PK on possible oil crisis

["Devine, James" <jdevine@xxxxxxx>]

New York TIMES/April 9, 2002

The Third Oil Crisis?

By PAUL KRUGMAN

In 1973 an Arab embargo sent oil prices soaring, and a global recession
followed. In 1979 the Iranian revolution provoked a second surge in oil
prices, and another global recession.

Are we now at risk of a third oil crisis? I wish I could say no, but I
can't.

Oil prices have risen about $10 per barrel since the situation in the Middle
East began deteriorating. So even if they stay where they are, this
represents a serious shock to the system - and there could be more to come.

True, political analysts assure us that despite Iraq's decision to stop oil
exports for a month, no broader, 1973-style oil embargo is likely. Let's
hope they're right. But the 1979 oil crisis wasn't the result of a
deliberate embargo.

Economists have never reached a consensus about what happened in 1979, but
my interpretation is that it was similar to the recent California
electricity crisis. In both cases the key was the combination of a tight
market and demand that wasn't very responsive to price. Under those
circumstances, individual producers - power companies in California,
oil-producing countries in 1979 - have a lot of market power. That is, it is
in each producer's interest to cut back production to drive prices higher.
The result is a price surge, even though there is no real capacity shortage.


Are world oil markets that tight? Not yet - the world still has about seven
million barrels' worth of spare capacity each day. So Iraq, by taking away
its two million barrels a day, cannot create a crisis by itself. But the
remaining slack in the system is just about equal to the combined production
of Iran and Libya, which have also proposed an embargo.

The point is that it would not take much worsening in the political
situation to produce markets so tight that the logic of market power kicks
in and countries decide that, quite aside from politics, their financial
interest lies in reducing, not increasing, their output.

If an oil crisis can happen so easily, why haven't we had one since 1979?
The answer is that we made ourselves crisis-proof for a while, then became
complacent. After the oil crises of the 1970's, Western economies sharply
increased their energy efficiency: the U.S. economy was a third bigger in
1985 than it was in 1973, but it consumed less oil. The result was the
marginalization of the danger zone: in 1985, the Persian Gulf produced only
18 percent of the world's oil, less than half of its share in 1973. But
rapidly growing oil consumption in the S.U.V. era was met, inevitably, by
increased Persian Gulf production. So oil prices are once again hostage to
Middle Eastern politics.

If oil prices do surge, will this have the same disastrous effects as the
price spike in 1979? No, but it may have different disastrous effects.

In 1979 the clear and present danger from soaring oil prices was that they
would send already inflation-prone Western economies into an out-of-control
inflationary spiral. To fight that, all the leading economies raised
interest rates - which controlled inflation, but also generated a nasty
recession.

Today, after a decade of price stability, fears of inflation are much more
muted. Instead, the main concern is the drag of oil prices on purchasing
power. Each $10-per-barrel increase in the price of oil is like a $70
billion tax increase, one that falls most heavily on middle- and
lower-income families.

And this is not a good time to slash purchasing power. Business investment,
which plunged last year, has still not recovered; optimistic economic
forecasts depend on the assumption that buoyant consumer spending will keep
the economy afloat until businesses do decide to invest again. If consumers
are made poorer by higher oil prices and cut back instead, that assumption
goes out the window. And the Fed can't respond with another big round of
interest rate cuts: since it has already reduced rates from 6.5 to 1.75
percent, it doesn't have much ammunition left.

So I'm sorry to say that under current conditions, a third oil crisis could
indeed happen. It doesn't have to happen: a diplomatic breakthrough could
calm oil markets, and even if oil prices rise, the U.S. economy may be more
robust than I fear. But it's easier to tell a downbeat, even scary, story
than any of us would like.

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comments?

Jim Devine jdevine@xxxxxxx &  http://bellarmine.lmu.edu/~jdevine