An examination of how higher-priced oil affects various regions and business sectors, citing evidence that the oil shock accompanying Iraq's invasion of Kuwait will have a smaller impact on the overall U.S. economy than that of previous shocks.Power resources - Prices ; Regional economics

Paul W. Bauer

Susan M. Byrne

English

Research Papers in Economics

January 15, 1991
eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland
The Sectoral and Regional Effects
of Oil Shocks: Who's over a Barrel?
by Paul W. Bauer and Susan M. Byrne
o "nee again the United States has been
jolted by an oil price shock. Since Iraq's
August 2 invasion of Kuwait, the cost of
crude has soared as high as $41 a barrel.
And although prices have since moder-
ated, they continue to exceed the pre-
invasion level. The U.S. economy has
already begun to register adverse effects,
as rising energy costs have contributed to
the economic slowdown and a general in-
crease in prices. Furthermore, heightened
uncertainty about future oil prices and the
prospects for war in the Persian Gulf
could weaken the economy even more as
some firms reduce, delay, or cancel proj-
ects in the face of these added risks.
Although the sluggish economy has
touched almost every region and busi-
ness sector, some have been hit harder
than others, while a few have actually
benefited. Oil producers in Texas and
Alaska, for example, have enjoyed in-
creased revenues from the doubling of
crude prices, while New Englanders have
had to brace for escalating home heating
costs. This Economic Commentary pro-
vides a framework for analyzing the
regional and sectoral effects of higher oil
prices, identifying those areas most likely
to be hurt and those that might benefit. It
also presents evidence that the impact of
the current oil shock will not be as severe
as that of previous ones.
• A General Framework
Oil is essential to industrialized econ-
omies, both as an input in many produc-
tion processes and as a major source of
energy. Three factors determine the in-
fluence that an oil price shock will have
on firms and, ultimately, on sectors and
regions: 1) oil's share of firms' total
costs, 2) the ease with which firms can
substitute other inputs for oil (for exam-
ple, by purchasing more fuel-efficient
capital equipment or by altering produc-
tion techniques), and 3) consumers' abil-
ity to switch to other products if a firm
attempts to raise its prices.
The importance of these factors is illus-
trated by current difficulties facing the
airline industry. Oil price shocks tend to
hit the airlines faster and harder than
many other industries because airlines
buy oil on the spot market, and oil com-
prises one-fifth of the industry's total
costs. Also, there are few opportunities to
substitute other inputs for jet fuel. Com-
pounding the injury is the fact that oil
shocks tend to be followed by a generally
weakened economy and a consequent
drop-off in the demand for air travel,
making it difficult for airlines to recoup
their higher costs through increased fares.
• Oil Usage by Sector
In order to examine the differences in oil
consumption across industries, we
divide the economy into five sectors:
transportation, industrial, residential,
commercial, and electric utilities. Of
these, transportation will probably be hit
most severely by the current oil shock,
because the industry accounted for al-
Although rising oil prices have a net
negative impact on the U.S. economy,
certain regions and business sectors
suffer disproportionately, while others
actually benefit. This article examines
the regional and sectoral effects of
higher-priced oil, citing evidence that
the current shock will have less of an
impact on overall economic perform-
ance than previous shocks have had.
most 63 percent of all oil consumed in
the United States in 1989 — more than
that of the other three sectors combined
— and because the short-run opportu-
nities for switching to alternative fuels
are so limited (see figure 1).
Higher oil prices may also induce signif-
icant movements of cargo and passengers
from less-fuel-efficient to more-fuel-
efficient modes of transportation, such as
from truck to rail and from private auto-
mobiles to public transportation. Because
most industries and consumers depend
on transportation services, the price in-
creases in this sector also affect other
areas of the economy.
Although the industrial sector accounts
directly for about 25 percent of all U.S.
oil consumption, a price shock should
have less impact there than on transpor-
tation, since oil accounts for no more
than 7 percent of total industrial costs
ISSN 0428-1276FIGURE 1 OIL CONSUMPTION BY SECTOR
Quadrillion Btu
25
20
15
10
1965 1970 1975 1980 1985
FIGURE 2 OIL USAGE RELATIVE TO TOTAL
ENERGY USAGE
Percent
^^*~*^ Transportation
^^0-^^ Industrial
1UU
90
80
70
60
50
40
3D
••••••* New England *«%
Mid-Atlantic
West ... _
<> South
Midwest "•—__«- «,
.i....i....i....if...i...
1965 1970 1975 1980 1985
FIGURE 3 REGIONAL OIL EFFICIENCY
Thousand Btu per dollar of output
a
22i
18
14
,' \New England
,•** Mid-Atlantic *, *•
^~ \ '..South
FIGURE 4 INDUSTRIAL OIL EFFICIENCY
Thousand Btu per dollar of output
a
18
14 -
10
6 -
-
• • *
Midwest
, .
New England
*
•
\South
iMid-Atlantic
X
 Wes
t
• ..* »^>^-
1965 1970 1975 1980 1985 1965 1970 1975 1980 1985
