-

nUIIUlIUIIU"iIR\1 H.\:\KOfU\IJ.\<; :\0\1 \IKI R I'NO

Oil Pricesand the

EconomicOutlook

Events in the Middle East have pro­pelled oil prices to highs nO( seen

since 1981. september prices represent

sever.d factors: the shortfall in world oilsupply C.luscd by the loss of lr:tqi and

Kuwaiti exports, increaM.-d production

in other countries and fears of a greater

disnlplion in oil supplies. 111C outlookfor oil prices will depend on the length

of the Middle East crisis :111<1 the natureof ilS resolution.

Higher oil prices come al a timewhen both the nalional and Southwesteconomies 3re weak. If higher oilprices are sustained, they will weaken

the national economy while strengthen­

ing the SoUlhwcSl economy. JUSt howmuch they hurt lhe nation:.] economyand help the SCx.llhwest economy will

depend on how much oil pricesincrease and how long the increase isglJS(ained.

WorLd Oil Prices Today

lraq's invasion of KU\\''3it and thesubsequem embargo more thandoubled the price of od cwer a IWo-

month period. By lhe lasl week ofSeptember. thc price of Wesa: Telt3SImenne<!i:lte erode rose to nearly 540per barrel-a price 1'1()( seen since

March 1981. Adjusted for inflation. theSeptcmber high was only 70 percent ofthe 1981 peak price (Chart I).

Before Iraq invaded Kuwait. the lWOcountries logether exponed 4.3 millionb-J.rrels of oil per diy, which is about 8percent of free-world oil consumption.By September, Saudi Arabi:_, Vcnczuelaand the Uniled Arab Emir.Hes (UAE)increased their production by anestimated tolal of 2.6 million I):mds perday, reducing the shonf:11I from the lossof IrJ.qi and Kuwaiti oil to 3 percent.Had Saudi Arabia, Venezuela :J.nd theUAE not incrc:J.scd production. pricesprob:J.bly would have re:lched :Ilmost$50 per barrel.

O\'er time, more of the shortfallcould ~ made up by incre:J.scd pro-

Chart 1Real Oil PriceWest Texas Intermediate Crude

1990...-s 1* bamil

55ss

"..55

'"""I-r-----"",o~ n n ~ u ~ M M ~

Chart 2Petroleum Supply

duetion in Saudi Arabia, Venezuela, theUAE, Indonesia and J\lexico (Chart 2).Together, these countries could sustainproduction of an additional 0.8 millionb.'1rrels of oil per day. That extraprodUCtiOn would reduce the shortfallto 0.9 million barrels--less than 2percem of free-world oil consumption.The United States could also addanother one-half million barrels perday, but only jf environmental restric­lions in California and Alaska are

overcome.In the authors' judgment. continu­

alion of the political standoff in theMiddle East would suppon oil prices nohigher than $30 per barrel. In the lastweek of September, however, the spot:price of West Texas Imennediale crudewas much higher, reflecling market

fears lhal military conflict in the MiddleEast would further disrup( oil suppliesand push prices much higher.

Oil-Price Oullook

assume normal se;lsonal patterns in oildemand-unlike the abnormally warmwinter of 1989-90, which greatlyI\.-duccd dcmand for hcaling fuel.

As the crisis in the Middle Ea~ isresolved. we expect prices to gr:witltctow·,1rd the base C-.lse. 11lC actual pricepath will (k:pend on the structure of theOrganization of P(:troleum F..;II:portingCountries (OPEC). [f OI}EC is moreeffeai\'c in restraining its productionttun il \\.'35 bcfore the Middle East

crisis, prices will be higher than thosein the I):;l,se case. If OPEC is less

cffectivc than it was before the crisis,prices will be lower than those in the

""" ~,Case 1 In the tiTSl sC(·nario. we assume

The outlook for prices over the nextfew rears depends on how long theMiddle East crisis bsts and how it isresoh·ed. 111e authors fOI\."C3st pricesfor WCSI Texas Intcnm'diate crudeunder t1m_'C scenarios that represent awide range of possibilities: a prolongedMiddle East standoff, a brief conflictwith minimal damage to Iraqi. Ku\.vaitiand saudi Arabian oil fl("lds and aprolonged conflia \\. ith cxtl'Jbivedamage 10 oil fields in lhese threecountries (Chart 3). We contrast these

