Ben S Bernanke: Energy and the economy
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, before the Economic Club of Chicago, Chicago, 15 June 2006.
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In my remarks today, I would like to discuss the relationship between energy markets and the
economy. As I am certain all of you are aware, the steep increases in energy prices over the past
several years have had significant consequences for households, businesses, and economic policy. At
least since the time of the first oil shock in October 1973, economists have struggled to understand the
ways that disturbances to the supply and demand balance in energy markets influence economic
growth and inflation. At the most basic level, oil and natural gas are just primary commodities, like tin,
rubber, or iron ore. Yet energy commodities are special, in part because they are critical inputs to a
very wide variety of production processes of modern economies. They provide the fuel that drives our
transportation system, heats our homes and offices, and powers our factories. Moreover, energy has
an influence that is disproportionate to its share in real gross domestic product (GDP) largely because
of our limited ability to adjust the amount of energy we use per unit of output over short periods of
time. Over longer periods, energy consumption can be altered more easily by, for example, adjusting
the types of vehicles that we drive, the kind of homes that we build, and the variety of machines that
we buy. Those decisions, in turn, influence the growth and composition of the stock of capital and the
productive capacity of the economy.
Over the past thirty-five years, the U.S. economy has experienced some wide swings in energy prices.
The oil price increases of the 1970s were followed by price declines in the mid-1980s and then a price
spike in 1990, with numerous fluctuations since then. From the mid-1980s until fairly recently, market
participants tended to look through these price cycles and did not allow their longer-term expectations
for oil prices to be greatly affected by short-run swings in spot prices. But beginning around 2003,
futures prices began moving up roughly in line with the rise in spot prices. Thus, unlike in earlier
episodes, the significantly higher relative price of energy that we are now experiencing is expected to
be relatively long lasting and thus will likely prompt more-significant adjustments by households and
businesses over time.
This higher relative price of energy poses many important questions for economists and policymakers.
Why have the prices of oil and natural gas risen so much? What is the outlook for energy supplies and
prices in the medium term and in the long term? And what implications does the behavior of energy
prices have for the ongoing economic expansion and inflation? I will touch briefly on each of these
questions.
Developments in oil markets
Let me begin with the market for crude oil. What accounts for the behavior of the current and expected
future prices of petroleum? Supply and demand are among the most valuable concepts in the
economist's toolkit, and I believe they are the key to understanding recent and prospective
developments in oil markets. For the most part, high oil prices reflect high and growing demand for oil
and limited and uncertain supplies.
On the demand side, world oil consumption surged 4 percent in 2004 after rising a solid 2 percent in
2003. The rise in 2004 was much larger than had been expected and was, in fact, the largest yearly
increase in a quarter-century. A significant part of the unexpected increase in oil consumption that
year reflected rapidly growing oil use in the United States and East Asia, notably China. In 2005,
growth of world oil consumption slowed to 1.3 percent, partly reflecting the restraining effects of higher
prices. Nonetheless, the level of oil consumption was still high relative to earlier expectations. Thus far
this year, underlying demand pressures have remained strong in the context of a global economy that
has continued to expand robustly.
On the supply side, the production of oil has been constrained by available capacity, hurricanes, and
geopolitical developments. In 2003 and 2004, as oil consumption and prices rose briskly, Saudi Arabia
and other members of the Organization of the Petroleum Exporting Countries (OPEC) pumped more
oil. OPEC was able to boost production relatively quickly in response to changing market conditions by
utilizing productive capacity that had been idle. By the end of 2004, however, OPEC's spare
production capacity was greatly diminished. As a consequence, OPEC's oil production flattened out
over the past year even as oil prices continued to soar.
Oil production outside OPEC also leveled off last year, contrary to earlier expectations for continued
growth. This development in part reflected the devastating effects of last year's hurricanes. Katrina
and Rita were enormously disruptive for our nation's production of energy. At the worst point, 1.5
million barrels per day of crude oil were shut in, virtually all of the U.S. production in the Gulf of Mexico
and nearly 2 percent of global oil production. Recovery of oil production in the Gulf has been slow, and
the disruptions from last year's storms linger even as we enter this year's hurricane season. The
cumulative loss in oil production attributable to Katrina and Rita amounts to more than 160 million
barrels of oil, a figure equivalent to nearly half the present level of commercial crude oil inventories in
the United States.