a. Measured in 1982 dollars using real gross state product data.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Energy Information Administration, State Energy Data Report.
(excluding petroleum refining). How-
ever, industry's indirect use of oil
(through purchases of transportation
services, for example) could compound
the effects of a price hike.
The residential sector represents only
4.7 percent of all oil consumed in the
United States, primarily for home heat-
ing. But because price increases are
paid directly by consumers, the psycho-
logical impact may be greater than the
share of consumption would suggest. In
those regions where oil is the predomi-
nant home heating fuel, residents have
few short-run alternatives. However,
over the long run they can switch to
propane or electricity, or even add in-
sulation. And although the installation
of natural gas lines is expensive and dis-
ruptive, some communities are moving
in this direction.
The commercial and electric utility sec-
tors combined comprise just 7.7 percent
of U.S. petroleum consumption. Higher
oil prices are likely to have only a small
direct effect on these industries, because
oil's share of total costs is minimal.
During the 1970s, electric utilities were
the third-largest consumers of oil. repre-
senting almost 12 percent of total U.S.
consumption. Since 1978, however, that
figure has plummeted to 4.6 percent,
and electric companies now typically
use oil-fired generators only during
high peak-load periods.
• Regional Variations in Oil Usage
Relative to total energy usage. New
England consumes the most oil, follow-
ed by the Mid-Atlantic, the West, the
South, and the Midwest (figure 2).
These regional variations stem from dif-
fering industrial compositions and oil ef-
ficiencies within sectors. These same
factors also lead to regional differences
in the effects of higher oil prices.
The regional variation in industrial com-
position is substantial. For example,
with respect to states, manufacturing
employment as a share of total employ-
ment ranges from a low of 4.4 percent
for Nevada to a high of 28.3 percent for
North Carolina. With respect to specific
industries, the midwestern states have aTABLE 1 RANKING OF STATES BY THE EFFECT OF HIGHER OIL
PRICES ON THE GROWTH RATE OF GSP
a
State
Top Ten
Alaska
Wyoming
Louisiana
Oklahoma
New Mexico
Texas
West Virginia
North Dakota
Montana
Utah
Bottom Ten
Oregon
Georgia
Florida
Massachusetts
Hawaii
South Dakota
Maryland
Rhode Island
Michigan
Arizona
Initial
effect
0.20
0.41
0.16
0.07
0.09
0.04
-0.04
-0.04
-0.09
-0.06
-0.13
-0.24
-0.15
-0.25
-0.06
-0.10
-0.23
-0.29
-0.33
-0.13
After
1 year
0.92
0.05
0.10
0.07
0.04
0.08
0.03
0.07
0.12
-0.01
-0.07
0.01
-0.03
0.07
-0.07
-0.15
0.07
0.11
0.04
-0.11
After
2 years
-0.33
-0.02
0.07
0.10
0.04
0.05
0.02
-0.04
-0.05
0.05
-0.01
0.02
-0.04
-0.03
-0.10
0.03
-0.06
-0.06
0.02
-0.07
Net
effect
0.79
0.43
0.32
0.24
0.17
0.16
0.01
-0.02
-0.02
-0.02
-0.21
-0.21
-0.21
-0.22
-0.22
-0.22
-0.22
-0.23
-0.28
-0.30
a. Numbers reflect the impact of a 1 percent increase in oil prices on real GSP growth. For example, a 1 per-
cent increase in oil prices initially leads to a 0.20 percent increase in Alaska's GSP growth rate.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis and Bureau of Labor Statistics;
and Federal Reserve Bank of Cleveland.
much heavier concentration of transpor-
tation equipment firms than do other
regions.
The relative efficiencies in the use of oil
also vary across the nation. The impact
of these variations in industrial composi-
tion and oil efficiencies can be seen in
regional differences in oil usage per dol-
lar of output (figure 3). The southern
states rely most heavily on oil to pro-
duce a dollar's worth of output, because
many of their industries use significant
amounts of oil in the production process
(petroleum refineries, for example).
Other regions tend to be much more
alike in this respect.
Oil usage within individual sectors also
differs across regions. Within the in-
dustrial sector, for example, oil usage
per dollar of output ranged from a high
of 11,000 Btu in the South to a low of
3,100 Btu in New England in 1986. The
Mid-Atlantic, Midwest, and West have
been reducing their industrial oil con-
sumption since the late 1970s (figure 4).
Note, however, that New England's in-
dustries began to lessen their depend-
ence on oil much earlier, possibly re-
flecting that region's shift away from
petroleum-intensive manufacturing and
toward industries such as electronics and
telecommunications. The South's pat-
tern again deviates from that of the rest
of the country, mainly due to the heavy
concentration of oil refineries in Texas
and Louisiana and the in-migration of
manufacturing from New England and
the Midwest.
Wide variations in oil usage across
regions are also apparent in other sec-
tors. For example, New England's resi-
dential and electric utility sectors com-
bined comprise the largest share of that
region's total oil consumption. The resi-
dents of New England depend more
than other Americans on heating oil,
with a per-capita consumption rate more
than two and one-half times that of the
Midwest. New England's electric utili-
ties also are quite dependent on oil. Like
its homes, the region's electric generat-
ing plants were constructed before the
relative shift in fuel prices, when oil
could compete successfully with other
