Why will the current energy shock hit consumers harder than in 2011?

UBS Chief Economist Arlende Kaptan points out that, since the U.S. shale oil industry failed to deliver a strong supply response like it used to, this energy shock is fundamentally different from the period of 2011-2014.

Today, the oil industry’s sensitivity to price changes has fallen, meaning the hedging effect brought about by the domestic oil investment boom that helped the U.S. economy a decade ago will no longer exist.

Shale oil lacks elasticity, indicating that the pain caused by rising energy prices is more likely to hit consumers directly by weakening their purchasing power, and it may also accelerate the overall economic deterioration.

Arlende Kaptan, UBS Global Economic and Strategy Research Director and Chief Economist, told clients that a key reason why the energy shock triggered by the conflict in the Middle East is “different from 2011-2014” is that the shale oil industry has not been able to provide a response of a similar magnitude, suggesting that consumers are more likely to absorb the main shock.

Kaptan notes that, adjusted for inflation, real oil prices during 2011-2014 were actually higher than today. However, at the time, the U.S. economy absorbed that shock because the shale oil boom provided support for the industrial base. Back then, West Texas Intermediate crude prices surged, prompting oil and gas companies to increase drilling activity, raise production, and expand investment in the energy sector. This created favorable conditions for the U.S. manufacturing base and offset some of the drag from rising fuel costs.

Yet it is precisely this that makes the optimistic view of the U.S. economy seem less solid now. As Kaptan put it: “Today, the oil industry is far less sensitive to prices than it was a decade ago.”

The Trump administration has said that the current oil price shock is temporary, and it also hinted that shale oil drilling activity is unlikely to see any significant increase, and it would be difficult to provide much help to the manufacturing base.

This means that the pain from this rise in energy prices is more likely to hit consumers directly by weakening their purchasing power, while the hedging effect that the domestic oil investment boom could offer will be greatly reduced.

The shock at gas stations has already begun:

Zerohedge previously warned:

If diesel prices rise to $5 per gallon, that means American consumers face a 35% price increase

Kaptan further noted:

A common question is: since oil prices were far higher than today in 2011-2014 and economic growth remained solid, why is the current oil price becoming a concern for the U.S. economy? During 2011-2014, Brent crude’s average price was about $110 per barrel—roughly equivalent to about $145 today—about 23% higher than the current spot price, while U.S. GDP growth still averaged slightly above 2%.

Of course, there are many differences today versus then: the labor market is weaker, household liquidity is tighter, and the inflation shock is more severe. This reflects that the pace of price increases is far faster than it was back then (during 2011-2014, the year-over-year increase in oil prices never exceeded about 55%, whereas if today’s prices persist, the increase would approach 100%). But the key difference—also the focus of this article—is in shale oil.

In early 2010, America’s mining industry (mainly the oil and gas sector) accounted for about 14% of total industrial output value. By 2012-2013, that industry contributed more than half of the growth in America’s industrial output value, and in some periods it even contributed virtually all of the growth. After the oil price collapse in 2015-2016, U.S. mining output showed a mechanical rebound from a low base—yet investment in the shale oil industry and the number of rigs did not recover to levels before 2014. Oil production will still adjust at the margin with price changes—through completing wells, increasing utilization, and improving productivity—but the elasticity of investment has been greatly reduced. In other words, if today’s oil price is viewed as a temporary phenomenon, the U.S. is unlikely to see a supply response driven by shale oil similar to 2011-2014, to offset the erosion of consumers’ net income they may face.

Developments overnight— including retaliatory strikes by Israel and Iran against upstream energy infrastructure in the Gulf region, and Qatar’s warning that Iran’s attack on its world’s largest LNG integrated facility could cause capacity shutdowns for months or even years—further reinforce expectations that global energy markets will remain tight for the long term. The current risk is a price shock from oil pumps; if turmoil in energy markets continues, market confidence may face pressure over the coming weeks. At the same time, the credit market has shown signs of stress, intensifying concerns that the outlook for the overall economy may worsen.

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