Could Expensive Oil Be Good for the U.S. Economy?

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Everybody knows that high gas prices hurt families and slow down business. It is possible that what everybody knows is wrong?

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An oilfield worker walks past the Statoil oil sands facility / Reuters

A basic disagreement lies at the root of many of today's most heated energy debates: some people think that expensive oil is bad for the United States, while others think that it's good. One side asserts that the economic benefits of cheap oil outweigh all else, while the other insists that the environmental and other damages stemming from inexpensive oil are clearly paramount.

Economists have a standard answer to this: low market prices for oil are good, but low consumer prices often aren't. Pursue policies that maximize potential supply, but tax oil consumption in order to internalize the damages, and presto, you've resolved your concerns. If the pro-oil dream is twenty dollar crude, and the anti-oil dream is hundred dollar oil, the economists' dream is twenty dollar oil and a two dollar per gallon gasoline tax.

But that option does not appear to exist in reality. This raises a big question: Are there conditions under which high market prices for oil could be beneficial? This isn't an easy question to answer, but it's an important one, so I'm planning to write a series of posts that tries to resolve it. (This is something of an experiment: if the posts add up to something solid, I'll turn their content into an article.) These are preliminary thoughts, and they might be wrong. Criticisms, particularly technical ones, are very much welcome.

One of the first things you realize when you start to think about this question is that the source of high oil prices matters to your conclusions. If, for example, oil prices rise because Saudi Arabia has cut back production, that has one set of consequences; if they rise because regulators have curbed U.S. production, that has another; and if they increase because Chinese oil demand is booming, that has a third. This post is going to focus on a simple and instructive, though ultimately unrealistic, case: I'm going to ask what happens if oil prices rise but nothing else changes (except as a result of that oil price increase). Think of this as a case where a country on the margins of the international economic system, and from which the United States doesn't buy oil, cuts its production a bit, raising prices. If you want a picture, that country might be Iran. And I'm going to focus on the long term - it's hard to imagine a case where short term price rises are beneficial.

I'm going to look at a $1 (i.e. 1 percent) increase in the oil price. This choice shouldn't make a difference to my conclusions. Let's also start with a few more assumptions to keep things concrete. We'll assume that world oil consumption is about 90 million barrels per day (mbd); U.S. oil consumption is about 20 mbd; U.S. oil imports are about 10 mbd; world oil prices are about $100 per barrel; and marginal damages from climate change are about $20 per ton of CO2. (The last figure is the social cost of carbon that the U.S. government uses in regulatory assessments.) I'll revisit several of these later.

How much does the oil price increase cost the U.S. economy? I'm going to focus on two long term consequences. The supply side impact should be equal to the fraction of oil in U.S. output multiplied by the decrease in U.S. oil consumption. Given our assumptions, oil consumption is equal to about 5 percent of the U.S. economy. If the long term elasticity of U.S. oil demand is about -0.5, our price increase leads to a 0.5 percent drop in U.S. oil consumption, and hence to a loss of 0.025 percent of U.S. GDP, or about $10 million each day. The second cost is the additional wealth transfer to the sources of U.S. oil imports. That's also equal to $10 million each day. That gives us a total cost of $20 million each day. My instinct is to offset that by the reduction in oil imports due to lower U.S. consumption, though I'm not certain that that's correct. Including that effect brings the net cost down to $15 million.

One might ask whether I should account for the fact that some of the money the United States sends abroad for oil comes back through purchases of goods and services by oil exporters, thus reducing the net cost. Strictly speaking, my guess is that the answer is yes. I'm going to ignore it, though. Other U.S. trading partners will also transfer wealth to the oil exporters as a result of the higher oil prices. The net impact will be more U.S. exports to the the oil exporters but fewer to other trading partners. Since most oil exporters have trade patterns tilted away from the United States, I'm basically underestimating the cost of higher oil prices.

But enough with the costs. What about the benefits of higher oil prices? Greenhouse gas emissions are the obvious place to start. If we assume that global elasticity of oil demand is -0.4, and that a barrel of oil is on average associated with about half a ton of greenhouse gas emissions, we get incremental damages of about 4 million dollars a day.

