Oil Price Change on the United States Economy - Research Paper Example

The impact of oil price change on US economy Affiliated Abstract Out of ten recessions, nine have been preceded since WWII, by a large increase in the oil price. This paper will use time series analysis to focus on the GDP growth using prices of oil. The methodology from Hamilton (2009) will be used. Functions of the impulse response will be used to analyze the performance of the historical models. The International Monetary Fund changed its forecast of the GDP growth in U.S in 2011 from 3.0% to 2.8% as a result of the persistently high prices of oil. The increase of oil prices 2011 would lead to a 2% growth in 2011 in the U.S economy. An increase of 54% in the prices of crude oil in 2011 would lead to a double recession in the U.S. Keywords: GDP, U.S economy, oil price, recession, crude oil I. Introduction This paper aims at examining how shocks of oil prices in the past have impacted the U.S. economy, and makes predictions on how the economy will do in light of the recent oil prices. Using the methodology of forecasting from Hamilton (2008) with time analysis, the paper will use the impulse response functions from the prices of oil to predict the response of GDP. The literature review will be used to describe how oil is an integral part of the economy, and how recessions and oil shocks have coincided ever since World War II. The paper will point out the disagreements in the literature about the impacts of oil shocks on the U.S. economy as well as the asymmetry of price increases and price decreases. According to Hamilton (2010) when an embargo on oil was instituted by the Organization of Petroleum Exporting Countries (OPEC) the global supply of oil fell by 7.5%. The 1973 oil crisis effects were far reaching. According to Forrester (1984), the U.S set the target of reducing the consumption of oil by 25% at that time led by Richard Nixon. A country wide speed limit of 55 miles per hour was temporarily passed by the congress, and this continues until 1988 (Frum, 2010). The use of Christmas trees was banned in Oregon State (Frum, 2010). Many gas stations in the U.S were shut down as a result of insufficient oil supply, as many other gas stations rationed the gasoline supply (Hamilton, 2010). The American lifestyle was threatened by the Middle East instability which had a huge effect on the American people (Dahl, 2003). As a result of the political turmoil in Libya in 2011, the prices of crude oil went up to two and a half year high. As the issue was addressed by the U.S president, it became clear that, the U.S used 7% less oil in 2011 than in 2005, but still depends on the foreign oil. According to the U.S. imports over 55% of crude oil from outside. Although this does not directly come from Libya, other countries such as the European countries import it from Libya, then shipped to the U.S. for refinery, then shipped to the European. The International Monetary Fund changed forecast for growth in the U.S. from 3.0% to 2.8%, in April 2011 mainly as a result of increase of oil price (Smith, 2009). With the persistent rising of oil prices, the Justice Department suspected fraud in the gasoline price setting and initiated an investigation (Pindyck, 1999). While the price of oil is the most important and frequently making headlines in the news front page, there has been a huge disagreement in the literature about the impacts of the oil prices in the GDP of the U.S. The instances of oil shocks are of high interest (Linn and Zhen Zhu, 2004). 2. Literature Review I review the literature on the shocks of oil. I will examine the history about oil in the past and explain theories of the impacts of oil prices on the economy. 2.1 Oil Shocks The cause of oil shocks and its effects have the same effects on the industrialized countries. According to Kilian (2007), all the G7 countries except Canada are big oil importers. Increases of oil are associated with a real GDP hit generally the second year after the shock. There is a substantial amount of disagreement in the literature over the amount of prices that have an effect on the economy of the U.S and through what mechanisms these effects are noted. Gali and Blanchard (2007) argued that, the present economy can easily adapt in case of shocks than in the past. Their argument made sense in the focus of the price increases from 2002 to 2007 without commensurate recession. Nordhaus (2007) also accepted that, the effects were small in 2002 to 2007 as they were not fast. Edelstein and Kilian (2007) realized a declining impact of energy price shocks on the measure of aggregate consumption. From a sample in 1970 to 2006, an increase of 1% of energy prices led to a 0.03% decline in consumption in a year later, but 0.08% for the next second and a half. The reasons for this was attributed to lack of recession in combination of automobile industry, which had decreased since the previous shocks as well as a Federal Reserve, which set up a credibility in maintaining the flow of inflation (Blanchard and Gali, 2007). Unfortunately, the 2007-2008 recessions gave a challenge to the literature that the economy was immune to oil price shocks. Though the intensity of energy had fallen greatly in the 1970s, according to Kilian (2009), it began increasing after 2000. The intensity of energy was around 8% in the 1970 and increased steadily to 13.7% in 1981. In 1999, it declined to 5.9%, but again increased in 2008 up to 8.8%. Hamilton (2009) argues that, the increase of intensity of energy fueled the effect of oil price shock. He further says that, that with the earlier increases in many people could still afford to buying energy, but by the end of 2007 they could not afford and a threshold was reached which led to the collapse of the housing market as well as the financial crisis. According to Hamilton (2009) the recession in 2007-2008 was not supposed to be there without the increase of oil price. However, the claim by Hamilton does not attribute the housing bubble as well as the falling of the financial industry, which is the main cause of the Great Recession. In his argument, demand was increasing globally starting in 2002 to 2007 and as a result of the increase in supply, it increased in 2004 to 2006. The impacts of the price of the demand increase were not realized until the decline in production in 2007-2008. Since the housing market had created an economic drag, the increasing prices of oil turned the economy into the housing crisis as well as the financial meltdown (Hartley et al, 2008). 