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Implications of higher oil prices for U.S. industry.

Iraq and Kuwait produced 8 percent of the world's oil supplies prior to the United Nations' embargo. A shooting war in the Persian Gulf could encompass countries producing a combined 26 percent of the world's oil. An input-output analysis found that a 50 percent increase in oil prices from the 1988 level raises overall costs some 1 percent in the U.S. business sector, about equal to this year's expected real economic growth. However, the price impact is not distributed evenly across aU segments of the economy. Higher energy prices are likely to result in a lower standard of living for U. S. consumers.

TWO MONTHS AFTER Iraq invaded Kuwait, the world market price of crude oil rose from about $21 to $40 per barrel. This doubling in price reflects the great uncertainty over future oil supplies and has little connection with existing supply conditions. Before the invasion, Iraq and Kuwait together accounted for only 8 percent of total world crude oil production. Nevertheless, the conflict poses a potential threat to future oil supplies from the entire Persian Gulf region, which produces 26 percent of world crude oil, has by far the lowest oil production costs, and contains the majority of the world's known oil reserves. Consequently, the great uncertainty concerning the availability of future oil supplies produced an immediate and large disruption, as oil prices soared and financial markets reacted adversely around the world.

Where oil prices will finally settle is still anyone's guess. A war in the region would surely send oil prices skyrocketing, well above $40 a barrel, while an Iraqi pullout from Kuwait and the eventual resumption of normal oil trading could send them plummeting to their preinvasion level. For this article, the potential implications of the present crisis are based on the assumption that the price of oil stabilizes at about $27 per barrel, some 50 percent above the 1989 price. The analysis begins with some basic economic information important to an assessment of the loss of Iraqi and Kuwaiti oil. Data on world oil production and U. S. consumption by sector are highlighted, as are certain measures of the changing importance to the U.S. economy of oil products and their derivatives. The probable impact on the U.S. economy and on final product prices are estimated for 135 industries.

WORLD SUPPLY OF CRUDE OIL

The impact, both in the short and long term, of the loss of Iraqi and Kuwaiti oil on world markets will depend on many factors. One of the more immediate concerns is the sudden drop in world supply as the United Nations embargo takes bold. Chart I indicates the relative importance of the major crude oil producers in supplying the current world market demand for about 61 million barrels of oil per day. The world's largest single country producer of oil is the Soviet Union (18.2 percent), followed by the United States (12.1 percent). The eleven members of the Organization of Petroleum Exporting Countries (OPEC) accounted for 39.6 percent of total world production in the first five months of 1990. Within OPEC:

1. Saudi Arabia is the largest producer in OPEC (24.1

percent of OPEC) and is the world's third largest

producer (9.5 percent of total world production);

2. Following its takeover of Kuwait, Iraq now controls

21 percent of the preinvasion OPEC production,

or 8.3 percent of total world production;

3. More than 64 percent of OPEC production (and 26

percent of world production) is accounted for by

the Arab members of OPEC: Algeria, Iraq, Kuwait,

Libya, Qatar, Saudi Arabia, and the United Arab

Emirates.

Chart 2 shows that current world oil production is only about 8 percent higher than in 1973. Between 1973 and 1990, OPEC's proportion of world production declined from 55.6 percent to 39.6 percent. During most of this period, OPEC reduced production in an attempt to offset the rising output from non-OPEC countries. As with all cartels, it is difficult to allocate lower production. Frequent disagreements and widespread cheating on production quotas among its members during the 1980s limited OPEC's success in controlling prices. In the mid-1980s however, non-OPEC production leveled off as the price of oil declined and the long-run decline in OPEC output was reversed as their share of rising world production increased during the past several years.