Greenhouse gas emissions are not, of course, the most significant source of damages. A National Academy of Sciences study recently estimated that the non-CO2 damages due to transportation are about 1.4 cents per mile traveled, due to things like conventional pollution, accidents, and congestion. (They actually presented a range, but I'm using a central value.) Let's say that the average U.S. vehicle (including heavy trucks) gets 15 miles per gallon. This translates to damages of nearly 9 dollars per barrel of oil, roughly the same as from climate change. Unlike in the case of greenhouse gas emissions, though, the impact is restricted to U.S. (rather than global) oil consumption. The consequence thus ends up being about a million dollars a day. (I've actually overestimated this a bit - more later.)

One quick note before moving on: it isn't clear that it's self-consistent to include global climate change damages while counting wealth transfers as costs. To put a sharp point on things, I'm basically saying that if higher oil prices enrich Africa through their oil exports, that's a cost to the United States, but if they enrich Africa by reducing climate change, that's a benefit. Self-consistency suggests that I should either ignore at least part of the wealth transfer costs, or ignore part of the climate benefits, but that I shouldn't include both in full. For now, though, I'm going to stick to what I've already done; I'll circle back in a moment.

We can now take a look at the net impact: $15 million in costs and $5 million in benefits for every dollar increase in the price of oil. With this set of assumptions, at least, expensive oil looks bad for the United States.

What happens if I vary some of the basic assumptions? Let's take a look at each one that might plausibly be wrong:

  • Different world oil prices. The cost of a dollar increase in the price of oil shouldn't depend on the reference price. For a higher reference price, the impact on volumes drops, but the per-unit consequences rise; the reverse is true for a lower reference price. The benefit, though, should increase at lower oil prices and rise at higher ones,  since only the volume impact should matter. At $50 oil, for example, the benefits of a 1 dollar price increase should double to $10 million, while the costs should remain at $15 million. The net impact of higher prices, though, would still be negative.
  • Different demand elasticities. Pretty much everything in this calculation scales with the elasticity of U.S. demand; one can change that figure, then, without changing the net outcome. The one exception is climate impacts, which are determined by global elasticities. My calculation assumed that the ratio of U.S. to global demand elasticities was 4:5. It would need to become something like 3:1 before we'd see costs equal to benefits. Intuitively, we're imagining a situation where higher prices do far more to depress global consumption, and hence emissions, than they do to the United States. That's not a plausible case.
  • Different climate impacts. The most obvious way to tip the balance is to crank up the climate impacts. If, say, we increased the damage assumption to $65 per ton of CO2 (the upper end of the U.S. government range), the benefits of higher oil prices would rise to about $13 million dollars a day, similar to the estimated costs.
  • Different non-climate impacts. The National Academies estimate for maginal non-climate damages is substantially lower than many others. Another reputable estimate pegs the impact at being on the order of 6.5 cents per mile (plus 6 cents per gallon in pollution damages), with a high-end estimate of about 16 cents per mile. Let's assume that the higher oil price reduces U.S. consumption half through less driving and half through greater efficiency. Then the impact of a one dollar rise in oil prices would be a bit more than $2 million less in non-climate damages each day (or about $5 million for the high end number). The costs of more expensive oil would still outweigh the benefits.

We should also take a look at what happens if we resolve the self-consistency problem I flagged earlier. If we take a purely nationalistic approach and largely ignore climate damages, the costs of higher oil prices outweigh the benefits even more. If we take a more globalist approach, keeping the climate damages but ignoring wealth transfers, we end up with $10 million dollars in daily costs and $5 million in benefits. With somewhat higher climate damages, though, higher oil prices end up actually looking good.

What's the bottom line? For the scenario I've examined, the costs of higher oil prices appear to usually outweigh the benefits. But a mix of lower background oil prices, greater assumed climate and non-climate damages, and a more cosmopolitan approach to thinking about costs and benefits could change that. I have, of course, left a lot out. I haven't looked at cases where higher oil prices result from lower U.S., Canadian, or Saudi production, all of which would have different consequences. (My instinct says that, all else being equal, the former two cases will raise the costs of higher oil prices.) And I haven't looked at non-economic consequences, like the potential security impacts of increased funds in the hands of some oil exporters. I also haven't looked at how higher oil prices would affect the political economy of oil and climate related regulation. And I'm sure I've missed a bunch of other things (and gotten a some things wrong). That's going to be all for now, though. Thoughtful feedback would be most welcome.

This article originally appeared at CFR.org, an Atlantic partner site.

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Michael A. Levi is the David M. Rubenstein Senior Fellow for Energy and the Environment at the Council on Foreign Relations. His newest book is The Power Surge: Energy, Opportunity, and the Battle for America’s Future.

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