Why the Economy Is Weathering Oil's Swings

A return to peak price levels would hamper U.S. GDP, but overall the economy needs less oil to be productive

Rising oil prices often fuel worries about the economy, but now lower prices are generating optimism. Since the benchmark grade of West Texas Intermediate crude oil reached a peak of $78 per barrel last summer, prices have fallen, even breaking below $50 in January before recovering to around $61 as of Feb. 23—still well below the 2006 high. Unseasonably warm weather, stronger-than-expected supply, and weaker demand are among the reasons for the decline in the past several months.

Even when oil prices surged, the economy remained strong, and inflation—at least outside the energy sector—rose only slightly. This held true not just in the U.S. but throughout the world. And despite extreme fluctuations in the price of oil, the U.S. economy has continued to chug ahead at a consistent rate.

Now that oil has drifted down to just north of $60, how much will lower prices boost the economy? If it climbs back up to $78, will the economy falter?

To answer these questions, it's important to look at why the economy survived the earlier increase and how great an impact sustained lower prices will have on growth. The dependence of oil markets on the uncertainties in the Middle East makes predicting how high they could go impossible, especially in the short run, but we can at least look at the likely long-term trends and measure the short-term risks.

Shortage Concerns

Oil prices have always been hard to forecast, over both the short and long run. Political conditions and weather, for instance, are among the volatile factors that affect short-term prices.

In the long run, the supply of oil is finite, and demand continues to grow, contributing to upward pressures. How quickly a finite supply of oil will run out and how effectively industrialized nations are able to shift to alternative sources of energy will determine whether an oil problem or crisis lies ahead.

Although there has long been talk of energy shortages looming, such worries are misplaced. There's plenty of energy on and in the planet Earth. What's in short supply is cheap crude oil.

The Energy Information Agency (EIA) of the U.S. Energy Dept. estimates that there are 6 trillion barrels of conventional petroleum in the world. Of that, however, 5 trillion are concentrated in areas that are either difficult to tap (offshore or in the Arctic), politically unstable (the Middle East, Nigeria), or environmentally sensitive.

Among other forms of fossil fuels, nonconventional oil sources—such as tar sands and shale oil—could contain another 3 trillion barrels, and reserves in North America could exceed Saudi Arabia's crude reserves. Natural gas deposits probably exceed oil deposits; proven reserves are at about a 65-year supply at current production levels, according to the International Energy Agency (IEA).

Estimated coal reserves are at a 155-year supply at current production levels. Although such quantities seem abundant, estimates are highly uncertain. In addition, these other fossil fuels are more expensive to use than conventional petroleum, which provides energy in a form that is relatively easy to extract, transport, and burn.

Demise of Cheap Energy?

Another price factor is that demand for fossil fuels is rising, largely as a result of strong economic growth in Asia. The EIA estimates that demand for oil will rise by 40% during the next 25 years, with 70% of that increase coming from emerging economies (31% from India and China) as industrialization continues to spread.

Still, oil has dropped to 36% of the world energy supply in 2003 from 44% in 1971, with most of the drop offset by increased use of natural gas and nuclear power. This indicates that even if oil supplies become scarce, energy will still be available.

In any event, though the recent decline in prices has raised hopes, the era of cheap energy might be coming to an end. Over time, the world will be forced to shift away from inexpensive, abundant oil to more costly energy sources. And the development of alternative technologies, whether motivated by concerns about global warming or diminishing reserves of fossil fuels, will come at a price.

The drop in oil prices from July's high indicates that the economy is unlikely to dip into recession. If the Middle East remains calm (or at least doesn't get worse), investment in conventional and unconventional oil should keep energy prices at about $60. But oil prices are volatile, and a supply shock from Iran, Nigeria, Venezuela, or elsewhere could easily send prices right back up to the $78 level of last summer, or even higher.

If Oil Rebounds

What effect will prices have on the economy? One scenario assumes that they rebound to the $78 peak. A baseline scenario assumes that prices hold near $60.

A jump in oil prices back to $78 would shave 0.5% off the expected 2.6% growth rate in 2007. This wouldn't lead to a recession but would leave less wiggle room if other setbacks were to arise. Built into this scenario is an assumption that prices would come back down after a year, and, as a result, the economy would return to its previous path.

Although the total inflation rate hits higher levels in the high-priced oil scenario, the core rate rises only slightly more than in the baseline scenario. At its recent peak, the load on consumers from higher oil prices was still bearable, though not pleasant, especially for farmers, truckers, and others in energy-intensive industries.

Poorer Americans, who spend a higher percentage of their budget on energy, were also hit hard. Americans responded by continuing to spend at the expense of saving. With the savings rate already negative, there could be less room to maintain consumer spending if prices were to rise again.

Fuel for GDP

Rising oil prices raised overall consumer costs and cut into household purchasing power. Falling prices are having the reverse effect. Real hourly earnings in the nonfarm business sector were up 2.1% from a year ago in December. That and warm weather encouraged shoppers to spend more during the holiday season.

Falling gasoline prices have led to improved consumer confidence, which rose to 110.3 in January, the highest level since May, 2002. But when gasoline prices hit $3 per gallon last May, consumers remained upbeat, with confidence rising to 109.6. Even sales of gas-guzzling light trucks didn't suffer much.

The biggest reason for this may be that oil is less important to the economy than it once was. The average household spent only 6.1% of its income on energy when prices hit record highs in the third quarter of last year, compared with 8.2% in early 1981 and 6.6% in 1960, when gasoline was selling for one-tenth the current price.

Incomes have risen, while per-capita energy use has remained flat. The result is that today the U.S. economy needs only 0.22 metric tons of oil or equivalent to produce $1,000 of GDP (at 2000 prices) compared with 0.41 in 1971 and 0.35 in 1980.

Driving Big Cars

U.S. oil use is still less efficient than the average for member nations of the Organisation for Economic Co-operation & Development (OECD) of 0.19 metric tons. Per capita, the average American guzzles 7.9 metric tons of oil equivalent per year, compared with an EU average of 3.8 and an OECD average of 4.7.

In part, Americans use more energy because the U.S. is larger, has a wider-ranging climate, and is less densely populated than Japan or Europe. However, profligate habits such as driving big cars and the use of home heating and appliances that are not as efficient as they could be are also the result of lower taxes on energy, and thus lower prices compared with Europe and Japan.

In the meantime, the U.S. has continued to become more dependent on foreign oil. The Middle East's share of world oil production has remained relatively constant. In 1980 the region accounted for 31% of world production; in 2003, it was 30%. But in 1983 the U.S. supplied 63% of its own crude oil. By 2005 that share had fallen to 27%.

America's appetite for oil has both geopolitical and environmental consequences. It is overly dependent on imports of crude oil, increasingly from unfriendly nations. Oil imports are contributing to an unsustainable trade deficit, offset by foreign investment.

Although the timing and extent of global warming are still uncertain, its existence is no longer disputed. Thirty years after the first energy crisis, Washington has not created a consistent, rational energy policy. Until it does, long-term prospects for the U.S. economy remain cloudy. The capacity to absorb rising oil prices does have its limits, after all, despite the low impact of last summer's surge.

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