With the background of strong demand and limited spare capacity, both actual production disruptions
and concerns about the reliability and security of future oil supplies have contributed to the volatility in
oil prices. The oil-rich Middle East remains an especially unsettled region of the world, but political
risks to the oil supply have also emerged in nations outside the Middle East, including Russia,
Venezuela, and Nigeria.
Compounding these difficulties in markets for crude oil have been constraints and disruptions in the
refining sector of the energy industry. In the wake of Hurricane Rita, one-quarter of domestic refining
capacity was offline, and here, too, the period of recovery has been protracted. Even before last year's
hurricanes, however, a mismatch appeared to be emerging between the incremental supply of crude
oil, which tended to be heavy and sulfurous, and the demand by refiners for light, sweet crude, which
can be converted more easily into clean-burning transportation fuels. These developments have
highlighted the need for additional investments in refining capacity to bridge the gap between
upstream supply and final demand.
What about the longer term? We can safely assume that world economic growth, together with the
rapid pace of industrialization in China, India, and other emerging-market economies, will generate
increasing demand for oil and other forms of energy. In all likelihood, growth in the demand for energy
will be tempered to some extent by continued improvements in energy efficiency which, in turn, will be
stimulated by higher prices and ongoing concerns about the security of oil supplies. Such
improvements are possible even without technological breakthroughs. For example, Japan is an
advanced industrial nation that uses only about one-half as much energy to produce a dollar's worth of
real output as the United States does. Of course, the Japanese and U.S. economies differ in important
ways, but the comparison nevertheless suggests that there is scope to boost energy efficiency in the
United States and other parts of the industrialized world. Newly industrializing economies such as
China appear to be quite inefficient in their use of energy; but as they modernize, they can adopt
energy-saving techniques already in use elsewhere, and their energy efficiency will presumably
improve as well.
Still, as the global economic expansion continues, substantial growth in the use of oil and other energy
sources appears to be inevitable. How readily the supply side of the oil market will respond is difficult
to predict. In a physical sense, the world is not in imminent danger of running out of oil. At the end of
2005, the world's proved reserves of conventional oil - that is, oil in the ground that is viewed as
recoverable using existing technologies and under current economic conditions - stood at more than
1.2 trillion barrels, about 15 percent higher than the world's proved reserves a decade earlier and
equal to about four decades of global consumption at current rates. These figures do not include
Canada's vast deposits of oil sands, which are estimated to contain an additional 174 billion barrels of
proved reserves. In addition, today's proved reserve figures ignore not only the potential for new
discoveries but also the likelihood that improved technologies and higher oil prices will increase the
amount of oil that can be economically recovered.
The oil is there, but whether substantial new sources of production can be made available over the
next five years or so is in some doubt. Some important fields are in locations that are technically
difficult and time-consuming to develop, such as deep-water fields off the coast of West Africa, in the
Gulf of Mexico, or off the east coast of South America. In many cases, the development of new fields
also faces the challenge of recovering the oil without damaging delicate ecosystems. Perhaps most
troubling are the significant uncertainties generated by geopolitical instability, as I have already noted.
Much of the world's oil reserves are located in areas where political turmoil and violence have
restrained both production and investment.
In both the developed and the developing world, another factor holding back investment in oil
infrastructure has been concern on the part of producers that oil prices might fall back as they did in
the 1980s and 1990s. In light of that recognition, some oil producers have been reluctant to launch
exploration projects even with today's high prices. Such concerns have been reinforced by the huge
reserves of oil in several OPEC countries that could be extracted at very low cost if sufficient
resources and expertise were directed toward doing so.
Developments in the natural gas market
The story for natural gas shares some similarities with the story for oil, but there are important
differences as well. In the 1990s, the U.S. spot price of natural gas at the Henry Hub averaged about
$2 per million Btu. However, in recent years, the United States has seen a marked increase in the
price of natural gas. The average spot price climbed to nearly $9 per million Btu in 2005, with the price
spiking to $15 per million Btu following hurricanes Katrina and Rita. So far this year, natural gas prices
have fallen back to around $7 per million Btu as an unusually warm winter curtailed consumption and
boosted natural gas in storage to record levels. Futures markets currently anticipate that the price of
natural gas will be about $9 per million Btu next year.
Why have natural gas prices risen so sharply over the past few years, and why are they expected to
remain elevated? As with oil, high prices of natural gas reflect strong demand and diminished supplies.