2.2 History of Oil before World War II The first commercial crude oil was produced by Edwin Drake in 1859 (Hamilton, 2010). The tax for alcohol added to the oil in 1862 made it too expensive to produce. This led to the making of petroleum, which became a norm. Although the oil industry grew after the civil war, it only accounted for 0.4% of the GDP in 1900. As the use of petroleum increased, petroleum products became of value in all aspects of the economy (Hooker, 1996). The oil industry changed in two ways after the Great Depression. First, it was constantly regulated, and secondly, it became highly controlled by Texas. While Texas became the major producer of oil in 1930, it would produce up to 40% of the crude oil in the U.S (Hamilton 2010). 2.3 Oil price behavior after World War II From 1948-1972, the TRC would forecast demand for the upcoming month and set production levels to meet the demand (Hamilton 2010). According to Hamilton (2008), countries exporting petroleum became played a major role in the global oil market, by changing the levels of production in response to demand fluctuations in demand. Hamilton (2008) states that, out of the ten recessions in the U.S since WWII, nine recessions have emerged as a result of the rising prices of oil. 2.4 Mechanism of effects The demand for oil depends on the income. More oil is needed to fuel the growth of the economy. The price elasticity of demand, which measures demand in a 1% increase in price, is necessary in metric. Since individuals are not willing to change the consumption of oil, the price elasticity of demand for oil is therefore low. Hamilton (2009) gives an estimate of the price elasticity of demand for gasoline in the short-run as 0.23-0.36 from 1970-1980 and 0.035-0.078 in 2000-2006. This indicates a lack of adjustment to the changes in price. The intensity of energy to the economy of the U.S. has been constantly dropping since the 1970s. With 1 % income elasticity and below, the increase in oil income, increases consumption by a smaller percentage, resulting in a fall in energy intensity (MacDonald, 2003). However, with low price elasticity in the short-run, when the oil price increases, the demand decreases by less the increased price and the intensity of energy increases (Hamilton, 2009) A production a firm function Y can be expressed in terms of its labor (N), the capital (K) and energy (E), with the following formula: Y =F (N, K, E) . If P represents the nominal price, W represents wages, Q as the price of energy, and r as the nominal interest rate, and then the profits can be given as: PY- WN- rK- QE This means that, the firms will consume energy until the marginal product of energy will be equals the energy price. Therefore, the elasticity of output for energy change use can be predicted using the intensity of energy (Hamilton, 2008). 2.5 Asymmetry Hooker (1996) argues that, changes in price are no longer the cause of GDP growth. When Mork (1989) ran the equation of Hamilton with different coefficients for increases and decreases of prices showed no statistical significance. Hamilton refuted the claims of Hooker and then gave a new form of asymmetry to solve the differences. His proposal showed some sort of asymmetry, but there the nature was not clear. 3. Methodology 3.1 Data The dataset used contains real GDP and crude oil prices from the first and fourth quarters of 1947 and 2010 respectively. My Gross Domestic Product data used was in real values. The 2005 was used as the base year. The prices of oil measurements used for domestically produced oil was the oil Producer Price Index (PPI). The values for each month are the averages of payments by the oil refiners for crude oil produced in that month. Since the U.S. imports 55% of the crude oil and petroleum products it uses and all the prices are established by the forces of global supply and demand, then the PPI for domestic crude oil is easy to measure. As the crude oil values of PPI are recorded monthly, I took the end values of each quarter to convert the values to a quarterly dataset. For instance, the first quarterly value for the year 2011 is equal to the crude oil PPI for March. Oil shocks can be measured the same way as Hamilton (2008). By using the data from each month, the recordings of the previous three year high are taken in each quarter. If the quarterly value is greater than the three year high, the percentage increase in the past three-year high is the oil shock. 3.2 Discussion The International Monetary Fund (IMF) in April 2011 decreased its forecast for U.S. 2011 nominal GDP growth from 3.1% to 2.9%, as a result of increasing oil price. The PPI for December 2010 which is the fourth quarterly value is 242.0. This value increases 18% to 293.5 in March 2011 in the third quarter value. Since the oil prices dropped largely in July 2008, the value of March 2011 is two and a half year high. Therefore, I conclude the shock include is nonetheless. The three quarters after the shock are at the end of 2011. Given the oil price increased 18% from 2020Q4 to 2021Q1, the real GDP will be lower by 1 % or lower. Conclusion As this paper has examined the forecasts of GDP growth based on oil shocks, the prices of the retail gas have continued to rise to date. As the U.S. is coming out of a recession the demand is expected to rise, which will continue to rise until the market realizes that this commodity is overvalued. The falling dollar also increases the chances of the continued rise of prices will for Americans. The economy of the U.S. needs demand to be stimulated, and that the oil prices would decline once the global demand is slowed. References Dahl, C. (2003), “International Energy Markets: Understanding Pricing, Policies, and Profits” Ch 15. Energy Futures section. Hamilton, J. (2009). “Understanding Crude Oil Prices.” The Energy Journal, vol 30, no.2: 179-206. Hamilton, J. (2010). Historical Oil Shocks. Prepared for the Handbook of Major Events in Economic History Hooker, M., (1996). What happened to the oil price-macroeconomy relationship? Journal of Monetary Economics, 38, 195-213. Linn, S. and Zhen Zhu (2004), “Natural gas prices and the gas storage report: Public news and volatility in energy futures markets” Journal of Futures Markets, Vol 24, No. 3, pp. 283-313 Hartley et al, (2008) Peter R. Hartley, Kenneth B Medlock III and Jennifer E. Rosthal, The Relationship of Natural Gas Prices to Oil Prices, The Energy Journal, Vol 29, No 3, pp. 47-65 MacDonald, R. (2003), “Derivatives Markets”, published by Addison Wesley, Chapter 6. Pindyck, Robert (1999), “The Long-Run Evolution of Energy Prices” Energy Journal, Vol 20, No. 2 Smith, J. (2009). “World Oil: Market or Mayhem?” Journal of Economic Perspectives, vol 23, no.3: 145-164. For questions contact: denjax54@gmail.com Read More