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Get Four
|  | AUGUST 20, 2004
 DAVID WYSS ON THE ECONOMY By David Wyss The Good News About Costly Oil Expect prices to slowly come down -- and if they don't, fear not. Even at $75 a barrel, we wouldn't see a recession in the U.S. Oil prices are surging again, leading to fears that the age of cheap energy is coming to an end. In the mid-1970s and again in the early 1980s, oil prices surged only to drop back. This time, we at Standard & Poor's expect oil prices to slide gradually to the $30 range over the next two years. We do recognize, however, that many things could cause them to remain high or even rise further. In the past few weeks, oil prices have continued to hit new records, reaching more than $48 per barrel for the benchmark West Texas Intermediate crude on Aug. 19. Prices seem significantly higher than the balance of supply and demand would suggest, with an estimated risk premium per barrel of $10 to $15. So prices are artificially high. CRIMPED GROWTH. Economists have cried wolf about oil prices before. In 1974 and again in 1980, following the OPEC crises of 1973 and 1979, many believed that crude would continue to rise. In both cases, the pessimists were proved wrong. Although we think prices will fall again, at some point the wolf really will be here, and oil will climb sharply as the finite supply is consumed. Remember that in the folk tale, the boy gets eaten by the wolf when the villagers no longer respond to his cries. In the $30-to-$35 range, where it was a year ago, oil was only moderately above its long-term average, and the damage to the economy was minimal. At $45, which oil hit in the second week of August, the damage became greater. Every $10-per-barrel hike in oil prices reduces economic growth for the next year by about 0.25% to 0.35%, largely by reducing real consumer disposable income. At S&P, we have lowered our consumer disposable income forecast for 2005 to 3.6% from the 3.9% we projected last month, largely because of costlier oil. The long-term problem is that energy demand is likely to continuing rising. The International Energy Agency forecasts that worldwide demand for energy will rise 50% from current levels over the next 20 years. Asia will account for 85% of the increase, as energy demand is outpacing gross domestic product growth in China. It's unclear where the additional oil will come from. ASIA'S PERIL. In the short term, instability in the Middle East adds to the fear that oil prices will continue to climb. The threat of a shutdown at Russian oil and gas supplier Yukos -- which accounts for only 2% of world oil production -- has sent prices up $5. What would happen if Saudi production were seriously threatened? During the Iran hostage crisis in 1981, oil peaked at $37 per barrel ($75 in today's prices, corrected for inflation). If oil companies were convinced that prices would stay near current levels, they would invest more heavily in drilling and alternative sources such as tar sands. However, they were burned in the late 1970s and early 1980s, when they made such investments and then saw oil prices drop sharply. A continued reluctance to respond to higher demand could help send prices even higher. Drilling activity has resumed, but not longer-term investments such as searching for alternative energy sources. The good news is that energy is a much smaller part of the U.S. economy than it was during the first and second OPEC crises. Today, the average household spends 5% of aftertax income on energy, up from 4% two year ago, but down from 8.1% in 1981 and even below the 5.7% of 1973, before the first OPEC crisis. Although total energy use is up 40% since 1973, the ratio of energy use to real GDP is down 43%, and per capita use is up only 1.1%. In fact, higher oil prices could cause greater damage to the Asian economies than to the U.S. China is one of the few countries where energy consumption is rising faster than GDP, while most industrial countries are reducing their power needs relative to GDP.
Energy Usage Is Less Important to the Economy
Indeed, oil prices would have to be higher than they are now to again cause a recession in the U.S. To examine the impact of higher oil, I simulated the Global Insight model of the U.S. economy with a $75 price, instead of a gradual decline to $30. That higher cost takes 1.2 percentage points off GDP growth in 2005, and 0.5 percentage point in 2006. Inflation rises to 3.1% next year, from the 1.2% in the baseline projection. This is not intended as a worst-case scenario, just a bad case. Even if oil rose to $75, it wouldn't cause a recession. It would merely lower growth, to 2.4%, from the 3.6% expected in our baseline projection. WILD CHASE. The silver lining to such a scenario is that higher oil prices will make the Federal Reserve less anxious to raise interest rates. Although the overall consumer price index will rise because of higher oil prices, the core rate (excluding food and energy) will be little affected, and the damage to the real economy suggests the Fed should avoid rate hikes. The central bank focuses on the core rate precisely because it doesn't want to chase food and energy prices up and down. Unless oil prices rise significantly more than they have so far, the impact on the economy should be moderate. The Federal Reserve may pause, but it will continue to tighten as the economy improves. To cause a recession, oil prices would have to go higher (adjusted to today's dollars) than they did the last time around, in 1981. The bottom line is that oil is still important to our economy, but not as much as it used to be.  Wyss is chief economist for Standard & Poor’s Edited by Karyn McCormack All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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