scenarios 10 the base case, whichrepresems our opinion about probableprices if no disruption of oil suppliesfrom the Middle East had occurred. [n

the base case, we assume that theworld economy and energy (k:rnand

grow at an allL'mic pace through earlr1991, then strengthen by 1992. We al.'iO

Chart 3West Texas Intermediate Crude Price-­Base Case and Three Supply-ShodlScenarios

R<....-iSf.-"d dala rrom lhe U.S, Depart­ment of Commerce re\'eal thai gros...national product (GKP) gro\.\.'Ih slowed

dramatically in 1989, compared 10 ilSpace in 1987 and 1988 (Cb(lr14).

GroWlh remained sluggish into 1990.Thus, lhe economy gTe\\. at a 1.7­percent annual f31e in the fir'Sl quarterof 1990 and at only a O.4-percenl

A Weakening National Economy

Oil Prices and the

National Economy

Ilighcr oil prices rome al a timcwhen n:ltional economic growth h;15Ix'{'n :;Iuggish, but inflation has <:ontin­u(,'C! to increase. !lad oil prices llOI

Ix.....n driven llpW·..rd. growth wouldhave remaint.'C! .slow lhrough early1991. butlhe United St:lIc.s prol)ablywould ha\'c avoided a recession. Ane:tsing or inflationary pressures wouldhave accompanied somewhat higheruncmployment T:1tcs.

f [igher oil prices will push then::tlion;ll economy toward recessionwhile proViding :l tempoT:1ry stimulusto inflation. TIlt: depth and dUT:1tion orany nalional t.--'Conomic slowdown willdepend on how high oil prices rise.But, in any case. higher oil prices willlcad 10 greater inflation through lhecod of this year and into 1991.

about 9.3 million barTels per day-alillie less Ihan 20 percent of rree-worldoil consumption.

As with the brief conflia, price5would rise to near s60 per barrel in thefourth quarter of 1990. As the confliacominucs into the tirsl quarter of 1991,

oil demand would hit ilS seasonal peakand prices could climb 10 more ltunS~O JX'! barTel. Pri\.'3le and Slralegk

stocks would likely be drawn down 10cushion the price shock. Without adt:lw-down of inwmories. prices muchhigher ttun S70 per barrel wouldpTC\.-,1il. After the conflict ends, priceswould fall as fields are gr,lduallyrestored to production. Prices In this

scenano remain above those in theOase c-,e,e because lhe lime needed 10reston: fields and rebuild inventoriesextends beyond our fOR-"C:Ist hori7.0n.

that the September 1m standoff is 1)rQ­

longed and that oil produaion IOSI in[rJ.q ::md KlIW;lit is parti:llly nmdc up byincreased produnion from countrieswith cxcess cap.1dt)'. In this case, t1~

price of WCSI Tcxa~ ImemJe<hate crudcca.n be eXpt:tR"d 10 r:lngc rrom S2'} to

$30 per oorrel. If market fcars ofmilitary conflia pT'C\'3il throughout the

standoff. lhe price could range fromS30 to S-i5 per barTel.

As the srandoff conunucs. theshortfall in production will incn.'3sebecause demand will rise fa~{'f ttunproduction. TIx: growing shortfall \\. illexen continulOg upward pressurt: onprice. Pores from S2:5 to S30 pt.... barrelshould reduce consumption suffici\.-ntl)

to close the shonfall. IIiWJcr pri~ willreduce oil consumption in '>(....•...'r,ll\\.-,1)"5: through swildlin~ from pt:tra­Icum prodUCb to other energy sourcc.:.,through encrgy ron.-'iCn,':ltl0n. throu~h aslOWing world t.'COllOm)' and throu~h ashift in the composilion of outpOl fromthose goods whose production a...encrgy-intcmive to those ~oods whose

production is not Given the pos..."ibllltyof milit;uy conflictth;lt could run herdisrupt the oil supply. we a.s~ume tl1:Hcrude oil im'enlories will nm pIa)' muchOr;t role in the first ~'Cn:Lrio. (&'t: thebox, "lnlJ(!lIIolies o[Cnu/e Oil. ")C(fS{' 2. For the M:cond sCcn:lrio, we

:Issutne tl1:11 a brid military conflictresults in moder:Hc c!:Jmage to the oilfidds in Kuwait, 1r:1{] and Saudi Ambia.

