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The Texas economy: will the recovery continue?

The Texas Economy: Will the Recovery Continue?

Since the Texas economy began to recover in early 1987, its growth has been modest, but persistent. Will this expansion continue?

Traditionally, the answer to that question would have hinged in major part on expectations for the price of oil. However, following the peaking of oil prices in 1981, the Texas economy underwent a major structural transformation, the effect of which was to increase its dependence on national economic conditions and to reduce its reliance on the oil and gas industry. this intuitive observation has recently been confirmed by an econometric study which found that compared to ten years ago, nonagricultural employment in Texas today is 62 percent less sensitive to unexpected changes in real oil prices and 338 percent more sensitive to unexpected changes in national employment.

Nonetheless, the oil and gas industry remains significant in Texas. Most forecasts for the state's economy base growth projections on expectations for national economic growth and for oil and gas prices.

Continued Expansion of U.S. Economy

The U.S. economy has completed nearly six years of expansion - a peacetime record - and shows little sign of stopping its growth in 1989. However, most observers expect the rate of advance in the national economy to moderate this year - averaging 2.5 percent to 3.0 percent on an inflation-adjusted basis as compared to 3.5 percent for 1988.

Why has the current expansion gone on for so long? First, while the national economy has been able to sustain growth since the first quarter of 1983, the pace of growth has varied widely across sectors of the economy. Thus, the energy, farming, and manufacturing sectors have experienced "minicycles" of contraction and expansion, while the overall economy has continued to grow, spurred by rather constant growth in consumer demand.

Second, most expansions since World War II have been brought to a halt by higher interest rates resulting from Federal Reserve action to fight inflation. In the current expansion, however, the bond market has shown such sensitivity to the prospect of inflation that at the first signs of accelerating prices it has made what might be termed "pre-emptive strikes" to drive up the market rate of interest. This has enabled the Fed to moderate its actions. While real interest rates have remained relatively high, the country has avoided the sharp spikes in rates so characteristic of earlier peaks in business activity.

Third, structural changes in the economy have enhanced its stability. The U.S. has become more of a service economy, and the service sector is inherently more stable than the manufacturing sector. Moreover, part of the instability in manufacturing results from the difficulty of controlling inventories. However, with modern computer information systems and improved inventory control methodologies, an unwarranted buildup of inventories is much less likely today than in the past.

Finally, some credit for the economy's sustained growth should go to the adoption of public policies to reduce marginal rates of taxation on income, to deregulate specific industries, and to permit flexible exchange rates. At home and abroad the movement toward greater reliance on market mechanisms has encouraged entrepreneurship and stimulated trade.

A popular conception is that the expansion of the economy is threatened by the existence of the twin deficits - the budget deficit and the trade deficit. A good argument can be made that neither deficit poses a threat to the continued expansion of the economy. But even if one accepts the argument that the deficits are potentially detrimental, there is little evidence that they will bring economic growth to a halt in 1989.

While many economists expect a recession in 1990, their justification for this pessimistic outlook is based more on an attitude of "things can't go up forever" than on any hard evidence of an impending crisis. In short, in 1989 the Texas economy should continue to find support from both national and international economic growth. If inflationary pressures can be kept under control, there is no reason that growth should not continue in 1990.

The Prospect for Oil Prices

Econometric forecasts of the state's economy generally assume prices for West Texas Intermediate crude in the $15 to $18 a barrel range over the next few years (1988 dollars). How realistic is this assumption and what impact would different price expectations make on the performance of the Texas economy?

Given the instability shown by oil prices in recent years, it is difficult to have much confidence in any forecast. While supply and demand forces can be measured and projected with some degree of confidence - particularly in the short run - oil prices are determined by the actions of the OPEC cartel in restricting output. The cartel's success in setting prices is limited both by the imperfections of the price-setting mechanism (e.g., the seasonal volatility of oil demand, the absence of perfect information on actual output and prices) as well as by the difficulties involved in obtaining agreement among the cartel members on pricing objectives.

The firming of oil prices over the past few months has resulted from decisions made at the OPEC meeting in Vienna in November. The major impact of that meeting was to bring Iraq under the quota system and to obtain agreement on a reallocation of output among members of the cartel. It remains to be seen if members will abide by their quota allocations. In addition, fluctuations in demand could invalidate the quota system, and overproduction could once again drive prices below targeted levels.

Even if this should occur, however, it is doubtful that a $3 to $5 a barrel fall in world oil prices would result in much of a reduction in the rate of growth of the Texas economy over the next two years. Today's rig count reflects mostly workovers and infill drilling - very little true exploration activity can be sustained at today's prices. Most production activity would remain profitable at WTI prices of $12 to $15 a barrel. Moreover, OPEC has demonstrated its ability to "get its act together" when oil prices fall low enough to threaten domestic budgets (with the critical level being about $12 a barrel). Thus, producers would expect oil prices to rebound and would act accordingly.

Clearly, if oil prices could be held at $12 to $15 a barrel for a sustained period of time, the rate of growth of the Texas economy would be slowed - perhaps by as much as 15 percent (e.g., from an average annual rate of growth of 3.2 to 2.7 percent). However, such a prospect seems unlikely. At these lower prices, consumption would spurt and without incentives to drill, non-OPEC output would probably decline. This would have the effect of placing OPEC back in the driver's seat.

A more likely scenario is for oil prices to gradually strengthen over the next few years, setting the stage for more substantial increases in the 1990s. Demand for oil is increasing at about 1 to 1.5 percent annually. Since most non-OPEC oil is coming from depleting fields and current prices cannot sustain exploration to replace reserves, non-OPEC production should decline in the early nineties, paving the way for OPEC to regain control of world oil markets.

One factor that could increase the rate of growth of the Texas economy over the next few years is a recovery of the natural gas market. On a Btu equivalent basis, gas should sell for about one-seventh the price of oil. In recent years, natural gas has been in surplus and oil has been selling at ten to eleven times the price of gas.

The key to higher gas prices is improving the marketing of natural gas. Given that gas is clean burning and emits fewer pollutants than other fuels, it should sell at a premium. If public policies support the use of gas in place of other fuels, demand should increase and prices should firm. This would help the Texas recovery since the state has large reserves of natural gas.

In summary, expansion of the U.S. economy over the next two years should support the continued recovery of the Texas economy. By the end of this period, the rate of growth of output and employment in Texas should approximate that of the nation as a whole. Moreover, it is unlikely that the state's economic growth will be impeded over the next few years by a reduction in world oil prices. Finally, the potential exists for accelerating the rebound of the Texas economy if natural gas becomes widely viewed as a premium fuel.

Jared Hazelton Economist Southwest Econometrics, Inc.
COPYRIGHT 1989 University of Texas at Austin, Bureau of Business Research
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Author:Hazelton, Jared
Publication:Texas Business Review
Date:Apr 1, 1989
Words:1429
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