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Oil: Shocks, But No Megashocks

Economic Trends

Oil: Shocks, but No Megashocks

Thank the economy and technology

Even an oil shock that jolts the price per barrel to $50--an increase of 67% above the current price of about $30--could be absorbed by the U.S. economy. That's the conclusion of a new report by William C. Dudley, director of U.S. economic research for Goldman, Sachs & Co. While inflation would certainly rise and economic growth might slow, neither effect would be severe or long-lasting, he argues.

To be sure, oil price hikes of that magnitude aren't something to take lightly. "The past three economic downturns were precipitated, in part, by higher oil prices," writes Dudley. For example, an increase that brings the price to $50 a barrel--up from about $21 a year ago--is roughly equal in percentage terms to the one that rocked the economy during 1978 and 1979.

But the economy is far better prepared to handle an oil shock this time, in part because businesses and consumers use oil much more efficiently than they did a few decades ago (chart). Indeed, despite the recent attention paid to fuel-guzzling sport-utility vehicles, real gross domestic product per barrel of oil has continued to rise in recent years. Over the past five years, real GDP is up by more than 20% while oil consumption has increased by only 9%.

In addition, today's low inflation rate, combined with the tremendous inflation-fighting credibility enjoyed by the Fed, means that the economy can more easily absorb an increase in oil prices without starting an inflationary spiral. The 43% oil price increase of the past year had practically no effect on inflationary expectations or on consumer confidence and financial conditions, says Dudley.

Also, any oil price shock is likely to be short-lived because technology has reduced the cost of exploring for new oil. "The long-run equilibrium price for crude oil is only about $17.50 a barrel," writes Dudley--far below the current price. That means eventually the supply will increase enough to hold down the price of oil, even if prices spike in the coming months.By Charles J. WhalenReturn to top

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Downsizing Spending

It's smarter than cutting workers

When it comes time to cut costs, most companies first try to trim their payrolls. However, bringing discipline to unnecessary capital spending can often boost profits more than slashing the workforce, claims Tom Copeland, director of the corporate finance practice at Monitor Co. in Cambridge, Mass. Based on his experience with more than 200 companies, Copeland argues that a business with hefty capital expenses that slashes outlays by just 15% can increase its market capitalization by 30% or more. And the major advantage over downsizing, says Copeland, is that "the company gets to keep the heads--no, make that brains--that would have been fired."

Copeland isn't advocating big cuts in productivity-enhancing capital expenditures, such as new information-technology systems. Rather, the secret to increasing cash flow by reducing capital outlays is to rigorously evaluate "the small-ticket items that usually get rubber-stamped," writes Copeland in an article in the latest Harvard Business Review. Those "little" requests, which he claims account for the bulk of most capital budgets, often prove to be too extravagant, unnecessary, or a duplication of what has already been purchased by another part of the organization.

Since there has been a spectacular capital-spending boom in the 1990s, it only makes sense to look for fat in the capital budget rather than in the payroll. Copeland concludes: "Paying more attention to small items in the capital budget creates that business rarity: a win-win situation in which spending is cut without sacrificing output quantity or quality."By Charles J. WhalenReturn to top

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