Under this scenario. lhe confliel beginsin the fourth quarter of 1990 and isn:soIR'C! by 1991. Repairs to thc fieldsoccur over the next six months. [n thiscase. we expca the price of oil to <;Qar

to about s60 per harn'l in the fourthquarter of 1990 before dt.--'Clining towardthe IY.lse<:iSC prices. In the scenario.we assume fears thaI the conflia couldbe prolonged will prc\.ent eXlenshcuse of .sIrategic and commercialinventories of crude oilcase 3. For the third scenario, weassume a prolonged conflict that la:>l"up to nine month... and fl..'Suh.:. inextensi\'e dama~e to the oil tieltb inSaudi Af3bia. Iraq and Kuwail_ Again.we assume that lhe conflict lx:gins inthe fourth quarter of 1990. In this case,the initial oil-supply shortfall would be

Stando!t

1991 1992

"

~ Brier Conrlicl

"\ ... ....

B'M

/'../ \ Prolonged ConfitCI

'"'"""""0

1989 ""

GNP Deflator

.....Forecast

.......... ,.,

........

......... ForecaSl"'- .. ....... . ..

AClual

•

Chart 6Base·Case Scenarios for Real GNP Growtharn:llnflation

Higher Oil Prices and theRevised National Outlook

Given the reality of the invasion :lndthe subsequent hikes in the price of oil,how has the outlook for the national

economy changed? Chart 7 depicts theimpact of oil prices on the economy'sgrowlh r.l1e in each of the three oil­price scenarios described earlier.

[n the first scenario. where:tprolonged standoff in the Middle E:1Stoccurs, the economy just manages tomaintain its forward momentum. 111e

'111US, our base·case forecast---the pathwe fL.oe1 the economy would have takenhad Ir.lq not invaded Kuwait----e'.llIs forweak, but positive, real GNP growthover lhe ncar teml (C!Jart 6). Growthreturns to nonmtllevels toward the

middle of 1991.

Even before the increase in oilprices, firms were beginning to limitexpansion of their work forces inanticipation of continued sluggishgrowth in demand. Even without higher

oil prices. l:lbor-market sl:lck wouldprobably have developL>d, puttingdownward pressure on the rJle ofinflation. Ac(.'()rdingly, our base-caseforecast caUs for gradual reductions inthe rate of inflation during the remain­der of 1990 and into 1991 and 1992

(Cbar16).

Thus, had Ir.tq not invad(.-'d Kuw;tit,the economy would probably have;lchieved the soft landing that many

an:llyslS were predicting. GNP ,s.:rowthwould h:lve stabilized at aboul 2.5percent without first dropping torecession levels, and infl:ltion would

have begun to ease.

,,

Chart 1AMarket Economies' Oil Stocks,First Ouarter 1990

mect a sllpply shortfall are only 2,4

billion barrels. Given the septembershortfall in production of 1.7 millionb:trrels per <l:Iy, stocks would supportconsumption at predisruption levelsfor nearly four ye:lrs. If all countriesother than Kuwait and Iraq increasedtheir oil production to capacity. stockswould support consumption at predis­

ruplion levels for about seven rears.Given expected increases in demand.Mocks would have 10 be deplctL>dmore r.lpidly than these estimatessuggest if the loss of Kuwaiti and Iraqioil is to be completely offset.

Employmam Cost Index

P9tcanl change from lour quanetS betora

55

Chart 5The Rate 0' Inflation

lightness in labor markets has lx..oensubst:tntial upward pressure on wages:lI1d benefits (Chan 5). In Ihe bro..1dme:lsures of output prices, too, therehas been little, if any, indication thatinnation has been brought undercontml.

