Oil Crisis 2008: Economics Lessons Learned and Not Learned

Forty years ago, as a sophomore at Colby, I took my first economics course. (In those days economics was thought too complicated for freshmen.) I still have the copy of Campbell McConell’s text from that class and, since I have made my living mostly as an economist over the past three decades, there is distressingly little in it that I have forgotten, though much has changed from the economic world it described.

Five years after that class came America’s first really hard lesson in supply and demand since the Depression: the Arab oil embargo of 1973. Oil prices doubled overnight. About six years later came the Iranian revolution. Oil prices tripled. This summer oil prices spiked again, reaching the once undreamed of level of nearly $150 a barrel. In each period the usual suspects were rounded up: oil company executives trooped to Capitol Hill to listen to accusations of profiteering, and unnamed speculators were condemned as everybody looked for someone to blame.

But less than 90 days after this summer’s peak, oil prices have dropped by more than 40 percent and everyone is saying how lucky we are. The rise and fall have been breathtaking, from minor problem to epic calamity to no problem in six months. In the midst of a crisis in the financial system that will force a rewrite to every economics textbook published, what do we make of an oil crisis that has receded into memory like the mosquito bites from summer days at the beach?

Actually, the “energy problem” is still here in important ways. Prices may have fallen 40 percent, but they are still 300 percent higher than just a few years ago. While a collapse in demand has temporarily better balanced oil supply and demand in the world, output has not been growing, while demand from countries like India and China has been—rapidly.

Absent the current business cycle, the imbalance between supply and demand means that oil should be priced higher than it has been most of this decade, probably $80 to $90 per barrel, which still translates into much higher priced gasoline and fuel oil in the United States than we are used to.

Another issue is the dollar. Oil is priced in dollars throughout the world. While the dollar has recovered some of its value as oil prices have fallen, it will remain weak for years to come because of the massive U.S. trade deficit, and this will contribute to higher oil prices.

Another enduring problem is the “risk premium.” This is the additional price people are willing to pay to hold oil for fear of more problems in the Middle East. The risk premium has shot up repeatedly during the Iraq war, and while it is currently low, it is only one violent event in a violent region from coming back in full force.

What is new is extreme volatility. In the 1970s energy crisis it took about six years to reach the peak and another six years for oil prices to begin to fall. Now the swings happen at hyper speed: six months from bottom to top and back again.

Given that none of the fundamentals for higher oil prices have gone away, and new reasons such as carbon taxes to mitigate global climate change are in the offing, should we all just breathe a sigh of relief and say, “Wow! Glad that’s over”? If we do, the only certain thing is that we will experience all of this once again in a few years—or a few months—or maybe even weeks.

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Comments

• On November 2, 2008, C Smith wrote:
  It shows how conditioned we quickly became to oil at $140 a barrel that we should be relaxed now. You are right of course. Oil production has peaked and the present banking crisis with its consequent economic regression will lull many of us into believing that, in a couple of years, all will return to normal. This is the political mantra after all. Indeed, I see some commentators are suggesting we can go out and buy gas guzzlers again: heat off. Nuts. Normal had become very, very expensive oil, that we could not, cannot, afford. Any minute now there will, as you suggest, be another oil supply shock. At this point head for the hills, if you have access to a hill, and nobody else is on it of course. My contention is that we have entered a new fifth century, and you know what happened to the west then.
• On December 3, 2008, Ken Bruder wrote:
  Alternative energy is being hit with a triple whammy--not only does the lull in oil prices depress development, but also the fact that many deployments of clean energy are early stage and capital hungry impedes build out of new infrastructure. The credit crunch could not have come at a worse time. However the fundamentals remain strong...energy security is a top concen and nearly all scientists say climate change is still getting worse. Also the post WW-II energy infrastructure is falling apart and needs radical updating. Rather than tax oil (something that Congress will never pass), the more expedient route will be to impose a carbon cap and trade system or a neutral revenue carbon tax...any revenues generated can be used to invest in smart grid deployment and energy efficiency retrofits. This would be a radical restructuring of the markets and can only come about if we have some true energy leadership...something sorely needed in America.