Oiling the Wheels: When Oil Prices Bite

The Colonel: More Excuse than Cause. Credit: EnemyKe

8 March 2011.

The Colonel: More Excuse than Cause. Credit: EnemyKe

8 March 2011.

The world is entering an oil supply crunch because the demand for oil is increasing so rapidly, global oil production can’t keep pace with the level of demand. As demand exceeds supply in the midst of political turmoil and crisis in oil producing countries, prices are escalating.  

The price of oil has risen sharply in the last few months and today Brent crude sells for just under $116 a barrel following OPECs plans to boost oil output.

However, unlike the OPEC price shock in the 1970s, this hasn’t derailed the global economy. The world is less dependent upon oil today. The International Monetary Fund (IMF) estimates that a 10 percent increase in oil prices reduces global output by 0.25 percent.

There aren’t many conceivable scenarios which would cause the oil price to more than double than the current violence in the Middle East and North Africa. But if oil did hit US$200 a barrel the world would plunge into a recession. Bad news for you, good for oil producers (and their shareholders).

Expensive oil makes for expensive food

Food prices have increased in the past few months and oil is as responsible as higher inflation. Yet, higher oil prices don’t just increase the price of food because they put up the price of transportation and fertiliser.

They also encourage food turned into biofuel – reducing the amount of food that’s available on world markets which causes further price increases. And that’s not a problem, as long as there’s a food surplus.

Sadly, recent harvests in Argentina, Brazil, Canada, Russia and Ukraine have been poor, so there’s a global food shortage. People in the less developed countries have felt the largest impact of increasing food prices – and their need to turn food into biofuel is in essence starving the poor in the developing world.

Libya produces roughly 2 percent of the world’s oil supply, half of this has been shut down by the fighting. But markets are more concerned about trouble breaking out in Algeria or Saudi Arabia.

If part of Saudi’s production was taken off the market oil could hit $200 a barrel in no time.

Economy Watch asks: Are there macroeconomic policies that we could use that could reduce the risk and severity of oil shocks?

 One idea proposed by OilPrice.com is a variable oil tax:

A variable oil tax that would reduce price volatility and, at the same time, offset the national security and environmental harms of oil dependency.

How would it work?

Congress establishes a floor oil price of X dollars per barrel.

Whenever the world market price P fell below X, an oil tax T would come into effect to fill the gap: T=X-P.

Whenever the price rose above the floor, the tax would be zero.

The main argument for a tax of any kind is that oil consumption has adverse spill-over effects, known as externalities. Commonly:

·         effects on national security

·         effects on the environment

 Imposing a tax on oil would be one way to mitigate them.

Consumption of oil has a negative impact on national security because so much of the world’s oil comes from countries that are corrupt.

So increases in US oil consumption pushes up the world price and enriches bad guys in exporting countries while reduction in oil consumption undercuts them.  

A variable tax would in addition provide an anchor for expectations over oil prices.

And finally;

during episodes of high prices, investments in conservation and alternative energy production become more attractive, but there is also a risk. If oil prices crater again, those investments will not pay off – the variable oil tax would help mitigate the impact of oil price spikes on the business cycle.

As James Hamilton points out;

“ recent oil price spikes, including that of 2008, have been followed by US recessions, and argues that the depth of those recessions has been greater than would be predicted by the effects of higher oil prices acting alone.

One reason seems to be that retail gasoline prices have such a high visibility that price spikes disproportionately undermine consumer confidence.

Another is that oil price spikes disrupt the automobile market. They not only harm new cars in general, but also shift the mix from large to small cars.

A third advantage of a variable oil tax compared to a fixed one would be political, especially if it were  introduced at a time when oil prices were already above the chosen floor.

Right now, for example, a tax with a price floor of, say, $85 per barrel would produce no immediate pain at the pump, but the knowledge that prices would never again fall below $85 would encourage long-term investments in conservation and alternative energy.

Introducing a variable oil tax at a time when prices were already high could make an actual virtue of the often-lamented tendency of politicians to operate on a much shorter time horizon than business investors.”

Liz Zuliani

EconomyWatch.com