FROM THE OFFICE OF PUBLIC AFFAIRS

October 15, 2004
JS-2089

Remarks of Mark J. Warshawsky
Assistant Secretary for Economic Policy
Current Macroeconomic Activity and Conditions in the
Crude Oil Market
Charlotte Economics Club
Charlotte, North Carolina

Good afternoon.  I'm delighted to be here today to talk to you about the U.S. economy.  I began my tenure at the Department of the Treasury as Deputy Assistant Secretary for Microeconomic Analysis, specializing in issues related to terror risk insurance, pensions and Social Security.  After taking over the responsibilities of Assistant Secretary for Economic Policy a year and a half ago, I have had the opportunity to become more deeply involved in investigating the forces that shape the performance of the macro-economy.  I would like to begin today by discussing my view of current economic conditions and then focus on one of the major issues influencing the outlook - oil prices and their potential impact on the economy.

Current Economic Conditions

I think that it is fair to say that the last three and a half years have been unique in our economic history.  The bursting of the NASDAQ bubble and the substantial decline in stock market values in 2000, along with the resulting pullback in investment, caused an actual decline in economic activity in the third quarter of that year.  By 2001, we had entered recession and its effects were compounded by the terrorist attacks of September 11.  We appeared well on our way to recovery in early 2002, when growing evidence of widespread corporate malfeasance dating back to the late 1990s once again undermined business activity.  Slow growth abroad provided an additional headwind.  The war with Iraq further raised uncertainty in the early part of 2003. 

Given this long succession of negative events, the performance of the economy has been quite remarkable.  Rapid monetary policy accommodation and perhaps the most well-timed fiscal policy response in our history resulted in the smallest GDP loss of any recession in the post-World War II era.  Three tax cuts in three years boosted household incomes to support consumption, offered tax relief on dividends and capital gains for stockholders, and provided large and small businesses with incentives to undertake investments in equipment.  The recently enacted Working Families Tax Relief Act of 2004 will assure that families and businesses will continue to benefit from tax relief.

By summer of last year, the economy was growing strongly again and in the first quarter of this year, real GDP was 5 percent above its year-earlier level, the largest 4-quarter increase in 20 years.  While North Carolina has been hard hit, we are seeing progress here.  State payrolls are up nearly 63,000 so far this year and, at 5 percent, the unemployment rate is below the national average.  More than 2.9 million North Carolina taxpayers and 665,000 North Carolina businesses will pay less in taxes this year because of the President's efforts.

Nationally, economic activity slowed somewhat in the second quarter of this year, although the final estimate of real GDP showed growth at a still-respectable 3.3 percent annual rate.  Gross domestic purchases – the demand of U.S. households, businesses, and government – increased by an even stronger 4.2 percent, mainly reflecting strength in business and residential investment.  The difference between the purchases and product figures is represented by the trade deficit, which widened further in the second quarter, exerting a drag on GDP.  Although there are signs of firming in demand for U.S. exports, slower expansion among many of our major trading partners than in the United States continues to be a factor in the faster growth of U.S. imports than exports.

The composition of economic growth has transitioned much as we had hoped.  The consumer supported the economy throughout the recession.  More recently, business investment has been the key driver.  Real investment in equipment and software has been increasing at a double-digit pace over the last five quarters and appears on track for another strong gain in the third quarter.  Investment in structures is also making a comeback, rising in three of the last five quarters.  Gains in corporate profits, declining risk spreads, favorable tax incentives and greater business optimism regarding the durability of the economic expansion have supported the rise in investment.  Economic profits (based on current production) have risen 19 percent over the past year.  Strength has been centered in domestic nonfinancial corporations, and in the second quarter, the largest increase in economic profits was recorded by the information industry - up $23.1 billion - a sign that the tech sector is coming back. 

Along with investment in capital goods, residential investment also continues to be remarkably strong.  Except for a small decline in the fourth quarter of 2001, real residential investment has increased in every quarter since the end of 2000.  A year ago, few expected further near-term growth.  But demand has held up very well, as 30-year mortgage interest rates have remained below 6 percent, generating record-high home sales so far this year.  In the latest quarter, real residential investment rose at a 16.5 percent annual rate, the second largest quarterly increase in eight years.

