alike. Now, this debate is getting to a key feature of the current run-up in oil prices that distinguishes it from those of the past — globalization and China. That raises another critical twist to this tale — the coming slowdown of an overheated Chinese economy. We all know the important role that China has played in shaping the supply side of the global economy in recent years. Not only has its overall GDP growth been exceptionally rapid, but the mix of Chinese economic activity has been heavily skewed toward the energy-intensive demands of urbanization, infrastructure investment, construction of new manufacturing activities, and the surging exports of China's offshore outsourcing platform. As China now slows, won't this have a significant impact on reducing a major source of global demand for oil?
Andy Xie: I think it will. Surging oil demand for oil from China is the primary cause for the high oil price. Chinese demand is currently increasing three times as fast as the trend in 1990s. Global demand was rising by about one million barrels per day every year in the 1990s. Chinese demand is now rising at that speed by itself.
Three factors are behind China's extraordinary increase in oil demand: First, its fixed investment is rising twice as fast as its long-term trend. Fixed investment accounted for 43% of China's GDP last year and the share is likely to move up to 46% in 2004. Thus, nearly half of China's GDP is growing at an annual rate of above 20% in real terms.
Second, China's auto sector is experiencing a takeoff. Auto sales reached 4.5 million in 2003, up 30% from 2002. Because China's fleet of motor vehicles is relatively young and small (about 30 million), most of the sales are net additions to the existing fleet. Thus, China's auto sector growth has a leveraged impact on oil demand.
Third, China's electricity shortage has triggered manufacturers to switch to diesel generators from grid supply. China's imports of refined products were 31% of crude imports in tonnage last year.
Those trends are all about to change. China's investment cycle is peaking, as its government implements tightening policies and the Fed is raising interest rate. The trend growth rate for China's imports of crude and refined products is about half as much as the current rate. When China's cycle turns down, it is quite likely that China's imports would decelerate sharply or even decline for a year. As a result, I believe that oil prices could fall sharply as a result — possibly even moving down through the $30 threshold.
Roach: That would certainly take the heat off the global economy and world financial markets. But Andy, it's your third point that intrigues me the most — China's shortages of electricity and energy. Inasmuch as China is suffering from a shortfall of power, isn't it reasonable to expect a muted reduction in Chinese energy demand as the economy slows?
Xie: I still think that a post-bubble Chinese economy will be a sharp negative for world oil prices. China accounted for 31% of the increase in global oil consumption between 1992 and 2002. The world's marginal buyer will be running at a much slower speed for a while. However, Steve, I think your point is correct over the longer haul. While the oil price may drop sharply in the near term, its long-term trend is likely to be upward, mainly due to the China factor. As China becomes bigger relative to the world and its auto sector becomes more important in its own economy, it is likely to account for half of the global increase in oil consumption. Oil should enjoy more pricing power in such a faster Chinese growth environment.
Roach: Is this sustainable for China or for the world economy over the long run?
Xie: Absolutely not. China will have to change its energy policy. If left to its own devices, an extrapolation of recent trends suggests that China's oil consumption could double over the next decade, from 7 million barrels per day in 2004 to 14 million barrels per day by 2014. The problem with this forecast is that China can't afford the resulting cost of higher oil. Considering the limited spare capacity in Saudi Arabia, the China factor, alone, could drive up the oil price above $80 over the next ten years. At that price, China would have to spend $300 billion to import crude and related products per annum by then. It would be a huge drag on the Chinese economy, to say nothing of its impact on the rest of the oil-consuming world.
Roach: I guess that means that China has to think out of the box in solving its energy problem, including giving active consideration to alternative fuel sources. Recent press reports suggest that China is considering a major expansion of its nuclear generating capacity. It currently has nine nuclear reactors on line, another two under construction, and reportedly is considering taking bids on four more nuclear projects before the end of this year. Is nuclear power the answer for China?
Xie: Nuclear energy could, indeed, be a viable alternative for the energy-constrained Chinese economy. The choices are relatively simple: China has to become either much more energy-efficient or find a substitute for oil. But it takes 10 years to build a nuclear power industry. China has to act soon if it wants to adopt the nuclear option. Another alternative is to limit the growth of the automobile industry. The current growth trend could result in a tripling of China's fleet size to 100 million by 2014. Unless China alters this growth path, it will be too late to slow oil demand.
Roach: Is the US really any better off than China in this regard?
Berner: US energy mainly depends on exhaustible fossil fuels, primarily gasoline, heating oil and natural gas. The surge in their prices in the 1970s encouraged energy conservation, so that energy consumption per unit of real GDP has dropped by 46% over the past three decades. But demand from other, less energy-efficient economies, like China's, has boosted global demand by far more than the limited growth in supply. And both demand and supply for energy are insensitive to price changes in the short run. As a result, despite still-sizable reserves, no oil producer outside the Gulf has been able to challenge the Saudis' hold on prices.
Ominously, according to energy consultant Bjorn Dingsor, worldwide crude reserves are growing, but at a slower rate than in the past. The average discovery rate for crude oil outside the US since 1995 has been less than 10 billion barrels, and some industry experts think that only one in four barrels consumed is currently being replaced by new discoveries. With worldwide annual depletion from existing fields at 5%, and demand expected to grow by 2% annually, new production will have to rise by 59% to achieve balance. Thus, long-term costs for exploration and extraction are rising, and rising prices will help curb demand. But supplies lie with increasingly hostile producers who want their full share of the rents.
Roach: It's always easy to blame the proverbial "other guy." But what could we in the United States have done differently in dealing with our energy problem in this daunting global context that what you just described?
Berner: Most importantly, we could have done a much better job in the areas of tax and environmental policies. Relative to other industrial countries, US energy taxation remains low, so the extra income from rising energy quotes goes to producers rather than to us. Higher prices make alternative energy sources attractive, but they require huge infrastructure investments that may be public goods. "Not in my backyard" attitudes and balkanized environmental regulation have created regional barriers to what could be national markets. And they have made energy companies reluctant to invest in energy distribution infrastructure, and voters reluctant to approve projects such as electric power distribution facilities, or refineries to process freely available high-sulfur crude, or LNG terminals. In addition, the legacy of Three Mile Island (the Pennsylvania nuclear facility that malfunctioned in 1979) has made US nuclear power unacceptable.
Roach: Dick, if what you and Andy are saying is correct — and I have every reason to believe that it is — then the world will have no choice but finally to face up to the imperatives of adjusting to both limited oil supplies and a much higher market-clearing price. In oil as in long-term economic growth, cycles come and go. Right now, the cycle is listing ominously to the upside. The near-term endgame is as much geopolitics as it is economics. In the 30 years since the first oil shock, there has been a stunning decline in the real price of oil. In the past 15 years, there has been an equally stunning mean reversion to periodic cycles in the nominal oil price. My guess is that history will judge these trends to have been an aberration. Globalization is an energy-intensive endeavor. Take a look at China and India — the laboratories of globalization. As economic development spreads, the real oil price could actually rise steadily over time. Wouldn't that be the biggest shocker of all?
morganstanley.com |