Unlike the globally integrated market for oil, however, natural gas markets are regional, primarily
because of the difficulty in transporting gas by means other than pipelines. Although the world's
capacity to trade liquefied natural gas, which is transported by ships, is growing, it is still a small
fraction of world supply and is not yet sufficient to fully integrate natural gas markets across
continents. Demand for natural gas in North America has remained strong in recent years, particularly
as environmental concerns have led clean-burning natural gas to become the fuel of choice for new
electricity generation. Moreover, increases in oil prices have boosted the demand for energy
substitutes such as natural gas. However, domestic production of natural gas has not kept up. Last
year, U.S. production was 7 percent below its 2001 level, with less than half of that decline reflecting
the impact of hurricanes Katrina and Rita.
Increased trade can often mitigate price increases, but net imports of natural gas from Canada, which
currently account for around 16 percent of U.S. consumption, have failed to increase in response to
higher prices. Between 1988 and 2001, net imports from Canada tripled, but they have since flattened
out. Both U.S. and Canadian gas fields have matured and are yielding smaller increases in output,
despite the incentive of high prices and a substantial increase in the number of drilling rigs in
operation.
Trade in liquefied natural gas, or LNG, is also likely to increase over time, but perhaps at a slower
pace than once envisioned. LNG imports into the United States nearly tripled from 2002 to 2004, but
they actually fell a bit last year as production disruptions in a number of countries limited supply and as
consumers in other countries competed for available cargoes.
Thus, natural gas prices are likely to remain elevated for at least the coming few years. It is possible,
however, that within a decade new supplies from previously untapped areas of North America could
boost available output here, while imports of LNG will increase to more substantial levels as countries
seek to bring their isolated natural gas reserves to market. Given time, these developments could
serve to lower natural gas prices in the United States significantly. Nonetheless, because of the higher
costs of producing these supplies relative to the traditional sources of natural gas, as well as the
elevated cost of other energy sources such as oil, natural gas prices seem unlikely to return to the
level of the 1990s.
Thus, the supply-demand fundamentals seem consistent with the view now taken by market
participants that the days of persistently cheap oil and natural gas are likely behind us. The good news
is that, in the longer run, we have options. I have already noted the scope for improvements in energy
efficiency and increased conservation. Considerable potential exists as well for substituting other
energy sources for oil and natural gas, including coal, nuclear energy, and renewable sources such as
bio-fuels and wind power. Given enough time, market mechanisms are likely to increase energy
supplies, including alternative energy sources, while simultaneously encouraging conservation and
substitution away from oil and natural gas to other types of energy.
Economic and policy implications of increased energy prices
What are the economic implications of the higher energy prices that we are experiencing? In the long
run, higher energy prices are likely to reduce somewhat the productive capacity of the U.S. economy.
That outcome would occur, for example, if high energy costs make businesses less willing to invest in
new capital or cause some existing capital to become economically obsolete. All else being equal,
these effects tend to restrain the growth of labor productivity, which in turn implies that real wages and
profits will be lower than they otherwise would have been. Also, the higher cost of imported oil is likely
to adversely affect our terms of trade; that is, Americans will have to sell more goods and services
abroad to pay for a given quantity of oil and other imports. For the medium term at least, the higher bill
for oil imports will increase the U.S. current account deficit, implying a greater need for foreign
financing.
Under the assumption that energy prices do not move sharply higher from their already high levels,
these long-run effects, though clearly negative, appear to be manageable. The U.S. economy is
remarkably flexible, and it seems to have absorbed the cost shocks of the past few years with only a
few dislocations. And conservation and the development of alternative energy sources will, over the
long term, ameliorate some of the effects of higher energy prices. Moreover, ongoing productivity
gains arising from sources such as technological improvements are likely to exceed by a significant
margin the productivity losses created by high energy prices.
In the short run, sharply higher energy prices create a rather different and, in some ways, a more
difficult set of economic challenges. Indeed, a significant increase in energy prices can simultaneously
slow economic growth while raising inflation.
An increase in oil prices slows economic growth in the short run primarily through its effects on
consumer spending. Because the United States imports much of the oil that it consumes, an increase
in oil prices is, as many economists have noted, broadly analogous to the imposition of a tax on U.S.
residents, with the revenue from the tax going to oil producers abroad. In 2004 as a whole, the total
cost of imported oil increased almost $50 billion relative to 2003. The imported oil bill jumped again
last year by an additional $70 billion, and given the price increases we have experienced in 2006, it
appears on track to increase $50 billion further at an annual rate in the first half of this year. Coupled
with the rising cost of imported natural gas, the cumulative increase in imported energy costs since the
end of 2003 is shaping up to be $185 billion - equal to almost 1-1/2 percent of GDP. All else being
equal, this constitutes a noticeable drag on real household incomes and spending. It is a tribute to the
underlying strength and resiliency of the U.S. economy that it has been able to perform well despite
the drag from increased energy prices.