energy sources.
The residential and electric utilities sec-
tors of the Mid-Atlantic are also relative-
ly heavy users of oil, but because of a
more moderate climate, the demand for
heating and cooling is not as great. The
South differs from the rest of the nation
in that a much higher share of its oil is
consumed by the industrial sector. One
reason for this is that some southern states
produce oil, so petroleum-intensive
industries have found it advantageous to
locate there. In the West, the transporta-
tion sector comprises a greater share of
total oil usage than in the nation as a
whole, reflecting that region's lower pop-
ulation density and greater mileage
between cities, hi the Midwest, oil con-
sumption patterns generally mirror those
of the nation, with one exception. Virtual-
ly no oil is used to generate electricity
here, since coal was the cheapest fuel
when most of this region's electric power
plants were constructed.
Note that to this point we have addressed
the issue of higher oil prices only by
examining consumption patterns. How-
ever, the United States is also one of the
world's largest petroleum producers. Fur-
thermore, three-fourths of the country's
total production is concentrated in only
four states: Alaska, Texas, Louisiana,
and California. Higher-priced oil obvi-
ously benefits these states' oil producers.
And in states such as Alaska, where oil
revenues comprise a large share of the
gross state product (GSP), the entire
state may emerge as a net gainer.• Putting It All Together
What, then, is the net effect of rising
oil prices on various regions of the
country? To answer this question, we
estimate how changes in oil prices over
the last several decades have affected
the growth rate of GSR Our results are
presented in table 1.
As expected, higher-priced oil boosts
GSP for the largest oil-producing states
by the end of the first year following
an initial shock. Alaska's and Wyo-
ming's economies seem to benefit from
a price increase in the short run, but
long-run adjustments within their oil-
consuming industries eventually offset
these gains to some degree. Higher oil
prices even appear to benefit West Vir-
ginia, a leading coal producer. The ini-
tial negative effect of an oil shock on
the state's economy indicates that con-
sumers need time to switch from oil to
coal.
The states most adversely affected by
higher oil prices are those with a large
manufacturing base (Michigan and
Maryland) and those that rely heavily
on agriculture and forestry (South Da-
kota, Arizona, Georgia, and Oregon). In
every case, oil shocks had an immediate
negative impact on these states' GSP.
• The Future Impact of Higher Oil
Prices
This analysis has examined the average
impact of oil price shocks on states
over the last several decades. Obvious-
ly, the structure of state economies has
changed since the early 1970s, both in
the composition of economic activity
and in patterns of oil consumption. One
of the most striking transformations
has been the significant reduction in oil
usage across all regions. As shown in
figure 3, oil consumption per GSP has
fallen nationwide since the oil shocks
of the 1970s. The greatest decline has
occurred in New England, where tex-
tile manufacturing has given way to
less oil-intensive concerns such as the
semiconductor and aerospace indus-
tries. The South, on the other hand, has
experienced the least conservation in
oil usage, as agriculture has become
more dependent on petroleum-based
products and manufacturing has
migrated in from the North.
Overall, oil price shocks have less of an
effect today than they did in the 1970s.
And if present trends in energy conserva-
tion continue, we can expect future price
shocks of similar magnitude to have even
less of an impact. A recent study suggests
that the United States is better shielded
against an oil shock now than it has been
in the past, particularly in the industrial
sector, where oil efficiency has improved
substantially since 1974. Nonetheless,
it is apparent that the regional and sec-
toral effects of oil price shocks vary
significantly, contributing to deviations in
the timing and intensity of regional busi-
ness cycles.
• Footnotes
1. In the short run, fuel efficiency can be
boosted by flying slower, but this requires
greater usage of other inputs, such as pilot
hours. In the longer term, worn-out jet engines
can be replaced with more fuel-efficient mod-
els. However, because of the expense and
longevity of these engines, early replacement
is undesirable even for relatively large in-
creases in fuel prices.
2. See Anderson, Gerald H., Michael F.
Bryan, and Christopher J. Pike, "Oil, the
Economy, and Monetary Policy," Federal
Reserve Bank of Cleveland, Economic Com-
mentary, November 1, 1990.
Paul W. Bauer is an economist and Susan M.
Byrne is a senior research assistant at the
Federal Reserve Bank of Cleveland. The
authors would like to thank Michael F. Bryan,
Randall W. Eberts, and Mark S. Sniderman
for helpful discussions and suggestions.
The views stated herein are those of the
authors and not necessarily those of the
Federal Resen'e Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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The sectoral and regional effects of oil shocks: who's over a barrel?

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