In the aUlhors' judgment, theeconomy would not h;lve f;tllen into areces...ion had oil prices not increased.

1990:1-'!'!"~"~"!-""""1987

As of March 1990, the InternationalEner~y Agency estimated the totalamount of crude oil inventories (alsoknown a~ stocks) held by the worldmarket econoll1ie~ to be 5.4 billionb:lTrds. 111i~ estimate includes bothcomllll:rdal and government stocks.As of Seplcmber, invelllories of cfiKleoil played little role in offsctting oilproduction I~t in Kuwait and Iraq.'111at situation could ch:tnge if theUnited Slales has a colder-than­normal wimer or if the oil-supplydisruption wor..ens.

The Unit(.'(] Staks holds 30 percentof world oil stocks, with mor~ than 1

billion barrels in privately held Slacksand 582 million I:rJrrels in thegovcrnmcnt-owned Strategic Pctro­leum Reserve (C!Jm1 fA). J;tpan holdsthe .-;econd-l:Irgest amount of stocks.with :\bout 10 perCell!. Togetht:r. theEuropean members of the Qrg;rniza­

tion for Economic Cooperation :lndDevelopment (DECO) hold aboUI 20percent of tol;ll world slocks.

With inventOries of abollt 3 billionb;lrrels ncc<k'(] 10 tnainwin refining

oper.ttions. the stocks available to

5

•,,

,

Petcenl (annual rata) adjusted tor 1988 dm'Jght

•

Chart 4Growth in Real GNP

Inventories of Crude Oil

:mnual rate in the second quarter.Despite the economy's slow growth

from the beginning of 1989 throughJune 1990. Ihe unemployment rate heJdsteady :Il a low level. 111is behavior isnot unusual: in the initial stages of aslowdown, employers, uncertain :\boutthe (."<xmomic outlook. often hcsit:lle toby ofT employees.

One consequence of the continued

Pe<cenl (annual rata)

•

.,L-;;;;;;;-----.o..----=,---1990 1991 1992

Economic conditions in tile South­west and the outlook for continuedweakness in the national c.."COnomysuggest that the region's economy washeaded for scveral qual1ers of weakbut positive growth before Imq inv~I(led

Kuwail. 111e Texas Index of LC:ldingl::Conomic Indicators provides a similarreading (Chart 10). [n the second half

of 1989, the index flallem:.-cl. Thatpattern has generJlIy continued into

1990

Higher Oil Prices Strengthen theSouthwest Economy

Southwest :ll1d its industries. Much ofthe recent weakness originated indL'Clines in the goods-producingindustries. Manufacturing employmentin the Southwcst has declined sharplysince the flrst pan of the year. ·111edeclines were Widespread acrossm:ll1uf:lClUring industries. Growth

remained strong only in the chemiciisand refining industries.

In construction, employment feU inIhe second qll:lI1er after growing earlierin the year. The energy industryshowed growth despite slipping oilprices. The private service-producingsector reporK'(1 slower growth. Growth

slowed in wholesale and retail tr.ldeand in business and pcrsomll services.Tmnsport:uion ~ll1d public ulilitiesshowe<1 strong growth throughout the

first seven months of the year.

Chart 9District Nonagricultural Emp[oyment

94 '98S 1986 1987 1988 1989 1990

..

AS:ll1 energy-producing and energy­exporting region, the Southwest shouldbenefit from higher oil prices. Higheroil prices affect the Southwest economythrough several channels. The South­west economy will panicipate in a

IroOux. January 1935.100

'"'"

",1/-",\'"

While growth of total nonagricultu­ml employment in the Southwest hasremained fairly strong in 1990, much ofthe recent growth occurred in thegovernment sector (Cbm19). SinceMarch, private nonagricultur::.ll employ­ment has inueascd at an annual mte of

about 0.5 percent. nlat flgure is downfrom the nearly 2-percent avemge mtethat chamclerized the recovery thatocgan in the second quarter of 1987.

