from Follow the Money

Adjusting to $125 a barrel oil

May 14, 2008

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This is not a post about the gas tax. Nor is it a post about how the United States existing energy-inefficient capital stock makes it harder for the US to adjust to higher oil prices. Dr. Krugman has already covered that ground well. It is rather a post about how the global balance of payments has to respond to what increasingly looks like a significant oil shock.

If oil -- using the price for sweet light crude -- stays to $125 a barrel for the rest of the year, the average price of oil over the course of 2008 will be around $115 a barrel. The average 2007 price was around $70 a barrel. The $45 a barrel y/y increase in the average price of oil is equivalent to going from $25 a barrel oil to $70 a barrel oil in a single year. It is a large jump.

It would lead to something like a $650-700 billion transfer of wealth from the oil-importing economies to the major oil-exporting economies

Assuming that the oil exporters don’t spend and invest all that much more than they already were planning to do in 2008, the rise in the oil export revenues will translate into a comparable increase in the oil exporters’ current account surplus – and a comparable rise in the oil importers deficit. Of course, there will be some adjustment in the imports of the oil-exporting economies. But spending and investment in the oil-exporting economies tends to adjust with a lag to rises in the price of oil. And it was already on a sharply upward trajectory, in part because of the exceptionally low real interest rates in the oil-exporting world. If oil had stayed at its 2007 level, it is safe to assume that the oil exporters surplus – roughly $425 billion in 2007 according to the IMF – would have fallen by $100 billion, if not more.

The Spring IMF World Economic Outlook assumed that oil would rise from $70 a barrel to $95 a barrel average oil price -- pushing the oil exporters (Fuel exporters in the WEO) current account surplus up to $620 billion. If oil says at $125 a barrel for the rest of the year and oil averages $115 a barrel for the year, the oil exporters’ current account surplus could approach $900 billion range.

That forecast assumes that the oil exporters collectively would need an oil price of about $55 a barrel to cover their import bill. It relies on a lot of ballpark math too -- I haven’t done a detailed update of my 2007 paper on oil and global adjustment.

But in some sense, the precise details do not matter all that much.

We know that there will be a big rise in the oil-exporters collective surplus.

And we also know that there will also have to be a big fall in the oil-importers collective deficit.

This adjustment though could happen in a bunch of different ways.

The world, broadly speaking, has three oil importing regions - Asia, Europe and the US – and each imports roughly 15 mbds of oil. The US and Europe import a bit less, Asia a bit more. The EU (which excludes Norway) actually imports a bit less than the US these days – 13 mbd v 14 mbd. So the “shock” will in the first instance have a roughly similar impact on all three regions (all data comes from BP). Each region should see its deficit rise (or surplus fall) by around $200 billion.

Nothing though guarantees that the adjustment of various regions to an oil price shock will be symmetric. In the past, it actually has often been asymmetric. MORE FOLLOWS

From 2002 through 2007, Asia surplus actually rose even as the oil surplus rose, largely because of the enormous increase in China’s surplus. If that happens again, the rise in the US and Europe’s deficit needed to balance the rise in the oil surplus would be corresponding larger.

But let’s assume that doesn’t happen again. Oil’s rise to $125 a barrel should single-handedly knock $60-70 billion off China’s trade surplus, and the US isn’t quite as robust a market for Chinese goods as it once was.

The adjustment could be asymmetric in another way. If an oil shock hits one oil-importing region with a large pre-existing deficit (the US), one oil-importing region with a small pre-existing deficit (Europe) and one oil-importing region with a large pre-existing surplus (Asia), the easiest way for the aggregate deficit of the oil-importing region to adjust would be for the fall in the surplus of the surplus region to be bigger than the rise in the deficits of the deficit regions.

A surplus country after all doesn’t need to attract any financing or run up its debt stock to sustain large deficits, while a deficit region both needs new financing and has to add to its outstanding debt stock.

So how is the world adjusting?

Well, so far China’s surplus is roughly flat. It hasn’t though absorbed the full impact of the rise in oil prices -- though the gap between oil prices in q1 of 2007 and q1 in 2008 is actually about as wide as the gap that one would expect for the entire year. But with China’s exports are still growing at a nice clip (20% y/y) it isn’t at all obvious to me that China’s surplus will fall. Its surplus should fall in q2 – but in the second half ongoing export growth would interact with slower import growth to bring the surplus back up.

If China’s surplus doesn’t fall even as its oil import bill rises sharply, that means the rise in the deficit of other oil-importing regions has to be bigger. That rise could come from other Asian economies, squeezed on their exports by China and facing a much higher bill for imported oil. Think India. It could come from Europe. Or it could come from the US.

Right now I would expect the US trade and current account balance to expand by roughly $100 billion, as say a $100 billion improvement in the non-oil balance is offset by a $200b or more deterioration in the oil balance.

If China’s surplus doesn’t fall and the US deficit doesn’t rise by as much as its oil import bill, that implies the rise in the deficit of the rest of the world has to be bigger. Europe and emerging Asia (ex China) almost by necessity will have to run bigger deficits to accommodate the absence of any fall in the Chinese surplus and the smaller than might otherwise be expected rise in the US deficit.

That at least is what I am thinking around now.

The FT understands this.   Their leader last Friday noted that the rise in the Euro had been overdone – and threatened to undermine Europe’s growth. Hence they welcomed the dollar’s mini-rebound. But they also noted that many Asian currencies need to appreciate against both Europe and the US to reduce the world’s imbalances.

And right now, unfortunately, it seems like China isn’t willing to help out. The fast rise in the RMB against the dollar didn’t produce broad based nominal appreciation, as the RMB fell against the euro. And now the RMB is stable against the dollar. The RMB will still rise in real terms so long as inflation in China outpaces inflation elsewhere.   But with productivity growing faster in China than elsewhere that may not be enough. And right now the world economy would benefit more than usual from a fall in China’s surplus, as it would help to dissipate some of the global impact of a major oil price shock away from the big deficit countries.

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