Also see our Economic Commentary which supplements the Laufenberg Economic Quarterly and primarily focuses on more recent economic developments.

Perspectives

This page is designed to offer you my perspective on economic fundamentals, ranging from business cycles to yield curves. It will provide more detailed economic analysis than is generally available in the Quarterly. For the most part, the essays provided here will attempt to discuss timely fundamental issues related to the forecast but are expected to have a longer shelf life than the content on either the Quarterly or Commentary pages. I hope that over time you will consider the information on this page as a source of reference when debating economic issues in the future.

Daniel E. Laufenberg, Ph.D. LaufenbergQuarterly.com

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Oil!

(January 15, 2015)

The price of crude oil has fallen dramatically in recent months, causing some market commentators to suggest that it is a net negative for the economy and the stock market. The consensus is that this assessment is wrong and I agree. Lower oil prices are a net positive for the U.S. economy and in turn the stock market. The primary reason lower oil prices are positive is that we consume more than we produce domestically, suggesting that not all of the production adjustments, if any, to lower prices must occur domestically. That being said, since most of the supply adjustments to higher oil prices occurred domestically, it should be no surprise if most the supply adjustments to lower oil prices were made domestically as well. This is referred to in economic jargon as sliding up and down the supply curve to changes in the global price of oil. Of course, the supply curve may be more inelastic to price changes in the short run than in the long run, which is another way of saying that price changes must persist for a while to encourage major supply changes.

In addition, price changes also induce adjustments on the demand side. When prices go up, demand falls, and when prices go down, demand rises. Although the demand adjustments may seem slow, I contend that short-term demand adjusts are faster than short-term supply adjustments; that is, the short-run demand curve is more responsive to price changes than the short-run supply curve.

At the center of the supply discussion is North Dakota's Bakken shale, which was experiencing an economic boom when crude oil was priced at $100 a barrel. Now with the price of oil less than half that, the frenzy has abated. Although some of the low profit margin rigs have been shuttered, North Dakota is still in the oil business. It stands to reason that some jobs have be lost, but what may be more important is that the North Dakota oil fields will not be a source of new jobs if oil prices remain low. And as the unemployment rate for North Dakota, which was 2.8 percent according to the latest reading compared to the 5.6 percent reading for the U.S., starts to rise, new arrivals to North Dakota looking for employment will slow.

Many seem to be concerned about a sharp drop in capital investment associated with substantially lower oil prices. There is no doubt that oil-producing state will see, if they have not already seen, a decline in oil rig count, less investment in retail establishments, hospitals, schools, roads and railroads, and housing just to mention a few items. There could be other adverse effects of lower oil prices, including lower profits for oil companies, lower real estate values in oil patch states, and some bad bank loans secured by mineral rights or oil leases.

The question is just how significant will the negative effects be to the overall economy and whether they will be more than offset by the positive effects from lower priced petroleum products. One thing to keep in mind is that pipelines, refineries, railroads, truckers, service stations, and plastics companies, just to mention a few, are still going to pipe, refine, ship, sell petroleum products. In fact, they may end up doing more because of the lower price of oil but using imported rather than domestically produced crude oil. Regardless of the source of oil, their input costs are now lower. Some of that lower cost may be pushed forward to their clients, but some of it may boost the profit margins on their services and products at all stages of production. In addition, the loss of investment in the oil patch states could be more than offset by increased investment elsewhere, as the lower price of petroleum products to consumers and other buyers increase purchasing power and profits for them. Indeed, the biggest winner under this scenario may be housing, as households may be more mobile with lower commuting costs.

This brings us to the issue of how important crude oil is to the overall U.S. economy. It may get a little technical here but the best way to make this assessment is to examine the "use table" of the Input-Output data provided by the U.S. Commerce Department's Bureau of Economic Analysis. This data is reported annually. The use table is a matrix that shows the commodities used by individual industries in their production processes (intermediate inputs) as well as processed commodities that are sold directly to consumers and other buyers (final uses). The table also shows each industry's contribution to gross domestic product (GDP). According to the 2013 use table, petroleum and coal products (the most detailed data available for that year) accounted for no more than 2.0 percent of GDP (the actual number was 1.7 percent) and no more than 3.0 percent of all output produced (the actual number was 2.7 percent). Recall that GDP is the value of all final goods and services produced in the U.S. regardless of who owns the resources used, it is not a measure of all transactions. Another way of describing GDP is that it represents the sum of the value added (and not total output) at each stage of production.