In the flrst qU:lner of 1990, all

sectors of the Southwest economy wereexpanding simultaneously for the flrsltime since the reulVery began. Growthwas :1150 apparent :Icross the region,with most subregions of Texas, ~IS weUas Louisiana and New Mexico. showingemployment gains.

In the .second qual1er, the slowdownbecame broadly evident across the

parison, the inflation r::.lte rose byalmost 10 percentage points in re­sponse to the tripling of oil pricesbetween 1973 ano 1974.

Even if the standoff in the MiddleEast continues, the tbreat of war maykeep oil prices ~llxlVe their C;1.se 1levels. Should this occur, omput growthwould lie somewhat below the standoffscenario dcpicte<l in Chan 7. Similarly,

Ihe actual inflation 1':1\11 would liesomewh;l( above the standoff scenario

depicted in Chan 8.

A SlOWing Southwcst F.cooomy

Oil Prices aod theSouthwest F.conomy

I[igher oil prices come :1\ ~l timtlwhen the Southwest L'C0110my reflects aslOWing nation~ll cconomy. During thesecond quaner of [990, priv;lw non­agricultuml employment showL'(1anemic growth across the Southwest.

As with the national forecast, higheroil prices alter the outlook for theSouthwest economy. As an energy­producing and energy-exponing region,Ihe Southwest will fare somewh:ltbetter than the nation in the face ofrising energy prices. JUSt how muchI~tter depends on how high oil pricesrise and how long higher oil pricescontinue.

"\.

.•......

Prolonged..·••...Conllicl

./ '.

Base

./Briat/Conflicl

,/Standotl .

~"•

•

,

,

i

:~'t--~---"'\---;.C,;C.C,--;-----

-I . Conlliet jprOIO"llad-2 i Contliel.,

"

PerQIln1 (allnlJal ratel

"

Chart 8Effects of Higher Oil Prices on Inflation-­A[ternative Scenarios

,,

,L--"..,_",,_--,;;,,---1990 1991 1992

incremenul slowing th~lt the economyeXI~riellces in Ihis case is roughlycomparable to th~1\ which result(:d fromthe 1988 drought. Oil prices at 525 or530 per b:lrre! would have h:ld diSI1Jp­tive effects grc;l1cr Ihan those depictedhere were the economy not still

adjusting 10 lhe 1986 oil-price decline.In thc sc:.'Cond and third s(:enarios,

where hostilities eSC-.lIMe, the imp;ld ofhigher oil prices on economic growlh issubstantially gre~llCr ~l1ld would almostcen:linly result in ~I rL"Ccssion. 111erecession is mild if Ihe military conflictis brief (Case 2) but quite severe if theconflict is prolongcd (Case 3).

nle effeL1S of higher oil prices onthe GNP rriL"C deflator (a measure ofinflalion) arc expected to be roughlyequal in magnitude but opposite indif(.'Ction 10 the effects of higher oilprices on output (Chart 8). [n Case I,the standoff scenario, inflation peaks at

an annu:11 rate belween 4.5 percent and5 percenl in the sccond qual1er of 1991.

[n the second and third scen;lrios,inflation rises to 7 percent and 10

percent, reSpe(1ively. By way of com-

Chart 7Effects of Higher Oil Prices on the GrowthRate of Real GNP-Alternative scenarios

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Ir>dex. January 1981.100

'"'

Chart 10Texas Economic Indicators

Summary

Before the oil-price disruption, thenalional and Southwest economieswere showing weak growth, withgrowth in the nation converging towardthe sluggish growth r:l1es that chameter­izcd the Southwest during the pastthree years. In the absence of higher oilprices, national economic growthwould have remained slow over thenext few quarters, but the United Slates

probably would have avoided arecession. Somewhat higher unemploy­ment rutes would have tx--en accompa­

nied by an easing of inflationarypressures.

Higher oil prices will slow national

economic growth. ,\ receS5ion may beavoidable, but just barely so. Inflation,on the other hand. is likely to risethrough the end of this year and into1991.