The loss of Iraqi and Kuwaiti oil supplies explains the recent surge in prices, but oil prices were moving up before the present crisis began. A more fundamental reason for higher petroleum prices is that oil demand has been increasing while many non-OPEC nations are producing close to capacity. Consequently, non-OPEC nations have limited ability to expand production to offset any supply shock and particularly the loss of Iraqi and Kuwaiti oil, at least in the short run. The experience of the last two major price shocks shows, however, that there is a substantial, longer term supply response to increased crude oil prices. If the price per barrel remains close to $30, investment in additional U.S. petroleum capacity will eventually occur. Prolonged high petroleum prices will also make investment in energy conservation and alternative sources more attractive.

SOURCES OF U.S. SUPPLY OF CRUDE OIL

Currently, the United States imports more than 45 percent of the crude oil consumed. Chart 3 traces changes in U.S. consumption over time and highlights the shift in relative importance of domestic production and imports. Since the mid- 1980s, U. S. consumption has increased slightly. During that same time period, domestic production has declined significantly. This loss of production is evident in the financial problems experienced in the oil drilling and oil equipment industries during most of the 1980s. In part, this is because remaining U.S. crude oil reserves, generally, have high production costs. The decline in the world price of oil during the latter half of the 1980s made most U.S. oil reserves too expensive to produce. As a result, over time, a rising share of U.S. oil consumption has been supplied by imports. Additional imports have come largely from OPEC production, particularly rising imports from the Persian Gulf.

Disruptions in the Persian Gulf region affect not only the United States, but also impact our major competitors, many of whom rely more heavily on oil imports than does this country. For example, Europe imports 64 percent of its oil, and Japan depends almost completely on imports (98 percent). in addition, these countries rely more on Persian Gulf oil, as a percent of their oil imports, than does the United States.

PETROLEUM CONSUMPTION BY MAJOR SECTORS OF THE U.S. ECONOMY

Chart 4 points up the relative importance of oil and oil products to the major sectors of the economy. These data show that the transportation sector, which includes demand by both consumer and commercial transportation, is by far the largest user of petroleum products. This sector accounts for almost 11 million barrels a day, some 64 percent of the 17.1 million barrels a day consumed in the United States. Manufacturing is the second most important consumer of petroleum, using 2.8 million barrels per day, which represents slightly more than 16 percent of U.S. consumption. In contrast, industries in the utility and commercial sectors each consume less than 3 percent of the total petroleum available.

Chart 5 shows in greater detail the manufacturing sector's petroleum needs. These data show the relative importance of three major types of oil products: fuel oil, oil-based gases, and oil feedstock. The demand for oil products by manufacturers is highly concentrated:

1 . Only 12 percent of manufacturing's petroleum consumption

(350,000 barrels a day) is needed to provide

heat and power to manufacturing processes.

2. Some 33 percent of manufacturing's petroleum consumption

is used in the manufacturing processes

in the form of various petroleum gases and coke.

3. The bulk of manufacturing oil consumption is in

the form of petroleum feedstock. About 1.6 million

barrels of crude oil per day are used by this relatively

small segment of the manufacturing sector.

These petrochemicals are critical to the manufacture

of numerous products such as rubber fibers,

plastics, medicines, pesticides, adhesives, and

solvents.

IMPACT ON THE U.S. ECONOMY AND ON SPECIFIC MANUFACTURING INDUSTRIES

To compare how one sector of the economy might fare relative to another segment requires a detailed knowledge of the cost structure within each industry. The Federal Emergency Management Agency (FEMA), using the University of Maryland's 1988 industry by commodity input/output tables, has compiled such cost information and estimated the cost implications on specific industries assuming a 50 percent increase in crude oil prices over the 1988 price level. [1]

Before presenting the results of the FEMA simulation, it is necessary to recognize some of the limitations of the assumptions underlying the study. First, the model assumes a full-cost pass-through of petroleum price increases in all industries. Each firm raises the price of its product just enough to keep profit margins unchanged. Furthermore, there are no demand changes as a result of the price increase, i.e., the model assumes that consumers and businessmen do not buy less of any product because of higher prices. Finally, all the price changes are measured on an annual basis after the initial shock has abated and the economy has stabilized. All these restrictions tend to maximize the overall impact of a change in price. The FEMA model should be viewed as generating likely short-term effects, recognizing that over time producers will conserve petroleum and consumer demand will shift away from products with relatively high prices.

