On June 19, 2014, the spot market price for Brent crude oil closed at $115 per barrel, its high point for the year. Amid worsening chaos in Iraq, deepening political instability in Libya, and concerns that global oil supplies could be stretched to capacity, the high price was not a surprise.
Over the following six months, driven by increased U.S. shale oil production and slowing world energy demand, oil prices collapsed, plummeting by more than 50 percent.
The number of oil rigs in the United States quickly fell by more than 50 percent. The magnitude and speed of the collapse was rivaled only by the 1986 OPEC shock and the 2008 financial crisis.
The price collapse of the most important global commodity provides an opportunity to examine how oil price instability, driven by key OPEC countries, becomes transformed into macroeconomic instability and how this, in turn, begets uncertainty in the behavior of monetary policy maestros who seek to manage the ups and downs of the U.S. economy.1 We emphasize that the crude oil market is not competitive in the traditional economic sense. Seventy-five percent of crude oil is produced by government entities that seek goals that need not include maximizing shareholder return as is presumed of private firms.
The first part of this article focuses on OPEC power. OPEC’s ability to manipulate oil supplies remains unencumbered. The result is economic instability in the United States; price hikes help produce recessions. We see OPEC’s reaction to shale oil expansion as part of a process that allows it to recover its historic market power position, though chastened by the presence of U.S. shale oil.
The second part addresses the difficulties posed to U.S. monetary authorities by oil price volatility in their efforts to achieve price stability and economic growth.
1. OPEC-generated economic instability
U.S. dependence on oil priced in a global market greatly impacted by OPEC has been a source of costly instability to the U.S. economy. Since the 1974 OPEC oil embargo, Middle East volatility has been associated with four of the last five U.S. recessions. Along with direct economic effects on a wide range of industries, petroleum price volatility disrupts fundamental monetary policy actions intended to provide employment and price stability.
Figure 1 shows the instability of the real price of crude oil, by looking at the number of barrels of crude oil that can be purchased with an ounce of gold. By denominating the price in gold, we avoid dealing with changing currency values. We identify five periods when the number of barrels purchased with an ounce of gold fell markedly. Four of these are associated with OPEC-inspired actions. See figure 1
Barrels of oil for an ounce of gold 1/1968 – 7/2015
Actions and reactions
Large swings in energy prices generate massive wealth transfers across producing and consuming countries. Countries such as Singapore, which relies on oil for 80 percent of its energy, receive a strong positive economic stimulus from declining prices. Others, such as Nigeria, which counts on oil exports for 60 percent of government revenue, receive a shock in the other direction.
The same is true for states within the U.S. Energy employment in Texas, for example, has fallen by at least 60,000 jobs in the current year. At the same time, the production and sale of large pickup trucks and SUVs, driven by cheaper gas prices, has stimulated hiring in the auto-producing states. Countries and regional economies have no choice but to ride the oil price roller coaster.
Venezuela and some other OPEC-member regimes have squandered their oil income and live hand-to-mouth. However, large producers such as Saudi Arabia, Kuwait, and the UAE have huge sovereign wealth funds. They are not reliant on today’s oil revenue to keep their governments afloat. They can weather a downturn in prices and take a longer view.
Due to rapidly rising U.S. fracking output, the Saudis experienced a 50 percent decline exports to the United States in the third quarter of 2014. They knew this trend could worsen, so it would be logical to try to stem the tide. The Saudis challenged the upstart frackers by cutting the price to the United States, while raising it elsewhere. According to Phil Flynn, senior market analyst for Price Futures Group, the Saudis were “threatened by U.S. oil production and [were] acting to try to break the U.S. producers’ back.”2
2. U.S. oil price volatility and policy makers
The effects of OPEC-generated volatility are seen in industrial production disturbances and recessions that reduce wealth and employment prospects for ordinary Americans. Even when the economy is expanding and work opportunities are improved, Middle East mischief can be a major source of gasoline pump pain when Americans fill up their vehicles. Rising gas prices play havoc with family budgets. When higher prices seem to be the norm, more consumers swap gas guzzlers for smaller fuel efficient cars. Then, when prices fall, more consumers opt for larger vehicles. Unpredictable prices make for inefficient household management and costly industry adjustments.
The policy makers’ macroeconomic challenge
By statute, the U.S. Federal Reserve Board is required to set monetary policies that deliver low levels of unemployment and price stability. Efforts to achieve the twin goals, which sometimes seem at odds with one another, form the basis for actions that ultimately involve influencing interest rates with the hope that higher or lower rates will help accomplish the Fed’s statutory goals.
