Will the Economy Skid on Oil?

A price spike in the near term probably wouldn't pose much of a threat. But a disaster in Iraq could mean recession

A year ago, the price of oil was less than $20 per barrel. At the start of 2003, it was more than $30, a two-year high, fueled by the strike in Venezuela and worries over how possible U.S. military action in Iraq will affect the flow of oil from the Middle East. Just how much should we worry about higher oil prices and their potential impact on the economic recovery?

There's plenty of reason for concern. The last five recessions were all preceded by substantial hikes in oil prices. Indeed, the tripling in the cost of oil during 1999 and 2000, from $12 per barrel to $36, may well have received short shrift for its role in provoking the 2001 downturn. Now, just as the economy shows evidence of emerging from its autumn swoon, based on surprisingly strong December readings on manufacturing activity and car sales, the prospect of costlier energy once again looms large in the outlook.

Higher energy costs boost inflation, cut into economic growth, and significantly increase the cost of doing business in a broad range of industries--especially now, when passing along higher costs is virtually impossible for many companies strapped by a lack of pricing power. That means profits take it on the chin. Already-struggling airlines are especially sensitive to higher fuel costs, but other energy-intensive industries, such as steel, lumber, paper, chemicals, and plastics, are also vulnerable.


  Still, outside of the worst-case scenarios for the Middle East in coming months, the U.S. should be able to weather $30 oil or even a temporary spike to a higher level, especially given the stimulus coming from the Bush Administration's new tax package. Moreover, market fundamentals and long-term trends imply that oil will be cheaper later this year.

Economists have a rule of thumb for gauging the macroeconomic impact of higher oil prices: Every $10 per barrel rise that lasts for a year cuts economic growth by about 0.5% and adds about 1% to inflation. By that rubric, even if oil averages $35 in 2003, up from an average of about $25 in 2002, the recovery should be little worse for wear.

But the real world doesn't always operate the way econometric models, whose projections are based on average historical trends, say it should. In reality, the response to higher oil prices is no clear-cut, straight-line relationship. That is, the impact of going from $15 oil to $25 oil appears to be a lot smaller than the jolt that occurs from, say, $35 to $45. Models tend to underestimate the adverse effects of oil spikes, and most fail to predict a recession, even at very high price levels.


  Oil price spikes going back to the 1970s bear this out. So a sustained move from $25 to $45 oil would likely do more harm than just shave one percentage point from economic growth. It could even tip the economy into a recession.

Consumer spending, a factor crucial to the recovery, tends to suffer the brunt of the blow from higher oil prices. Another rule of thumb is that every $10 hike in oil increases household energy costs by about $50 billion. Unless consumers save less, which is unlikely now as households try to rebuild their savings amid economic and war uncertainties, that's $50 billion unavailable for spending on discretionary items, such as another sofa or a snazzy laptop. That drain could subtract up to 0.75% from the growth in real consumer spending over a year's time.

The impact on consumer prices is already starting to show up. Based on current and expected levels of prices for gasoline and heating oil, energy costs, which make up 6% of the consumer price index, will add about 0.1% to the rise in the December index and up to 0.3% to the January index. That means January inflation will be running at about 3%, up from only 1.1% at the start of last year.


  It's important to note, however, that core inflation, which omits energy and food, is actually falling, due mainly to a sharp slowdown in housing costs, which account for more than a third of the core CPI. Costlier energy is being partly offset by cheaper mortgage payments, reflecting multi-decade lows in mortgage rates.

Still, even with no further rise in energy costs from the January level, the growth in first-quarter consumer spending over the fourth quarter would be depressed by about 0.5%, at an annual rate. Beyond that, though, the outlook depends on how events in Venezuela and the Middle East will play out.

The six-week-old strike in Venezuela, which had been supplying 10% of U.S. crude, has cut the country's output to only 20% of its 3 million barrels-per-day capacity. And analysts doubt that President Hugo Chavez can keep his pledge to restore full capacity by mid-February. Partly because of the strike, U.S. crude inventories are 11% below their year-ago level, according to the American Petroleum Institute.


  For now, at least, the price effect of Venezuela's reduced production is mitigated by the desire of other OPEC members to keep the global flow of oil on an even keel. OPEC members have an informal pact to keep prices in the $22-to-$28 range, a level that OPEC believes will generate a steady flow of oil revenues without damaging global growth, which would depress receipts. To that end, OPEC has agreed to increase output by 1 million to 2 million barrels per day to make up for Venezuela's shortfall, and prices are off their recent highs.

Yet Iraq still casts the biggest shadow on the outlook. Analysts offer only general scenarios. One: An uneasy peace with Saddam Hussein relieves war worries and allows oil prices to head back into OPEC's target range. Two: A quick war ousts Saddam, resulting in a sharp price drop, with obvious economic pluses. Even this best possible case, however, may not yield full benefits immediately, since huge investments will be needed to fully resurrect Iraq's oil infrastructure.

But it is fear that the war will go badly and the flow of oil will be disrupted that is keeping prices up right now. On this one, who knows? One extreme-case scenario: A nuclear device contaminates key oil fields for years, sending prices over $100 per barrel.


  Barring that, the best bet is that oil-market forces will reassert themselves later this year, allowing prices to fall. First, OPEC has learned the value of stable prices. Second, inflation expectations are low, meaning that a temporary oil spike will not fuel a generalized pickup in inflation. And three, higher oil prices have much less impact on the economy than they did in earlier years. Because the U.S. is more energy-efficient, it now derives twice as much gross domestic product from the same amount of energy used in the 1970s.

Nevertheless, oil is still a crucial factor in the economic outlook. So in the coming months, fill 'er up, lock in the best available contract for winter fuel oil -- and keep your fingers crossed.

By James C. Cooper and Kathleen Madigan in New York

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