The FEMA study assumes a 50 percent increase in world crude oil prices over those in 1988, a rise from about $18 to $27 per barrel. When this oil price increase is fully passed through all the various business sectors, the general price level will increase by 1 percent. This is a substantial increase. Such a price acceleration is just about equal to this year's inflation-adjusted economic growth. A 50 percent increase in crude oil prices also leads to a 26 percent rise in the price of gasoline and fuel oil. These refined products are widely used throughout industry. The large increase in gasoline prices will be transmitted to all products in the industrial sector. Every business sector either directly consumes refined oil products (the direct effect) or buys components in which petroleum products have been used in their manufacture (the indirect effect).

How is the cost of production in specific manufacturing industries likely to be affected by a $27 barrel of oil? As shown in Chart 6, the magnitude of the cost increase varies significantly by industry. The largest cost rise, excluding the effect on the transportation sector, is estimated to be in the category "other petroleum products," which includes paving and roofing materials, lubricating oils and greases, and petroleum coke. Cost increases for this industry are likely to be in excess of 5 percent. Industrial chemical costs are predicted to rise 4.9 percent, plastics and resins 2.8 percent, and paints and other chemicals 2.2 percent. Further down the petroleum intensity chain are primary aluminum and transportation industries where costs will go up about 1.7 percent, then electric utilities, rubber, tire, and fertilizer firms should experience a 1.3 percent cost impact.

Table 1 condenses the 135 industrial sectors to a 2 digit SIC code level. The table shows that even within the same industry, there can be wide variations. For example, in the chemical industry, there is a moderate 0.8 percent uptick of costs in drug and toiletries, while there is a rise of almost 5 percent in industrial and inorganic chemicals. Primary metals is another industrial sector that has a rather wide dispersion, because aluminum production is much more energy-intensive than other metals. Other than chemicals and primary metals, variations within 2 digit SIC code categories are generally less than one half of one percent.

LONGER RANGE IMPACT ON U.S. INDUSTRY AND THE ECONOMY

The results of FEMA's unpublished study are based on the static interrelationship of costs and prices among industries. The study is a short-run snapshot of the likely effects of a significant rise in oil prices. In the longer run, even if those OPEC countries with excess production capacity decide against increasing oil production to offset the loss of Iraqi and Kuwaiti oil, some non-OPEC producers will be able to expand capacity. In the future, the Soviet Union, which produces twice as much crude oil as Saudi Arabia, is potentially a significant source of increased world oil production.

In addition, industry will adjust to the higher production costs. Where possible, firms will try to substitute other forms of energy for oil. The U.S. Department of Energy has published estimates of industry's ability to switch from petroleum products to other sources.

1. Only 3 percent of the nation's oil demand could be

switched to natural gas or to other energy sources

within 30 days (4 percent within 6 months) using

existing equipment and with no loss in overall economic

activity. There are even more severe limits

on the substitution possibilities for petrochemical

feedstock since there are no convenient substitutes.

2 . For many manufacturing industries, however,

there is much more flexibility than is available for

the economy as a whole. Manufacturers report they

can convert 40 percent of their fuel oil burners

primarily to natural gas within six months. Another

9 percent of manufacturing's liquid petroleum gas,

still gas, and petroleum coke also can be switched

in a half a year. In total, manufacturers could reduce

U.S. oil consumption by 230,000 barrels a

day without adversely affecting economic output.

This represents about 8 percent of current consumption

by the manufacturing sector.

3. A 50 percent increase in oil prices will add about

1 percent to the bill for producing the same goods

and services as last year. This will reduce the real

income in most oil-importing nations. For the

United States, it will be difficult to continue even

modest economic growth.