Predicting the future level of inflation and making judgments on inflation expectations are part of a complex process faced by the Fed’s Federal Open Market Committee (FOMC) and Fed Chair Yellen.
The situation facing by the Fed is challenging.3
Since the 2008 credit market collapse, the Fed has maintained historically low interest rates. With the U.S. and world economy slowly recovering, what the Fed will do with interest rates has become the major monetary policy question.
The Fed has set a goal of achieving an ongoing level of 2 percent inflation. However, energy prices have become so volatile that the Fed focuses on “core inflation,” which is the overall CPI with energy and food prices omitted. Even so, energy price movements can assist or frustrate Fed decision-making as energy is embedded in all aspects of the economy.
Each month after the FOMC meets in Washington, it explains the Committee’s thinking about interest rates and the economy’s performance. Following the Committee’s January 2015 meeting, the Fed stated: “Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.”4
After making comments about other aspects of the economy’s outlook, the statement said this about energy and inflation: “Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.” The FOMC’s July statement again referred to energy prices when describing uncertainty with respect to the next interest rate move.5
Put another way, the Fed, like everyone else, is trying to guess OPEC’s next move. No one knows what OPEC will do in the future. Obviously, an uncertain Fed generates uncertainty across all financial markets. That in turn produces reluctant investors, cautious producers, and lower levels of wealth creation as investors and lenders await more interest rate certainty.
Led by the rapidly expanding output of unconventional oil producers, by late 2014 the United States was the world’s leading crude oil producer. The pre-2014 institutional arrangement could not hold. In an apparent effort to maintain market share, the Saudis and other OPEC producers cut prices and kept the valves open. While some OPEC members oppose the move, the Saudis and some of their OPEC friends have deep pockets that provide a war chest to rebuff the competition.
As Figure 2 indicates, many OPEC countries are low-cost oil producers. Unconventional U.S. oil is pricey. It does fine when oil is $110 a barrel, but at $50 or less a barrel, incentives for new production are dampened, as we see in the collapse of new drilling in the shale fields. As the Saudi governor to OPEC, Mohammed al-Madi, explained, if the price rises to $100, “the high-cost producers come back again.”6
Figure 2: Estimated crude oil average cost of production
Crude oil prices have fallen by more 50 percent, consumers are celebrating lower at-the-pump gasoline prices, automobile manufacturers are wondering how they will achieve government-mandated fuel economy standards when shoppers rush to buy SUVs, shale oil producers are laying off workers and reassessing their production plans, and the Federal Reserve Board is attempting to predict the path of inflation so that interest rate policy can be determined.
The crude oil economic landscape has changed. Yet OPEC and other government crude oil producers will continue to generate unpredictable petroleum price volatility. The existence of OPEC, and its ability to manipulate oil markets, creates costly economic uncertainty, as we have witnessed time and again for more than four decades and counting.
- See Andrew P. Morriss and Roger E. Meiners, Competition in Global Oil Markets: A Meta-Analysis and Review, report commissioned by Securing America’s Future Energy (SAFE), April 2013. http://secureenergy.org/sites/default/files/SAFE_Competition-in-Global-Oil-Markets-A-Meta-Analysis-and-Review.pdf.
- Pan Pylas, “Oil Prices Tumble after Saudis Cut the Price of Oil they Sell to the U.S.,” Seattle Times, 11-4-14. http://seattletimes.com/html/businesstechnology/2024952619_saudisoilxml.html.
- Thomas Hirst, “Janet Yellen Now Faces One Of The Most Bizarre Problems The Fed Has Ever Seen,” Business Insider, 1-8-15. http://www.businessinsider.com/the-oil-price-collapse-is-making-the-federal-reserves-job-almost-impossible-2015-1.
- Board of Governors of the Federal Reserve System, Press Release. 1-28-15. http://www.federalreserve.gov/newsevents/press/monetary/20150128a.htm.
- Board of Governors of the Federal Reseerve System. Press Release. 7-29-15. http://www.federalreserve.gov/newsevents/press/monetary/20150729a.htm
- “Return to $100 Oil Seen Unlikely by Saudis Amid Shale Surge,” World Oil, 3-23-15. http://www.worldoil.com/news/2015/3/23/return-to-100-oil-seen-unlikely-by-saudis-amid-shale-surge.