How Does The Price Of Oil Affect The US Economy?

There are records of "exploration" for petroleum as early as the 6th century B.C. in Central and East Asia. Historically, the product was mostly extracted from surface "oil seeps," and used for heating, ignition of fires, weapons and lighting. Use of oil was known to the ancient Greeks, but its exploitation only made its way to Europe in a widespread manner in the 15th century, with use in oil lamps in Poland. However, use of animal fat and vegetable oils remained prevalent for lighting and heating until late in the 18th century.

Commercial exploration of petroleum in the U.S. dates to the 1800s. Petroleum was found in salt wells drilled in Ohio and Kentucky as early as 1814, and it was sold as a by-product in surrounding states and in Europe. In 1859, Col. Edwin Drake was among the first to drill specifically for oil at a well in western Pennsylvania. The search for oil corresponded with the growing popularity of the oil-fueled internal combustion engine, and got a major boost in the 1880s with the development of the gasoline-powered automobile. Gasoline, which was historically a little-used by-product of petroleum, was found to be a more efficient fuel in the internal combustion engine than the heavier kerosene fuel that was available.^[1]

Since that time, with the onset of the Industrial Revolution, oil has taken on a major role in the U.S. economy. The demand, supply and price of the commodity has come to have a large influence on factors such as growth and inflation.

With its energy-intensive, mechanised economy and growing population, the U.S. quickly became one of the largest users and producers of oil around the world. By 1970 there were 80.5 million cars and 17.6 million trucks in operation in the U.S. That same year, the U.S produced 9.6 million barrels of oil per day (about 21% of the world total) and was consuming 31% of the world total. But with the discovery large quantities of oil in the Middle East in the 1930s, the Organization of Petroleum Exporting Countries (OPEC) soon overtook the U.S. as the world's dominant producer. By 1970, OPEC countries were producing 23.3 million barrels per day, or 51% of the world total.^[2]

The Influence of Foreign Oil: The Middle East

In 1970, oil production around the world had reached a plateau, and growing consumption placed pressure on prices in the U.S. By 1973, the situation became severe, prompting scarcity of supply, rising prices, long lines at gas stations and gasoline rationing. It was aggravated in October of that year when OPEC, in protest of the U.S. support for Israel's Yom Kippur war, launched an embargo on oil sales to the U.S. While the embargo lasted only a few months, world oil prices thereafter quadrupled, contributing to economic stagnation and rising inflation in the U.S. economy.^[3]

The oil crisis of 1973 and 1974 for the first time revealed the U.S. vulnerability to variations in oil supply and demand, and external political and economic factors affecting the price of the commodity. Several episodes since then, including the Iranian revolution of 1979 and the Persian Gulf and Iraq Wars of 1991 and 2003, also provoked spikes in oil prices and have continued to highlight that vulnerability.

By 2014 the U.S. was producing 11.5 million barrels per day (13% of world output), and consuming 19 million barrels per day (20% of world output). Transportation accounts for more than 65% of petroleum use in the U.S. That rose to 120 million cars and 132 million trucks by 2014. The total number of cars and trucks on the road has more than doubled since 1970.^[4]

Further compounding pressure on oil prices in the U.S. is growing use of oil in large emerging market economies, such as India and China. The latter country's consumption of oil has risen from 500,000 barrels per day in 1970 to 10 million barrels per day in 2014, making the country the world's largest importer.

Fortunately for consumers, the price of oil has not always proven to be a one-way street upward. Factors such as fuel conservation and efficiency measures, new oil finds abroad and the shale oil "revolution" in the U.S in recent years have contributed to increasing supply and have, to some extent, offset the impact of increasing consumption.

The Channels of Oil's Impact

The transmission of oil prices to sectors of the U.S. economy is both direct and indirect. Thirty percent of agricultural expenses are related to energy inputs, which affects the cost of food. The price of oil also impacts shipping transportation costs for industry and commerce, and it has a direct impact on the price of other commodities and raw materials, such as metals. It further impacts travel by raising the cost of fuels for the aviation and ground transportation sectors.

U.S. economic authorities note that the price of oil can make a direct contribution to the economy. In 2014 alone, oil use accounted for nearly 4% of the gross domestic product. Data analysed by the Federal Reserve shows that a 10 percent increase in the price of oil is associated with about a 1.4 percent drop in the level of U.S. real GDP.

There is also a strong correlation between oil prices and prices elsewhere in the economy, with rising crude oil prices pushing up core inflation indicators and inflation-adjusted bond yields. In the years since the 1970s oil crisis, however, oil-driven inflation has been attenuated by more elastic conditions of supply and demand, and it has appeared to be more influenced by the moment of the economy in the business cycle.^[5]

Exchange Rate Impact

Because of the dependence of the U.S. and the world economies on energy, oil prices and currency prices have a direct and two-way relationship. The more currency outflows from an economy, the weaker its currency tends to be. And in the case of the U.S., which is a major importer, oil purchases abroad are a large cause of currency outflows.

At some times, oil imports have accounted for as much as 40% of the U.S. foreign trade deficit. But because the U.S. is a major producer of other goods and services, the strength of the dollar can also have an impact on global crude oil prices. Thus, currency traders can frequently gain an edge in the market by following news on U.S. oil supply and demand, production and consumption, and oil reserve levels. They can also follow other indicators that might affect crude prices, like balance of payments data and monetary policy moves by the U.S. Federal Reserve.^[6]

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