At the same time that higher oil prices slow economic growth, they also create inflationary pressures.
Higher prices for crude oil are passed through to increased prices for the refined products used by
consumers, such as gasoline and heating oil. When oil prices rise, people may try to substitute other
forms of energy, such as natural gas, leading to price increases in those alternatives as well. The rise
in prices paid by households for energy - for example for gasoline, heating oil, and natural gas -
represent, of course, an increase in the cost of living and in price inflation. This direct effect of higher
first-round effect
energy prices on the cost of living is sometimes called the on inflation. In addition,
higher energy costs may have indirect effects on the inflation rate - if, for example, firms pass on their
increased costs of production in the form of higher consumer prices for non-energy goods or services
or if workers respond to the increase in the cost of living by demanding higher nominal wages. A jump
in energy costs could also increase the public's longer-term inflation expectations, a factor that would
put additional upward pressure on inflation. These indirect effects of higher energy prices on the
second-round
overall rate of inflation are called effects.
The overall inflation rate reflects both first-round and second-round effects. Economists and
policymakers also pay attention to the so-called core inflation rate, which excludes the direct effects of
increases in the prices of energy (as well as of food). By stripping out the first-round inflation effects,
core inflation provides a useful indicator of the second-round effects of increases in the price of
energy.
In the past, notably during the 1970s and early 1980s, both the first-round and second-round effects of
oil-price increases on inflation tended to be large, as firms freely passed on rising energy costs to
consumers, workers reacted to the surging cost of living by ratcheting up their wage demands, and
longer-run expectations of inflation moved up quickly. In this situation, monetary policymaking was
extremely difficult because oil-price increases threatened to result in a large and persistent increase in
the overall inflation rate. The Federal Reserve attempted to contain the inflationary effects of the oil-
price shocks by engineering sharp increases in interest rates, actions which had the consequence of
sharply slowing growth and raising unemployment, as in the recessions that began in 1973 and 1981.
Since about 1980, however, the Federal Reserve and most other central banks have worked hard to
bring inflation and expectations of inflation down. An important benefit of these efforts is that the
second-round inflation effect of a given increase in energy prices has been much reduced. To the
extent that households and business owners expect that the Fed will keep inflation low, firms have
both less incentive and less ability to pass on increased energy costs in the form of higher prices, and
likewise workers have less incentive to demand compensating increases in their nominal wages.
As I noted in remarks last week, although the rate of pass-through of higher energy and other
commodity prices to core consumer price inflation appears to have remained relatively low in the
current episode - reflecting the inflation-fighting credibility built by the Fed in recent decades the
cumulative increases in energy and commodity prices have been large enough that they could
account for some of the recent pickup in core inflation. In addition, some survey-based measures of
longer-term inflation expectations have edged up, on net, in recent months, as has the compensation
for inflation and inflation risk implied by yields on nominal and inflation-indexed government debt. As
yet, these expectations measures have remained within the ranges in which they have fluctuated in
recent years and inflation compensation implied by yields on government debt has fallen back
somewhat in the past month. Nevertheless, these developments bear watching.
In conclusion, energy prices have moved up considerably since the end of 2002, reflecting supply and
demand factors. In the short run, prices are likely to remain high in an environment of strong world
economic growth and a limited ability to increase energy supplies. Moreover, prices are likely to be
volatile in the near term, given the small margins of excess capacity to produce crude oil or natural gas
that traditionally have buffered short-run shifts in supply and demand.
However, in the long run, market forces will respond. The higher relative prices of energy will create
incentives for businesses to create new, energy-saving technologies and for energy consumers to
adopt them. The market for alternative fuels is growing rapidly and will help to shift consumption away
from petroleum-based fuels. Government can contribute to these conservation efforts by working to
create a regulatory environment that encourages the growth in energy supplies in a manner that is
consistent with our nation's environmental and other objectives. Given the extraordinary resilience of
the U.S. economy, I am confident our nation will be up to this challenge.