In the second quarter personal consumption spending slowed to only a 1.6 percent increase at an annual rate.  Explanations included the fading of the boost from refinancings, the extra demand on family budgets of higher gasoline prices, and the impact of a cooler- and wetter-than-normal spring on seasonal purchases.  While all of these explanations may have played a role, it now appears that the second quarter represented only a temporary pause in consumption growth.  With July and August data already on the books for the third quarter and today September spending showing an impressive increase, personal spending is on track for an increase of up to 4.5 percent annual rate.  A jump in unit auto sales in September appears to confirm strength in consumption through the end of the quarter.

I think it is reasonable to be optimistic about the outlook for consumption.  The wages and salaries generated by new jobs are becoming the driver for personal income.  Since the President's Jobs and Growth Plan went into effect in the third quarter of 2003, payroll employment growth has been revitalized.  Jobs have increased for 13 straight months by a total of 1.9 million.  The unemployment rate has fallen to 5.4 percent – lower than the average of each of the past three decades. 

Another positive factor is that the pickup in inflation we observed early in the year appears to be subsiding.  In fact, the personal consumption deflator was unchanged in the past two months.  Low inflation is consistent with the phenomenal growth of productivity that we have witnessed throughout the current business cycle.  Since the end of 2000 – a period that includes both recession and recovery – nonfarm productivity has risen at a 4 percent annual rate, the best performance for a three-and-a-half year period since the early 1960s.

The policies of the past three and a half years have been appropriate for the unusual circumstances we faced and have put the economy on the path to renewed expansion.  But, in addition, they have helped assure strong growth in the future.  Lower marginal tax rates have improved the after-tax rewards to work.  They also increase the returns to innovation and risk taking, because most entrepreneurs pay individual income taxes.  The cost of equity capital has been reduced through lower taxes on dividends and capital gains, thus promoting investment.  A tax system that supports greater risk-taking, investment, and innovation means greater productivity and capital accumulation and ultimately a higher standard of living. 

The Mid-Session Review in July projected a budget deficit for Fiscal 2004 of about $445 billion, but growth in the economy and jobs has already contributed to an improvement, with the deficit coming in at $413 billion, equivalent to about 3.5 percent of GDP.  This is much below deficits in the 4.5 to 6 percent of GDP range at various times in the 1980s and 1990s.  Though unwelcome, the federal budget deficit is manageable and understandable, given the extraordinary circumstances of recent history.  With continued economic growth and job creation, along with spending restraint, the President has a plan to cut the deficit in half over the next five years to less than 2 percent of GDP. 

The Administration is currently beginning the fall economic forecasting exercise that will underpin the fiscal year 2006 budget.  As we undertake the forecasting exercise this year, we will devote particular attention to the situation in petroleum markets.

Oil Markets

The stubbornly high price of crude oil has been one of the dominant economic stories this year.  Even though the oil intensity of U.S. GDP has fallen by nearly 50 percent since the first oil shock in the early 1970s, the price of oil remains a key variable in the macro outlook.

The U.S. consumes about 20 million barrels of petroleum products per day, a quarter of world oil production.  But we only produce about 40 percent of the oil we consume, so we're importing about 12 mbd each day.   Two-thirds of our petroleum consumption goes to transportation, and another quarter is taken up by industrial uses – with much going as raw materials for the chemicals and plastics industries.

Demand for oil rises with overall economic activity – a 1 percent increase in real GDP is usually associated with about a 0.5 percent increase in oil demand.  But it does not appear that U.S. demand for oil in the short run is sensitive to the price.  One recent estimate suggests that the price elasticity of demand for oil in the U.S. is -0.02 in the short run and rises to about

-0.6 in the long run (which takes about 10 years).  In these estimates, the short run is surprisingly long; at least a year.  The implication is that, for periods of up to a year, a rise in the price of oil increases outlays on oil almost proportionately.

From these basic facts emerge the estimates of the first round impacts from an increase in oil prices.  Each $10 per barrel rise in prices increases the annual oil import bill – the "oil tax" – by about $44 billion (12 mbd times 365 days times $10), or about 0.4 percent of GDP.  So what does the price experience of the last two years suggest?   The price of West Texas crude averaged about $26 per barrel in 2002, about $31 in 2003, and so far this year have averaged a little more than $39.  So the oil tax amounted to about $22 billion in 2003, and could rise to about $58 billion in 2004. 

