Energy blues

It is patently obvious that most international conflicts, even civil wars, are related to either fossil fuel deposits or to the distribution trajectory of proven reserves. Ukraine is no exception. However, such an observation doesn’t explain everything. Geopolitics is much more than just oil and natural gas. A timeline of the 20th century could give us hints as to when energy mattered most and when it didn’t. Now that Russian oil is being shunned by large market players – although it isn’t technically sanctioned – there is a void in the market. Russia supplies 11% of global oil production. Venezuela and Iran could be called back in to fill the vacuum, but even that couldn’t fix the short-term supply problems. Even so, I don’t think USD 150/ barrel is in the cards. Rather, USD 100/ barrel prices could be a temporary equilibrium for the remainder of the year.


As a reminder of what happened to oil over the last few decades, I will provide the following graphs. The left-hand graph shows the responses of U.S. (log) GDP and the (log) CPI to a 10% increase in the price of oil estimated using pre-1984 data. The right-hand graph displays the corresponding responses based on post-1984 data. One can easily observe that the response of both variables has become more muted since 1984. This pattern is also evident for other variables (prices and quantities) and many (though not all) other countries considered. In sum, the evidence suggests that economies faced an improved trade-off more recently in the face of oil price shocks of a similar magnitude. This is the first and most general argument.


We can then focus on the potential explanations for these changes over time. Let us consider three hypotheses that are not mutually exclusive.

First, real wage rigidities may have decreased over time. The presence of real wage rigidities generates a trade-off between stabilization of inflation and stabilization of the output gap. As a result, in response to an adverse supply shock and for any given monetary rule, inflation will generally increase more and output will decline more the slower real wages adjust. A trend towards more flexible labor markets, including more flexible wages, could thus explain the limited impact of more recent oil shocks.

Second, changes in the way monetary policy is conducted may be responsible for the differential response of the economy to the oil shocks. In particular, the stronger commitment by central banks to maintaining a low and stable rate of inflation, reflected in the widespread adoption of more or less explicit inflation targeting strategies, may have led to an improvement in the policy trade-off that makes it possible to mitigate the impact of a given oil price increase on both inflation and output simultaneously.

Third, the share of oil in the economy may have declined sufficiently since the 1970s to account for the decrease in the effects of its price changes. Under that hypothesis, changes in the price of oil have increasingly turned into a sideshow, with no significant macroeconomic effects.

In short, the four episodes between 1973 and 2008 involved oil shocks of a similar magnitude. In particular, the numbers did not seem to justify a characterization of the post-1984 shocks as being milder in size than the shocks of the 1970s, but their impact was much smaller. I believe the same will apply to the 2020 shock and its aftermath. The impact multiplier is smaller. People may not be ready to admit this, but capitalism is more stable than most think. What happens now is more the result of post-pandemic supply chain disturbances and job market and earnings re-adjustments than a commodity (oil) cycle.


After the Second Iraq war in 2003, I can observe seven U-turns, some of them short-lived. There was a second major turn after 2013 that proved even more decisive. Because the post-1984 data was mainly about how relatively ineffective an oil shock had become – that is, a discrete jump in the price of oil – the post-2013 situation is entirely new. According to many energy analysts, of which the famous James D. Hamilton is not the only high-brow example, oil prices were kept stagnant at around USD 100/barrel for almost a decade because China and the rest of the developing world were consuming more, supply was quasi-fixed, and to equilibrate the market the developed world had to cut back its demand for oil. The pivotal mean-reversion points, according to an application of the Vasicek model we had used for oil mean-reversion, indicated a range between USD 108 and USD 85 at that time, in line with the leading investment houses active in oil futures. This vision disappeared after 2013 when the U.S. fracking revolution cut the price drastically by increasing American production by millions of barrels per day. True, that initial rebound didn’t last due to falling stimulus through falling oil prices. Nonetheless, not only is the impact of oil and fossil fuels on the overall economy much less than before, but prices also no longer tend to go north as a trend. So, somewhere between USD 85 and USD 108 is the peak, and maybe USD 108 is the upper bound despite the pandemic’s aftershocks. The war in Ukraine won’t last long, although its impact will. However, this impact doesn’t suffice to keep oil prices high, for example, USD 130-150. Rather, we may be back to the old school model, which predicts that somewhere slightly above USD 100/barrel will be the new equilibrium for the rest of 2022. It isn’t that high if we remember that the USD 85-108 interval is based on pre-2008 means. In other words, this is nothing new. Prices are high but, historically speaking, not so high as to trigger stagflation. Oil prices were going up anyway, and the war in Ukraine has just tipped the balance.


Some might think this is hardly a good explanation, that I am downplaying the severity of the crisis. I think there will be a reshuffling in the energy cards, but natural gas will be the main focus, not oil. The Turkey-Israel rapprochement isn’t just about goodwill or trade of a natural sort. Israeli natural gas will eventually find its way to Europe, which means less dependence on Russia. The Leviathan and Tamar fields are too big for Israeli consumption; Israel must export anyway. Plus, the consortium’s share structure says Israel is in the minority. It is an international endeavor, and just how much of it is directly controlled by Israel isn’t easy to guess. Leviathan became operational only in 2020, a decade after its discovery. The pandemic erupted at about the same time, so the natural gas game stalled.


At the turn of the century, some excellent economists thought the U.S. economy was so resistant to shocks that the ‘new economy’ was about to eradicate the capitalist business cycle itself. As a corollary, American ‘soft power’ would suffice to keep the world in order. No major wars would be warranted because no severe energy or economic crises could happen in the 21st century. Technology and good economic governance would solve all problems. This proved incorrect. What proved correct is that although ‘the debtor’s empire’ (the U.S.) has had rainy days after 2008, other empires have fared no better. True, China’s march went on, and China is the U.S.’ only competitor. But China also has many problems, economic or otherwise. The U.S. is still the first and foremost global power, although nobody believes the ‘soft power’ story today. In the last two decades, Europe’s economic might has fizzled out. Europe is the biggest loser in the 21st century so far. Russia is back as a secondary power, but it is no match for either China or the U.S. This is why it is a secondary power, a power built on military prowess, diplomatic intelligence, and natural resources alone. The Ukraine conflict is a response to that status, as is the country’s being a link in the energy corridor.

Because the ‘new economy’, ‘soft power’, high-tech investments, internet, software development, the theme of permanently rising productivity and falling unemployment, and other mottos of the 1990s failed to persuade, people are suspicious about what AI and robotization will bring this time. It won’t bring peace, at least not in the short run. ‘Soft power’ never suffices to settle conflicts. We will probably see more of that soon.

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