The future performance of the U. S. economy also will be influenced by how public policy responds to the rise in the world price of crude oil. In the short run, a I percent rise in the price level is expected to occur. Whether this inflation is followed by continuing upward pressure on prices depends on how the Federal Reserve reacts to the initial price shock. If the money supply is increased to offset fully the effects of higher costs, there is a risk of reigniting the inflationary spiral that culminated in the double-digit inflation in the late 1970s, inflation that was only controlled by back-to-back recessions in the early 1980s. On the other hand, if the central bank rigidly continues a tight money supply policy, the risks of pushing the already fragile economy into recession will increase.

Currency outflow is another problem exacerbated by higher oil prices. Even with some expansion in domestic drilling, U.S. domestic oil production will probably continue to decline. Old oil fields are being depleted faster than new ones can be brought into production. Therefore, absent a large decline in demand, the volume of imported oil will continue to rise. This increase in imports, together with a higher world market price will increase the U. S. merchandise trade deficit and more dollars will flow out of this country. The economic impact of this trend on manufacturing is uncertain. If the dollar continues to decline in value, as is likely, this will benefit U. S. exporters as the foreign demand for U.S. products increases. However, oil is denominated in dollars, and a declining dollar makes oil less expensive to other countries. Reducing this gap also will be made more difficult if U.S. exports are adversely affected from a decline in the strength of the economies of our trading partners. The long-term implications for U.S. consumers will probably be a lower standard of living.

There are some clear "losers" and some "winners" among businesses in the industrial sector of the economy. As discussed previously, the escalation in oil prices will raise costs and reduce demand in such industries as plastics, rubber, aluminum, and other primary material suppliers. Consumer goods and equipment manufacturers will seek alternative sources of energy and pressure their suppliers for increased productivity and/or lower margins. Also, the transportation equipment industry is likely to be adversely affected by higher fuel costs, not so much directly as by purchasers' response to the higher operating costs.

The economic disruption from the current oil crisis will, of course, benefit a few industries. At the top of the list is the oil-exploration and oil-producing companies. Higher oil prices create the incentive necessary to drill for oil. As drilling activity picks up, drilling equipment makers and oil field service companies also will benefit from the rising demand for their products and services. Another beneficiary will be the natural gas industry since higher oil prices will encourage more fuel oil customers to convert to natural gas.

Large, sudden changes in the price of oil are roughly equivalent to a tax on consuming nations to the benefit of OPEC members and other nonaligned oil-exporting nations. The current crisis once again highlights U.S. dependence on foreign sources for a large share of its petroleum needs. While there are no gas lines, the decade of complacency concerning our energy vulnerability should now be over. Even after the current Middle East crisis is resolved, the time lag in bringing capacity back on line is likely to mean that oil prices will rise faster than general inflation, at least for a number of years.

Perhaps the most significant longer run implication of the current rise in the price of oil will be the realization that government policies should encourage a more rapid shift toward greater reliance on nonoil sources of energy. As a nation we must find more promising ways to encourage the construction and operation of nuclear power plants and do a better job of explaining to the public the high degree of safety associated with new nuclear technology. In addition, current government policies regulating the development of oil resources offshore and on federal lands should be reassessed. In essence, public policy must establish a more realistic tradeoff between legitimate environmental concerns and the need to develop domestic oil reserves and other potential sources of energy, in ways that recognize the importance of energy to the U.S. standard of living.

* Daniel J. Meckstroth and Patricia Buckley are economists with the Manufacturers' Alliance for Productivity and Innovation (MAPI) in Washington, DC. The authors are indebted to Ken McLennan, MAPI President, for his helpful comments and editorial assistance. A longer version of this study first appeared as a MAPI Economic Report ER-189, August 28, 1990.

FOOTNOTES

[1] E. Lawrence Salkin, Federal Emergency Management Agency, unpublished study, Washington, DC., August 1990. The results of this study do not necessarily reflect official opinion or policy of FEMA or the United States government. (TABULAR DATA OMITTED)
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Author:Meckstroth, Daniel J.; Buckley, Patricia
Publication:Business Economics
Date:Jan 1, 1991
Words:3175
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