But of course the first round impacts don't capture all the effects or possibilities.  A more thorough estimate of the real impact would include the potential crowding out of other imports in favor of oil and the differences in the propensities to spend between domestic oil consumers and producers.  We also need to consider short-term multiplier effects, potential inflation effects, and financial market feedbacks.  To capture these, we use estimates from simulations of macro models to assess the real effects of an oil price increase.  Our work suggests that had oil prices remained at about their 2002Q2 levels (slightly more than $26 per barrel), real GDP would be about 0.5 percent higher now (about $54 billion in chained 2000 dollars) and the Consumer Price Index would be about 0.6 percent lower. While these effects are noticeable – the real GDP effect implies that growth was shaved by about 0.25 percentage point on average for the last two years – they are not overly large. 

We need to point out, however, that simulation work did not capture the effects of rising oil prices on consumer and business confidence, the general level of economic uncertainty, or financial market responses.  Further, the results did not account for the effects of foreign economies slowing in response to higher oil prices. 

So far, we've re-established some pretty well-known ideas: (1) oil prices are important for the economy, (2) the recent oil price increases have slowed economic activity from what it otherwise would have been, and (3) oil demand is not very sensitive to price changes in the short run.  The main questions are, of course, why are prices high now, and what will happen to prices in the future?

As yet, we've found neither the smoking gun that tells us why oil prices are high now, nor developed the crystal ball that will tell us what prices will do in the future.  But I'd like to share some observations with you about oil markets and then raise the question of whether the price increases we've seen recently are fully justified by fundamentals.

We believe that oil market fundamentals are certainly tighter right now than they have been for many years.  Spare production capacity, refining capacity, and shipping capacity are all very tight.  And this is coming at a time when rapid economic growth in most parts of the world is increasing the need for oil every day. 

The important question that we need to ask ourselves is – is this a temporary phenomenon, common to vigorous economic expansions where bottlenecks occur in individual sectors until enough investors recognize the need and provide the new capacity, or is this a more serious long-term phenomenon?

First, there is considerable uncertainty about even the most basic demand and supply trends.  The last two years have seen an extraordinary surge in the world demand for oil even in spite of slow growth in Europe and Japan.  The main story is the emergence of China as a major oil consumer.  In 2002, China eclipsed Japan as the second largest oil consumer behind the U.S. Over the past 10 years, Chinese oil consumption has posted annual growth of about 7.5 percent.  And this year the International Energy Agency (IEA) is putting growth in Chinese oil consumption at nearly double that rate.  India, consuming less than half as much oil as China, also represents a growing force in oil markets.  In 1993, these two countries accounted for just over 6 percent of global oil demand.  Ten years later in 2003, that figure was nearly 11 percent. 

Looking at the situation today, it is easy to see why analysts are concerned about high prices resulting from strong demand; there is considerable upside potential for consumption.  The average person in the U.S. last year consumed about 25 barrels of oil.  In China, that figure was about 1-1/2 barrels and India consumed less than a barrel per person. While nobody thinks that either China or India will rapidly approach U.S. per-capita consumption levels in the near future, it's worth noting that each barrel per year increase in per-capita oil demand raises the daily oil demand figure for China by about 3 million barrels – about a 3.5 percent increase over current world levels.

Government stockpiling in these countries could also add to demand.  Both countries have expressed the intention to develop government-controlled stockpiles of oil much like the strategic petroleum reserve (SPR) in the U.S.  The market does not know how big these reserves will be or how quickly – or even if – they will be filled.  But the uncertainty surrounding their implementation probably has effect, at least temporarily, on world oil demand now and sometime through the near future.    

In developed countries, the concern is not so much that oil demand will be rising per unit of GDP, but rather that a sustained expansion – rising GDP – in the U.S., Europe, and Japan together will put additional demand pressure on prices.  Japan's economic troubles have crimped its oil consumption growth.  The country has actually seen its oil demand shrink in three out of the past four years.  Oil consumption in the European Union grew by just 0.5 percent in 2003.   In the U.S., oil demand grew by 1.5 percent last year.  Now the potential in oil markets is that Japan, Europe, and the U.S. will simultaneously accelerate, which, in the context of rising demand in China will cause a sharp jump in world demand.  (Each 1 percentage point increase in growth for these countries will tend to raise world oil demand by 200,000 barrels per day.)

 Along with uncertainty about demand, there are also significant uncertainties about supply.  Now, geopolitical uncertainty about supply has increased since September 11.  The probability of a terrorist-induced supply disruption appears higher now than, say, four years ago,  when analysts may have not have been paying as much attention to the possibilities as they are now.