The price of crude oil

Crude oil prices have plummeted in recent months, as measured by the price of a barrel of West Texas Intermediate sweet crude (see Chart 1). Most recently below $50 a barrel, the question now is how much lower it will go. Interestingly, it was about a year ago when the discussion was about how high the price of crude oil would go, which may help illustrate just how volatile the price of crude oil can be. What happens when the price of oil drops sharply? For the most part, the positive effects of lower oil outweigh the negative effects.

On the negative side of the ledger, profits at some oil companies will fall, especially if they are more involved in the extraction of oil and less involved in the processing of it. In turn, there will be some jobs lost, or at least fewer new jobs created. Also, oil patch states are likely to see a drop in tax revenue as a result of lower prices, possibly putting some pressure on state budgets. Finally, small regional banks in the oil patches that may have a disproportionate share of their loans to finance the exploration and extraction of oil could experience some problems. In particular, many old-timers remember the Penn Square Bank disaster in the early 1980s, which is often cited as being partly responsible for the collapse of Continental Illinois National Bank and Trust. Of course, the extent of the negative effects will depend on how leveraged the oil companies are to the price of oil. In the wake of Dodd-Frank legislation, I doubt that banks have been allowed by regulators to be overly exposed to any one credit risk or to engage in the activity that led to Penn Square's demise.

An important consideration is that despite the increased dependence on domestically produced oil, we still import roughly half of all the crude oil we consume (in 2013, 2.8 billion barrels out of the total 5.6 billion used in the U.S.). This means that the positive demand effect from lower crude oil prices outweigh the negative supply effect because only about half of the crude oil used in the U.S. is produced domestically and adds somewhat directly to GDP (more on this later). The implication is that the negative effect of lower crude oil prices will be far more pronounced in oil-exporting countries where oil is their major export. Several OPEC countries come to mind.

chart 1

On the positive side, lower oil prices mean lower prices of petroleum products, especially the price of gasoline as far as consumers are concerned. But this is only part of the story. Lower petroleum products means that input costs have declined for many companies. This includes transportation costs across the board, regardless of whether it is planes, trains, or trucks, and production costs for chemical and plastics companies that use petroleum based products as inputs. Whether the lower costs are fully passed on to retailers and in turn on to consumers depends on the strength of the demand for the products involved. To the extent that they are not, then it means stronger profits for the companies supplying these products. Nevertheless, consumers have already seen the benefit of lower prices for gasoline and fuel oil. In fact, lower prices most likely will lead to more demand, albeit slowly. Along this line, one could argue that the sharp drop in crude oil in 2008 provided some much needed stimulus at the time and may have been an important factor contributing to the U.S. economic recovery that began in the middle of 2009.

However, here too it is important not to overstate the potential gains. Remember that in the past it was the "shock effect" that mattered. Although the recent drop in crude oil prices may have been sharper than expected by many, it was not shocking given the well-advertised near-term supply gains without a corresponding boost in nearterm demand. Indeed, some analysts early last year predicted the price of crude oil would fall markedly in 2014. Unfortunately, I was not one of them. This is just another way of saying that the necessary adjustments to supply will be made in a somewhat orderly manner, albeit still unpleasant for those being adjusted.

Relative importance of crude oil to U.S. economy

Undoubtedly, petroleum products represent a major commodity in the operations of the U.S. economy because they are so widely used by various industries. This is shown to some extent in Table 1, which highlights a short-list of selected industries (from the 71 industries included in the detail data) as they relate to a few selected commodities (from the 73 commodities included in the detail data). The industries are listed in the far left column, while the commodities are listed in the top row. As mentioned earlier, Table 1 is a matrix that shows the commodities used by individual industries in their production processes (intermediate inputs) as well as commodities that are sold directly to consumers and others buyers (final uses).

For example, the first industry listed is Farms, which uses a total of $234.5 billion of intermediate products in its production process. Looking at some of the selected detailed commodities highlighted, farms use $20.7 billion of the output from the petroleum and coal products industry and $17.7 billion of the output from the chemical products industry as intermediate inputs but nothing directly from the oil and gas extraction industry. The total output of the farm industry in 2013 was $427.0 billion, representing the $234.5 billion of intermediate inputs and the $192.5 billion of value added. Recall that one way to measure GDP is the sum of the value added by all industries operating domestically regardless of ownership.

The next industry listed in the Table is that of petroleum and coal products. There are a few interesting aspects of this industry's production process that is worth noting, which in turn may help understand how the "use" matrix works. Not surprisingly, one aspect is that the principle input for the petroleum and coal products industry is output from the oil and gas extraction industry; a whopping $515.5 billion of the petro and coal industry's total intermediate inputs of $625.5 billion. Also, this industry is the only one that I selected to be included as an industry and a commodity Table 1.

