Oil & Housing: A Volatile Combination

How much damage from steep oil prices and the housing bust?

By Peter Coy

For the U.S. economy, already staggering from the housing bust, oil at nearly $90 a barrel comes like the second half of a one-two punch. On Oct. 17 oil for November delivery closed at $87.50 on the New York Mercantile Exchange after peaking during the day at an astonishing $89. The impetus, on top of soaring global demand and paltry supply growth, was a fresh threat of conflict in the oil-rich Middle East, where Turkish lawmakers voted to allow the use of military force against Kurdish rebels in northern Iraq.

Economists say the potential for harm to U.S. growth from high oil prices isn't as great as that caused by the severe recession in housing construction. But it works in the same direction, reinforcing the likelihood that subpar economic growth will continue through 2008. "I don't think it's decisive in tipping the economy into recession. It's not that bad," says Nigel Gault, chief U.S. economist at Global Insight in Lexington, Mass. "But it's adding insult to injury for the consumer."

It's hard to shrug off costly oil when it's only a few bucks below its 1981 all-time high, in inflation-adjusted terms. Back in 2004, when oil was a little over $40 a barrel, economists at Standard & Poor's (MHP ) estimated that every $10 increase in the cost of a barrel of oil subtracted about a quarter of a percentage point from the economy's growth rate. Trouble is, the higher prices get, the more harmful each $10 increment becomes, according to Beth Ann Bovino, an S&P economist. If prices stay in the mid-$80s per barrel through 2008, Bovino estimates, oil and housing combined could squeeze growth in the Presidential election year to as low as 1.5%, vs. 3.8% in this year's second quarter.

Worse yet, pricey oil doesn't just suppress growth; it also raises inflation. On Oct. 17 the Labor Dept. announced that consumer prices rose 0.3% in September on the back of higher energy and food prices. The worst-case scenario is a return of 1970s-style stagflation.

Strangely enough, the housing crash might even be contributing a bit to the jump in oil prices. Energy economist Philip K. Verleger Jr. of Aspen, Colo., points out in his monthly report, released on Oct. 16, that the wipeout in subprime mortgages has frightened lenders and contributed to a global credit crunch that has hit asset-backed borrowing. That is making it costlier for speculators to buy fuel and stockpile it, and it's indirectly contributing to the tightness of global oil inventories, Verleger argues.

Whether oil and housing are linked or not, they make a mean combo. The falloff in homebuilding is extreme and shows no sign of letting up. On Oct.17 the Commerce Dept. said starts on construction fell 10% from August to September, to an annual rate of just under 1.2 million, down from 2 million in 2005. Cutbacks in homebuilding alone will subtract roughly one percentage point from gross domestic product in 2007, knocking it from 3% to 2%, estimate Global Insight and S&P.

A SHARP LEFT JAB

So far, luckily for the economy, housing's big decline has had a surprisingly small impact on consumer spending, which is headed for a decent 3% increase this year. That, however, is where expensive oil comes in like a sharp left jab. The latest $10 jump in oil prices is likely to push the national average retail gasoline price back up to $3 or more in coming weeks, assuming that refiners and retailers pass through their higher costs to maintain profit margins. That will slice 0.3 percentage points off consumers' spendable income at a time when they're struggling with a decline in housing values and, in many cases, upward resets on adjustable-rate mortgages. Says Gault: "It just makes matters worse."

Analysts who think oil's impact will be minimal argue that prices will fall because they have been raised by speculation, not fundamentals. Joel Fingerman, president of OilAnalytics.net, estimates that oil prices are $30 to $40 higher than they ordinarily would be, given the current level of U.S. inventories. According to one research house, John S. Herold Inc. in Norwalk, Conn., the average cost last year to find oil, develop the field, pump the product, and deliver it to storage was only about $25 a barrel. That leaves lots of room for prices to fall without wiping out profits. "Industry fundamentals do not support prices above $60, let alone $80," says oil analyst Fadel Gheit of Oppenheimer. (OPY )

But other analysts worry that business and consumers will soon have to cope with even higher oil prices. Even if finding and producing it still isn't all that expensive, not enough fields are being developed. John Kingston, global director of oil for Platts, a unit of The McGraw-Hill Companies (MHP ), says it's no surprise prices are high when worldwide oil production is falling short of consumption. More than 1 million barrels of oil per day are being sucked out of inventories in the current quarter. That's more bad news for an economy that already had plenty of trouble to begin with.

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Federal Reserve Chairman Ben Bernanke is trying to keep the economy growing despite the housing bust, high oil prices, and an abrupt retreat from risk in the credit markets. In a speech at the New York Economic Club on Oct. 15, his first on the U.S. economy since credit markets seized up in mid-August, Bernanke warned that the decline in housing would probably hold down U.S. economic growth in the fourth quarter of 2007 and early 2008. He said it was too soon to say whether the weakness in housing would spill over into consumer spending, which has held up relatively well so far. He noted that the price of oil has been rising while the value of the dollar has been falling, making inflation a continuing concern. But he gave no clear signal whether he was leaning toward another cut in short-term rates at the Fed's next rate-setting meeting, on Oct. 30-31.

With Moira Herbst in New York

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