But even beyond the probabilities of disruption, there is considerable uncertainty about the longer-term outlook for oil supply.  There is, for example, apparently serious debate about when global oil production might reach a peak, and, by implication, when production will decline.   The topic was important enough that, in 2003, the editor of the Oil and Gas Journal dedicated a series of six articles to the topic, and these sparked so many comments that he published another series of articles in the spring and summer of this year.

This debate began in the mid-1950s, when geophysicist M. King Hubbert made his prediction that U.S. oil production would peak around 1970.  He turned out to be about right.  Some have used his techniques to argue that we may have already passed the world oil production peak (we're just temporarily pumping faster than could have been predicted). 

Forecasts of this type are typically grounded in geology, using variables such as the amount of ultimately recoverable oil reserves globally and oil field depletion rates.  Economists see another side to this debate, which is really about physical versus economic scarcity.  In general, economists feel that even if the Hubbert-type analyses are correct,  market forces and technological progress can compensate, albeit probably at an initially higher price, by making new energy sources such as unconventional oil – such as extra-heavy crude and bitumen and alternative energy sources and conservation economically viable.  The issues are when will these transitions occur and how much more expensive might energy and energy related products become.

By training, of course, I tend to take the economist's perspective.  But the fact that a group of knowledgeable observers are concerned about long-term supply, coming in the context of potential large demand increases, has apparently given oil markets an upward shove.

Evidence from the futures markets suggests private analysts have this picture of uncertainty in oil demand and supply – with the greatest risks on the upside for demand and the downside for supply – firmly in mind.  To review, the typical oil futures curve is "backwardated," where the longer dated futures price is almost always lower than the spot or shorter-dated futures price.  If there is a shock – like a hurricane – that temporarily disrupts oil supply, we would normally expect the futures curve to steepen further.  That is, we would expect the short-dated futures price to rise due to the shock, but the longer-dated prices to remain about where they were before the shock. 

But that isn't what is going on in futures markets.  In fact, the futures prices are higher across all futures dates.  For example, at the beginning of this week, the six-month futures price was trading at a discount of just over 5 percent to the near-month contract. Prices across average futures curves in October 2000 and October 2002 were obviously lower, but the curves themselves were slightly steeper. The upward shift in prices along the whole futures curve suggests private analysts believe that much of each day's rise in oil prices is permanent.

Now, economists are trained to be skeptics, and all of the discussion about permanent increases in oil prices, oil suppliers running dry, and continued extraordinary increases in demand have reminded me of the discussion about another market, which, not too long ago, also seemed to promise continued price increases as far as the eye could see (even as high as 36,000!).  In the event, the inevitable demand increases turned south, the market sagged, and we were left with an "excess" supply.  Could the same thing happen (and be happening) in oil markets?

There's at least some evidence to suggest that it could.  We recently looked through the economics literature to find empirical work that would help us estimate the "fundamental" price of oil, that is, the oil price that might be observed if there were no "geopolitical risk" premiums and, over the longer term, if investment and new supply respond to market incentives.  One equation we found related OECD inventory levels to the price of West Texas Intermediate.  Our re-estimate of that equation suggested that, based on the actual inventory levels through the early part of 2004, the underlying price of  WTI  had a two standard error range of up to $38 per barrel.  Inventories have tightened somewhat since early 2004, but still leaves a premium at current prices.  Some analysts gauge the "fundamental" level of crude oil prices by comparing them with the price of other fuels, such as natural gas.  One rule of thumb commonly cited is that the price of West Texas Intermediate (WTI) oil, in dollars per barrel, should be about eight times the Henry Hub natural gas spot price in dollars per million Btu.  Using that rule, natural gas spot prices in early October implied a crude oil price of about $47 per barrel – about $6 per barrel below the then current levels.

