Pricey Oil's Path to Your Pocket


By Pallavi Gogoi

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Worried about how the skyrocketing price of oil will affect your cost of living? You're not alone. Economists, consumer groups, and shoppers have all been abuzz since Goldman Sachs (GS) issued a report on Mar. 30 that projected crude oil prices could hit $105.

There's good news and bad news about superhigh crude prices. First the good news: By the time oil surges past $100 a barrel, the prices of consumer goods will likely have peaked and started dropping. And crude won't hit the century mark tomorrow: The Goldman Sachs report projected that oil prices won't see $105 until 2007.

ALL SQUEEZED OUT. The bad news: If crude costs $100 or more a barrel, gas prices will hit at least $4 a gallon. And prices at the mall will have shot up long before oil reaches the $100 mark, says Mark Zandi, chief economist at Economy.com.

Why? After all, even at today's price of roughly $50, oil costs twice as much as it did two years ago, yet consumer prices have risen a mere 5% since then. The reason is that productivity gains and cost savings from technology investments in the late 1990s have allowed manufacturers to better absorb the impact of more expensive oil. And some producers have chosen not to pass along increased costs to avoid losing market share.

But manufacturers and retailers can contain costs only for so long. By now, most factories are so lean they haven't any room for further cost cuts or productivity gains. "They have squeezed all the juice out of productivity efficiencies in the past few years," notes Mark Baxter, director of the Maguire Energy Institute at Southern Methodist University's Cox School of Business in Dallas.

MORE CASH ON DELIVERY. Meanwhile, almost all of the goods in stores today are transported from another part of the country or the world. Furthermore, petroleum is a critical ingredient in the production of many consumer goods, from medicine, cookware, and toys, to equipment, clothing, and air conditioners. Some factories also use it as a source of power.

So if oil starts inching toward $60 -- let alone climbing well above it -- manufacturers won't be able to absorb the higher prices without damaging their bottom lines. They'll have to start passing along the costs to consumers, slowly but surely. "We're just about getting there," says Zandi.

The time lag could vary from two to six weeks, according to Bernard Baumohl, executive director at Economic Outlook Group in Princeton, N.J. The first place price hikes will likely be seen is at package-delivery companies UPS (UPS) and Federal Express (FDX). Almost at the same time, food and perishable goods will become increasingly costly, and then the prices of durable items like building materials, furniture, and computers will follow suit.

CHINA SYNDROME. How much higher will your shopping bill be? It depends on what you put into your cart. The more oil-intensive the production of the merchandise, the bigger the hike. On average, if manufacturers have paid $100 extra for any product, they pass on 30% of it to consumers.

In the Goldman Sachs report, analyst Arjun N. Murti says he was surprised that the relatively high price of oil in the past year -- $40 to $60 -- didn't hurt demand or hamper economic growth in the U.S. and China. If high demand and fast growth continue, the report says oil prices would experience a "super-spike," to $75 next year and $105 in 2007. And if a supply disruption occurs, even these prices might be conservative, Murti suggests.

The report warns that $105 oil would lead to a sharp slowdown in China and other emerging-market economies. Many economists fear such a scenario. "If the Chinese economy shuts down, it would have global repercussions for growth and inflation," says Baumohl.

THE REAL PAIN. Baumohl believes that oil prices will go up to such a high level only if supply is severely disrupted. In that case, China's emergency reserves will likely last a mere two weeks. Once China uses them up, factories will shut down, demand for basic commodities like steel, copper, and aluminum will drop precipitously, and the U.S. and world economies will lose momentum.

If the U.S. economy sputters, prices on consumer goods will drop. Many economists, including Zandi and Baumohl, believe that consumer demand for goods will start to slow when oil is still below $100. Baumohl says the economy will feel recessionary pressures at $85. For Zandi, the figure is lower. "Even at $75 to $80 the consumer would pull back, and the economy will be so fragile that it will be near recession," he says.

So you have cause to be concerned about oil reaching the $100 mark. But the real pain will be felt along the journey -- not at the destination. Gogoi is a reporter for BusinessWeek Online in New York


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