Low Oil Prices Are Not Helping the Economy. What Can We Do About It?

When oil prices started their precipitous drop in summer of 2014, just about everyone (including myself) thought that this would be unquestionably good for the American economy: less money spent on oil, and especially imported oil, means that more is available to spend on things we really want, such as food, clothing, education, etc., and the additional spending would generate economic growth and jobs.

But now we are seeing some distressing outcomes: for the last several weeks, whenever the price of oil drops, the stock market drops, and vice versa. These outcomes are distressing (if they persist) not just because it means that investors make less money, but also because lower stock prices often foretell reductions in economic indicators that we all care about, such as personal income and jobs.

This result is accompanied by news stories showing that the consumer savings from lower oil prices has not generated new spending. Nor is there evidence that the increased consumer savings has done much good for the economy. Instead, the industrial production that used to go to drilling for oil is disappearing, with nothing to replace it.

Nobody seems to really understand what is going on. Worse, no one seems to know what to do about it, or to know if indeed there is anything we can do about it through policy.

This blog poses two ideas, or hypotheses, about what the problems are, and a solution that should help even if my explanation is wrong.

The first problem: stock market traders still don't understand that oil consumption is not linked to economic output

The business news articles on oil prices generally include a thread that goes like this: "faltering economic growth in China (or anywhere else that matters in the global economy) will lead to falling oil demand, which is a drag on oil prices." Business articles now seem to be reversing the direction of causality, saying that lower oil prices are an early warning of low economic growth. Investors are worried that the lower oil demand that is being reflected in low oil prices will mean that GDP drops as oil demand drops.

This argument is not incorrect in the short term, but it leads one astray in the longer term.

Over the last 40 years, the American economy has reduced its oil dependence, as measured in oil use per unit of GDP generated, by more than 60 percent, as illustrated in Figure 1. The declining trend, which differed from previous decades' experience of near-constant ratio of oil consumption to GDP, began as post-oil-embargo oil conservation policies, most importantly fuel economy standards for cars, kicked in.

Figure 1: U.S. oil consumption per unit of economic production (GDP)


This outcome is a result primarily of fuel economy standards for cars, along with other policies to save oil through efficiency and fuel substitution. In California, where oil used to be used for electric power, we have seen an even greater departure of oil consumption trends from GDP growth trends, as the state's energy policy caused the replacement of oil-fired power generation by gas and then renewables.

The problem with this misperception--that oil consumption is needed for economic growth, and that low oil prices will cut production and thus consumption-- is that it has consequences when the causation is assumed to go the other way: that low oil prices will cause lower economic growth.

As an aside, I wonder why no one seems to have noticed the internal contradiction: if higher oil consumption means higher economic growth, and if lower oil prices encourage consumption (which in fact they don't, (but which most people believe)), then low oil prices should promote economic growth, and thus investors should be buying stocks, not selling them.

The idea that oil (or energy) consumption is tied to GDP is an old argument that opponents of environmental protection used: they claimed that if we try to reduce energy use, we cut economic growth and prevent poor countries from emerging from poverty.

Figure 1 illustrates that this idea is wrong: the line would be flat if it were correct. We have shown on a regional basis as well as on a national basis that when a jurisdiction directs policies toward energy efficiency and other forms of clean energy, the economy grows without energy use growing, or in the case of oil, where policy efforts in the U.S, have been intermittent and often half-hearted, that the economy grows far faster than oil or energy use.

Despite this refutation by actual trial, a quick Google search of oil consumption and economic growth will turn up lots of articles that restate the myth.

The danger is that this misperception could become self-fulfilling: if low oil prices cause low stock prices and low stock prices lead to low growth, then we have a problem. Investors concerned that oil prices predict economic activity will hold back on all investments (not just those in the energy arena) due to (mis)-perceived risk, and that withdrawal of investment will cause economic growth to lag.

The bigger problem: what if low oil prices really do not help with growth?

Part of the re-industrialization of America over the past decade has been in industries that produce the equipment needed to drill for oil. At high oil prices, this amounted to lots of economic production and a modest number of jobs, especially in certain communities where a small number of jobs makes a big difference.

This is a problem because the growth was unsustainable--not just in the environmental sense but in the economic sense: the fact that it is not being sustained now that oil prices are back to the low end of the historical range. Consumers were being bled by high oil prices to feed an industrial program that was ultimately unaffordable. Again, I am arguing unaffordability by the observed outcome that American companies cannot keep producing as much oil profitably, not making a value judgment here.

With what can we replace this industrial demand? Here we move from hypothesis to demonstrable fact: the best way to revive an economy still suffering the after-effects of a financial collapse is to stimulate demand, especially for long-lived infrastructure.

Current low interest rates are a reflection of too much cash chasing too few investment opportunities. They tell us that more investment is needed. But it is not going to come from fossil energy supply.

Clean energy investment opportunities

We have a multi-trillion-dollar investment opportunity staring us in the face: clean energy. We have some 150 million homes in North America that need to be upgraded to save energy, and this would likely cost about $12,000 a house, for a total investment need of almost $2 trillion. Commercial buildings would need a program about as large. All of these dollars would be spent on local labor that cannot be outsourced and usually locally produced supplies, such as windows, insulation, heat exchangers, etc.

These investments are unlike those in oil drilling because they pay back. The $12,000 investment found in a typical house in current home retrofit programs would cut costs by some $30,000 over the 30 year life of the project, as well as making the home more comfortable. With a goal of reducing climate pollution, we ought really to be spending two or three times as much per home and targeting even greater energy savings: even this will pay itself back. So now the opportunity looks more like $10 trillion!

There is another great potential for investment in high speed rail. Rail investments today (which are partly government funds and partly private) can avert the need for 2 to 3 times more spending over future years on airports, runways, parking, and roads, all of which is government spending. More important to me, as a very frequent flyer, is that the rail alternative to flying is much more reliable, especially in bad weather, and often faster. For those who say that America is too big a country, I note that technology currently in commercial operation in Europe and Japan would allow me to board a train at 5 pm in San Francisco and attend a meeting the next day in Washington DC at 9 am.

(Perhaps I am overemphasizing rail investment here, but it is a pretty emotional issue for me now. I have traveled about 25,000 miles in the last two months, and only about 3 of 12 flights have been on time. 4 or 5 of them have been over 5 hours late. If you also travel a lot, you know first-hand that the domestic air travel system is broken, wasting a lot of would-be-productive time and causing emotional distress.)

Many states are expanding their mandates for renewable energy, which also represents a multi-trillion-dollar investment opportunity that makes financial sense.

This is just the tip of the iceberg. An accelerated clean energy investment is needed not only to solve our climate problem, but the markets are beginning to tell us it may be needed to solve the economic growth problem as well.