by Calculated Risk on 3/21/2008 01:17:00 PM

Note: this post is highly speculative and only a possibility that may be worth considering - something for a holiday. Best wishes to all.

Rachel Ziemba (filling in for Brad Setser) at RGE Monitor discusses how petrodollars are being spent by the GCC (Gulf Cooperation Council) countries in Petrodollars: How to Spend It

The following graph is interesting. This reminds me of how the surge in California state government revenues in the late '90s (due to the tech stock bubble), led to a concurrent surge in government spending. When the tech bubble burst, the state budget went bust.

The same pattern has been repeated across the U.S. recently with surging government spending based on revenues from the housing bubble. Now, almost every week, we see a story about some state or local government laying off workers and cutting their budget as revenues from housing decline.

So when I saw this graph, my first thought was: What happens if oil prices fall?

Click on graph for larger image.

Rachel Ziemba writes:

2007 was the first year that spending growth outstripped revenues [growth] in the GCC and many other oil exporters. 2008 budget plans imply even higher current (especially wages and subsidies) and capital expenditures. Even countries that have traditionally saved more (Kuwait) are ramping up spending especially on capital projects and in some cases transfers to the population or pension funds. ... With megaprojects in the works in a variety of sectors including energy and other infrastructure, capital spending will likely continue to rise.

Further Ziemba argues - based on spending growth - that "many GCC countries might have very small current account surpluses" within 5 year, if oil prices hold steady. It appears the GCC spending plans depend on fairly high oil revenues.

But could oil prices fall sharply?

Setting aside peak oil arguments for now, it's important to realize that both the supply and demand curves for oil are, in general, very steep. If there is little unused capacity, it takes time for more oil production to become available since this involves huge capital intensive projects. And, in the short term, demand is fairly inelastic over a wide range of prices; people stay with their routines and keep their same vehicle. With two steep curves (supply and demand), a small increase in quantity demanded will lead to a large increase in prices.

And, of course, the opposite is also true. A relatively small decrease in demand (or increase in supply) would cause a significant drop in price.

As the U.S. economy weakens, there is waning demand for oil in the U.S.:

According to the US Energy Information Administration's weekly inventory report, the overall consumption of oil and crude products dropped 3.2 percent in the last four weeks compared to the same period last year.

Perhaps the growth in demand in China and India (and elsewhere) will more than offset the small decline in U.S. demand. But there may be another important factor - the behavior of the GCC countries.

What if the supply-demand curve for oil has multiple equilibrium points? And what if the GCC countries have been limiting production because of the lack of other investment opportunities? The following is from a paper by Professor Krugman several years ago: The Energy Crisis Revisited

The fact that oil is an exhaustible resource means that not extracting it is a form of investment. And it is an investment that might look attractive to a national government when oil prices are high. If a country does not want to spend all of the massive flow of cash generated by a sudden price increase on consumption, it must do one of three things: engage in real investment at home, which is subject to diminishing returns; invest abroad; or "invest" by cutting oil extraction, and hence reducing supply.

Krugman: Figure 1.

So there is a definite possibility that over some range higher oil prices will lead to lower output. And given highly inelastic demand, as Cremer et al showed, that means that you can have multiple equilibria. Figure 1 illustrates the point: given the backward-bending supply curve and a steep demand curve, there are stable equilibria at both the low price PL and the high price PH.

So there is a possibility that what has looked like peak oil to some observers (something I believe is coming), was actually GCC countries investing by not extracting oil. If oil prices start to fall, and with rising expenditures (see first graph again), the GCC countries might increase production - causing prices to fall further.

And falling oil prices would have a significant impact on the U.S. trade deficit:

This graph shows the total trade deficit (in blue) over the last 10 years. The red line is the trade deficit excluding petroleum products, and black is the petroleum deficit.

The ex-petroleum deficit is falling fairly rapidly, but the overall trade deficit is declining slowly, because of the surge in oil imports (in dollars, not quantity).

There are many potential impacts of falling oil prices - such as geopolitical issues with oil producing nations - but from a U.S. perspective this would help with the trade deficit, possibly the dollar, and cushion the impact of the current U.S. recession.

This is just something I've been musing about ... best to all.