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A Libyan Oil Shock?

A new risk to the recovery.

Mar 7, 2011, Vol. 16, No. 24 • By IRWIN M. STELZER
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While political analysts are engaged in the morally elevated task of appraising the effects of events in Libya on the possible spread of democracy in the Arab world, economists are engaged in the grubbier task of figuring out what the effects will be on the economies of their countries. In America, this means taking a guess at the impact of higher oil prices on the nascent recovery.

A Libyan Oil Shock?

A service station in Easthampton, Mass.

AP Photo, Shana Sureck

This is no easy chore. For one thing, it is difficult to determine just now how much of Libya’s 1.6-1.7 million barrels of daily production, some 2 percent of the world total, has become unavailable. The International Energy Agency puts the figure at 500,000-750,000 barrels, analysts at Barclay’s Capital are guessing that 1 million barrels of production are now shut in, and Eni, the Italian firm active in Libya, puts the figure at 1.2 million barrels. Saudi Arabia has about 3.8 million barrels per day of excess capacity, has historically been willing to increase production to offset supply interruptions, and, after a bit of time, could do so again. Saudi oil minister Ali al-Naimi says his country will again “meet any shortage.”

So were it not for other factors, the loss of Libyan production would not be a serious matter, especially since the loss might well prove short-lived: Libyan crude comes primarily from Cyrenaica, an area of Libya in which the tribes now in control are hostile to Colonel Qaddafi and eager to increase their oil revenues. Nor would a permanent loss of Libya’s reserves create major supply problems. The oil under the Libyan desert accounts for only 3.3 percent of the world’s proved reserves, a portion likely to decline if the recent failure of exploration activity there to discover much by way of new reserves is any portent, and if forecasts of reserves to be found in Brazil and elsewhere prove correct.

But there is oil and there is oil, just as there is coal and there are diamonds, almost chemically identical but somewhat different in value. Libyan crude, known as Es Sider, is sweet​—​low sulfur, light oil easily refined into high-end products such as gasoline and diesel, while Saudi crude is sour​—​heavy and high in the sulfur content that environmental regulators increasingly frown upon. Refineries in Spain, Italy, and Germany rely on high-quality Libyan oil and are scrambling to find substitute supplies, mostly from Algeria, Nigeria, and the Caspian region or the North Sea. Which is only one reason prices have spiked. Another is the decision of the Department of Energy to sell 2 million barrels of high-sulfur heating oil from the Northeast Home Heating Oil Reserve and to shop for an equivalent amount of low-sulfur heating oil to replace it. 

Even though it is somewhere between difficult and impossible to get a fix on the supply consequences of the Libyan trauma, it is possible to imagine a best, a bad, and a worst case. In the best case, whatever government emerges from the Libyan chaos will need the revenues from resumed production and will promptly open the valves, in which case the price spike will prove no more than that​—​a temporary increase. In the bad case, the trouble spreads to Algeria, removing almost 2 million barrels per day from the market, thinning excess capacity to levels not seen since the Gulf war. Then, say the economists at Nomura, we will have to adjust to oil at above $220 per barrel. 

In the worst case, the Saudi regime is the next domino to fall. King Abdullah’s decision last week to allow a $37 billion “royal gift” of the kingdom’s riches to trickle down to civil servants, students, the unemployed, and to new infrastructure fails to appease the dissidents. And the country’s brutally repressive secret and religious police forces prove no match for demonstrators intent on overthrowing the House of Saud. If that happens .  .  . well, maybe it won’t.

One thing seems certain: The U.S. recovery is under threat. James Hamilton, a member of the economics department of the University of California, San Diego, has studied the effect of oil shocks from 1859 through 2010. He finds, “All but one of the 11 postwar recessions were associated with an increase in the price of oil. .  .  . The correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence.”

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