Temporarily higher oil prices will

prOVide only a slight stimulus toeconomic growth in the Southwest, andonly while they are sustained, As thecrisis in the Middle East is resolved andoil prices retreat, the employment gains

resulting from higher oil prices will bereversed. In any case, the benefit ofhigher oil prices to the Southwesteconomy may not be evident until

1991.

-Harvey RosenblumStephen 13rownEvan KoenigKeith PhillipsMine Y(kel

A SI change in the price of oil nowh;ls a smaller effect on the Southwestthan preViously estimated (S.P.A.Brown and John K. Hill, "lower OilPrices and State Employmcnt,~ COII/em­

para')' Policy Issues, July 1988). Sincethe earlier analysis, lhe Southwesteconomy has become more closely tiedto the nalional c<:onomy. In addition,the Southwest's energy-producingsedOrs have become smaller and icsenergy-using sectors have become

larger.

.......

1991 1992

Prolongad ConlliC,V Standoff

./ BrielConllicl

Chart 11Total Nonagricultural EmploymentLouisiana, New Mexico and Texas

energy-producing states. Growth in thenational economy has slowed, but theoil industry has not )'et responded tohigher oil prices by increasing explom­tion and development. Oil producersllrc not sure that high oil prices will besustained. [n addition, a shortage ofdrilling (.'(Iuipment :md qualifiedpersonnel prevents a quick response.Furthennore, half of current drilling isfor n;ltural gas, and naturn[ gas prices

remain depressed. A surplus of natumlgas and high inventories of residualfuel oil, the primary substitute fornatur:tl g.1S in industrial applic:.lliollS,arc holding down natuml g:IS prices.

As shown in Ch:lrt 11, the temporaryprice inCft:;I5CS that are likely to resultfrom the Middle East crisis will provide

only a slight stimulus to emplo)'mcnt inthe Southwest. And although lhe three

scenarios considered arc likely togener:ltc regional cmployment gainsduring the disruption, some 1I::mporaryprice increases could actu:llly reducethe growth of emplo)'mem in theSouthwest. While all the negativeeffccts of;l slowing national economywill be realized, only sm;lll gains willbe made in the energy-producingseclors, given the temporJ.ry nature ofthe oil-price hike.

Furthem10re, any employment gainsresulting from tempomri\y higher oilprices will be lost as prices fall back tothe base case. For the brief connictscenario, this happens by the cnd of

the forecast horizon. For the other twOscenarios, the tempomry employmentgains are lost after the forecast horizon.

"'"""~.9,400

9,350

9,300

9,250

9,200

9,150

9,100

9,050

9,000

""

1990

Privat&NonagriculluralEmployment

1989

'"''"

slowing of the national economy. TheSoulhwes['~ energy-producing seclOrswill expand while it~ energy~using

seClOrs, such as refining, petrochemi­(.<lls and tr,.1llsportation, comr:lCl. These

adjustments will have both positive andnegative multiplier effects in the

Southwest economy. The Mexicaneconomy, strengthened by higher oilprices, also will exert a positiveinfluence on the region's economy.

On the whole, higher oil prices GInbe expected to stimulate employmentin the Southwest. The extent of em­ployment gains depends on the sizeand duration of the price increase. Overa two-year period, each SI increase inthe price of oilth;lt is expected tocontinue indefinitely would boost

Texas employment by 17,200 jobs---­0.25 percent of total nonagriculturalemployment in the sUIte. Similarly, eachS1 increase in the price of oil wouldboost employment in l.ouisiana by4,800 job~,32 percent of its non­agricultural employment-and in NewMexico by 800 jobs---O.14 percent of itsnonagriculturJ.1 employment. '

In tot:ll, nine energy-producingStates---Abska, Colowdo, l.ouisiana,New Mexico, North Dakota, Oklahoma,Texas, West Virginia and Wyoming­will benefit from sustained higherenergy prices. The other 41 st:l\es andthe Districi of Columbia will be hurt byrising energy prices. Wyoming andOkl:lhoma show the largest percentagegains in employment. Delaware couldSL--e the biggest losses; nearly 10 percentof its employment is in the petrochemi­cals industry,

During 1990. however, higher oilprices could reduce employment in the