The total output of this industry in 2013 was $792.9 billion, but only $167.4 billion of it was value added (contribution to GDP). In the aggregate, the $792.9 billion of output from the petroleum and coal products industry represents 2.7 percent of total industry output, but the $167.4.0 billion of value added by the petro industry represents only about 1.0 percent of the value added measure of GDP. However, as a commodity, the total commodity output was $802.0 billion and the final uses was $285.7 billion. By this measure, petroleum and coal as a commodity still represented 2.7 percent of total output, but was 1.7 percent of the total final uses (GDP). In other words, petroleum and coal products are important to the U.S. economy because of the widespread use rather than their total contribution to GDP.

I am not going to go through each of the industries selected but it is worth noting that each one listed uses some petroleum and coal products, as well as chemical products, in their respective production processes. However, generally petroleum and coal products represent a very small portion of industry inputs. The exceptions listed in Table 1 are the air and truck transportation industries and to a lesser extent all levels of government. Obviously, the industries that use more petroleum products as intermediate inputs will benefit from lower petroleum prices than others.

Total output for all industries was $29.7 trillion 2013 (the highlighted number in the seventh column of Table 1). Of this total, $12.9 trillion represented intermediate product of industries, while $16.8 trillion represented value added at various stages of production. Value added is one way of measuring GDP. For example, when industries sell their products, they don't simply add up the cost of inputs and sell them for the sum of those costs. The concept of value added is that each stage of production adds some value to the final product. The output of one industry may be the input for another industry.

table 1

If it is not used as an input, then it is a final product (GDP) and represents the sum of the value added at each stage of production. For example, when you buy gasoline at a service station, you are buying the value added at each stage of production because the price already includes the cost of crude oil, the cost of refining that oil, the cost of the capital used in the production of gasoline, any transportation costs, a variety of taxes, such as sales and excise taxes, and any profits acquired at each stage of production. However, if a trucking company buys gasoline at a service station, it is an input into the service they provide, which may be an input to the retail or wholesale product they are transporting. It is the final sale of the product being transported that includes the cost of the gasoline used by the trucker.

My favorite example of a final product versus an intermediate (input) product is the price of an airline ticket. If the flight is for pleasure, then the price of the ticket is considered a personal consumption expenditure and included directly in GDP. However, if the flight is for work, then it is considered a cost of doing business and is not directly added to GDP but most likely will be reflected in the price of the good or service provided by the company paying for the ticket. In the first case, it is final but in the second case it is intermediate.

The bottom line is that crude oil is an important commodity for the U.S. economy in large part because so many industries use the products refined from crude oil rather than the extraction of oil itself. We need oil regardless of its source. In fact, we still use twice as much as we produce domestically, which means we will continue to rely on imports. Obviously, we would feel more secure in an uncertain world if we were energy self-sufficient but that is unlikely anytime soon. Hence, the goal of oil independence is more a national security policy than it is an economic policy. We seem more secure about our energy future if the imports are from Canada and Mexico. In that regard, do not be surprised at current prices if crude oil imports start to rise again in the months ahead. After all, with petroleum product prices less than half of where they were, the incentive to limit use may subside somewhat with price.

As noted earlier, the sharp drop in crude oil in 2008 provided some much needed stimulus at the time and may have been an important factor contributing to the U.S. economic recovery that began in the middle of 2009. There is every reason to think that lower crude oil prices will deliver a similar result this time around, albeit maybe not quite as powerful owing to more domestic-supply adjustments than earlier. square

Daniel E. Laufenberg, Ph.D.

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For the current economic forecast, as well as other analysis and commentary, please visit the Stonebridge Capital Advisors website.

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


Current Perspective

2015 Economic Perspectives

Oil! -- January 15, 2015
(current issue)

2014 Economic Perspectives

Things to Watch -- February 5, 2014

2013 Economic Perspectives

Made in the U.S. -- January 29, 2013

2012 Economic Perspectives

Going over the "fiscal cliff" -- November 2, 2012

Factors that drive consumer spending -- August 13 , 2012

House prices: the bottoming process continues -- March 8 , 2012

Equities and the political calendar -- February 7, 2012

2011 Economic Perspectives

Is the great American job machine finally broken? -- December 6, 2011

Recession fear, not fact -- September 4, 2011

Core inflation: a policy guide more than a policy target -- May, 2011

Help not wanted? -- Feb, 2011

Special Report: Health Care Legislation: Essay No.1 - Costs Essay No.2 - Revenue Essay No.3 - Budget Deficits

2010 Economic Perspectives

Causes of the financial crisis revisited --November, 2010

A less robust U.S. Economy longer term --August, 2010

Greece: A test of Europe's resolve to remain united --May, 2010

The U.S. jobs machine restarting at a slower pace --February, 2010

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