Can the Economy Handle $100 Oil?


Oil markets start the new year with another historic high. Will triple digits spur a recession?

After flirting with $100 in the final months of 2007, crude oil prices wasted little time crossing that threshold in the new year. Light, sweet crude for February delivery breached the historic milestone of $100 a barrel on the New York Mercantile Exchange (NMX), just after noon on January 2. After retreating to close at $99.62, prices again hit $100 Jan. 3 after the government reported a steeper-than-expected drop in crude oil inventories.

A variety of factors—including the inventory report, new violence in oil-rich Nigeria, a further slide in the dollar, and weak U.S. manufacturing data—caused the price surge. There's also speculation that the Federal Reserve could again cut interest rates, causing oil prices to rise as investors move out of stocks and bonds and into commodities markets.

Stock Market Impact

"Add it up and you have a wildly bullish day," says Stephen Schork, an energy consultant in Villanova, Pa., and editor of The Schork Report, a daily energy newsletter. "Fresh capital is charging back into the market and looking to buy." The question now: whether the faltering U.S. economy can avoid a recession in an environment of $100 oil. That's because the price of crude oil has knock-on effects throughout the economy (BusinessWeek, 10/29/07), from the price of gasoline to stock market valuation (BusinessWeek.com, 1/2/08). The worry is that consumer spending, which accounts for two-thirds of the U.S. economy, will suffer as prices rise, tipping the economy into a further slowdown or recession.

"Staying at [the $100] level will mean inflation and economic hardship," says Fadel Gheit, senior energy analyst for Oppenheimer Holdings (OPY). "The price has nothing to do with fundamentals, but it has a broad impact."

Despite the rise in oil prices, shares of some major oil companies closed lower Jan. 2 as the overall stock market lost 220.86 points. Shares of ExxonMobil (XOM), ConocoPhillips (COP), Hess (HES), PetroChina (PTR), and Sinopec (SHI) all finished lower. While high oil prices tend to increase incomes for oil majors, arrangements with oil-producing countries such as Russia divert much of the profit from high prices to the host government.

Oil-services companies such as Schlumberger (SLB) and Halliburton (HAL)—as well as companies with a greater reliance on natural gas prices than oil including Apache (APA), Devon Energy (DVN), and Southwestern Energy (SWN)—closed significantly higher.

$100 Oil — Staying Power?

How oil prices affect the economy in the coming months depends in part on how resilient consumers are as the subprime mortgage crisis unfolds. If higher heating oil and gasoline prices cause consumers to tighten spending further, the economy could tip into recession. That would send oil prices back down. As energy prices rise, consumer demand begins to fall off, and prices drop to more sustainable levels. "Trees can't grow to the sky," says Oppenheimer's Gheit.

The impact of oil prices on the economy also depends on how the Federal Reserve manages the money supply. If the Federal Reserve continues to cut interest rates and accommodate high oil prices, inflation will ensue. But if the Fed tightens the money supply, the U.S. could enter a recession.

"If the U.S. enters into a recession, the whole world could see a slowdown in demand," says Phil Flynn, an analyst and vice-president at brokerage firm Alaron Futures & Options in Chicago.

But some analysts say that $100 oil is not here to stay. Flynn and others argue that the price spike on Jan. 2 was a fluke that resulted from unusually light post-holiday trading. Indeed, the $100 trading mark at 12:09 p.m. EST concerned a single 1,000 barrel lot, according to financial-data service Reuters (RTRSY). The exchange canceled another trade at $100 one minute earlier, the wire service reported. "$100 oil is more of a trophy than a trend," says Tom Kloza, chief analyst for the Oil Price Information Service, in Wall, N.J.

Herbst is a reporter for BusinessWeek.com in New York.

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