Some of my feeling about at least part of the recent oil price run-up being overdone comes from watching the market media and trading reactions to the weekly oil inventory statistics released by the DOE's Energy Information Administration.  Over the past several weeks, each weekly inventory report was followed by an increase in oil prices in world markets both in the spot and short-dated end of the futures market and the long-dated end of the futures market.  Now the U.S. inventory situation is important but U.S. inventories represent about 40 percent of total OECD inventories, and about 20 days of daily world production.  I've been surprised that the response to U.S. inventories has been so strong, given that demand and supply conditions in other parts of the world might be exerting an even stronger pressure (either up or down) on prices.  The price increase following Hurricane Ivan which seriously affected U.S. production in the Gulf of Mexico is a case in point.  While Ivan's effect was real, it was exaggerated because markets focus on the U.S. market where statistics are much better and much timelier than statistics in other industrialized countries.  Furthermore, there may be a "push me – pull you" ratcheting effect going on here – as prices increase, inventory holders economize in the belief that there will be a fall, while market participants observe the stinginess in inventories and bid up prices, and so on.

The simple reason U.S. inventory data has this effect is, of course, because the U.S. produces good data quickly, and the markets are using the U.S. data in the place of full information about other developments. That's alright if U.S. inventories are a good indicator of world market tightness, but if there are conditions that are special to the U.S. – like hurricanes or a shift in the demand and supplies of crudes that the U.S. uses mostly – then U.S. conditions may be giving the wrong signal to market participants.  The markets may then be bidding up the longer end of the futures curve for world oil prices on the basis of limited information.

There's some reason to believe that is happening.  Despite our focus on "the" price of oil, there are, in reality, many types of oil.  It is possible that shortages of one type of desired oil (light, sweet is especially good for auto and jet fuels, which is most used in the U.S.) are driving up benchmark crudes relative to others.  So the relative changes in the demand among types of oil may be getting confused with a general increase in the demand for oil.  The price spread between West Texas Intermediate light sweet crude and Saudi Arabian heavy sour was more than $13 at the beginning of October, a record high, and roughly twice the average price spread seen last year.  So while the nominal prices for both grades of crude were at record highs, the record high for the U.S. benchmark WTI was much higher relative to less desirable crudes. And the wide price spread suggests that it may be inappropriate to characterize the "world" oil price on the basis of our old standby, West Texas Intermediate.

So, if I had to summarize my story about oil markets, I would say that current high prices appear to be the result of temporary tightness in oil markets and fears about supplies becoming even tighter.  Other, more mundane concerns that the market would ordinarily shrug off – unexpected increases in oil demand, concerns about long-term oil supply, transitory, but serious weather-related events – are affecting the market over and above the underlying terrorist concerns, and so have a multiplied effect on prices.  So far we've seen the upside potential for price movements.  But there's no reason to believe that the multiplier effect works only on the upside, and we have some reason to believe that WTI prices are high relative to some measures of the fundamentals.  If and when the oil price re-establishes the "normal" levels, and there is relief from the series of shocks, we could, just as we did in equity markets, observe a sharp, sudden, and large decline in oil prices.  Such a decline would be welcome, and produce a noticeable gain in GDP and jobs.

In the short run, our policy tool is the Strategic Petroleum Reserve, and our policy with respect to the release of the SPR is clear:  it is not going to be used as a general price stabilizer, and will only be used in a substantial way in the interests of national security.  (Our recent SPR releases were very small, and intended to offset the very specific dislocations associated with the hurricanes).

In the intermediate run, it would be very useful to have a better data collection and reporting framework for this key sector.  If indeed part of the oil price surge is related to a simple lack of data concerning the current state of demand and supply, then it seems that we could improve market efficiency by improving market information – probably a big payoff for a relatively small investment in data collection.  This would help ameliorate the complication from an over-reliance by market participants on U.S. inventory statistics.  In fact, the recent Group of Seven (G-7) Communiqué strongly supports work by the IEA to work on oil data transparency.

In the longer run, first and foremost, Congress needs to pass the President's energy plan, which would encourage domestic energy production and conservation.  On a fundamental level, the key to maintaining a sustainable long-run trajectory for oil prices is to expand domestic supply.  This is one of the goals of the President's energy initiatives and the Administration is committed to actions like increasing the use of domestically produced ethanol and biodiesel, increasing fossil fuel production, and supporting advanced technology research and development in alternative fuels like hydrogen and nuclear fusion.

In conclusion, the macroeconomy is doing well by any standard, but remarkably well considering the headwinds it has faced in the last three years.  While there is more to do, we're encouraged that our tax cuts have helped keep the economy afloat through the recession, stimulated the economy to rapid growth in the last four quarters, and have set the stage for future growth.

Despite good economic performance, high oil prices are slowing our progress.  As I've discussed, our strategy of improving domestic supplies and reducing the uncertainty premium by winning the war on terror will ultimately pay dividends.