$100 Oil: What, Me Worry?

S&P says a resilient economy could cushion the effect of rising oil prices

Writing in the New York Times in September 1980, Illinois Senator Charles Percy urged the United States to prepare for the oil supply shocks that were likely to occur after war broke out between Iran and Iraq the week before. He cited the "near certainty" of a supply disruption in the future, and gravely warned that unless the country took immediate action, oil prices "could double or triple again, and I don't think the world economy can afford $100-a-barrel crude."

A lot has changed since then. In mid-October, oil prices crossed the $90-a-barrel mark for the first time ever and kept on going, topping $98 per barrel recently. Amid the rise, a nervous press corps asked the White House if a crisis was brewing along the lines of the oil shocks of the 1970s. Spokeswoman Dana Perino agreed that "oil prices are way too high," but added they have yet to cause a major problem. "What is amazing is that our economy has been so resilient over the past several years, despite high energy prices," she said.

Once again, thanks are due to the indomitable U.S. consumer. What's more, Standard & Poor's Economics thinks the U.S. economy will stay healthy even if prices move somewhat higher. Rising oil prices have not yet forced consumers to cut back their spending, and until they do, the U.S. economy will likely keep growing even as oil prices approach $100 a barrel.

"The economy won't react unless we do," says David Wyss, chief economist at S&P. "Energy isn't as big a deal as it used to be, and we'll gradually get used to the higher price level."

That is not to say that soaring oil prices pose no threat, especially if they keep rising, he says. "There is still the risk that this could turn into a recession, and I think the risk is significant," Wyss says, adding the economy is much better able to handle the price shock now than it was in the 1970s. "You've got to keep this in perspective: core inflation is 1.8%. We've got real GDP growth slowing from 3% to 2%. This isn't the late 1970s, when you were looking at 1% to 2% growth, and 10% inflation."

Rising oil prices pose two major threats to the economy, Wyss says; they tend to depress consumer spending because there is less money left over after paying for necessities such as transportation and heat. In addition, they can push the price of other items up as well, causing inflation to accelerate.

So far, however, neither of those threats have caused a significant drag on the economy. Growth in consumer spending accelerated in the third quarter to an annual rate of 3% from just 1.4% in the second quarter, thanks to rising sales of durable goods such as refrigerators and computers. That helped the economy expand by a surprisingly strong 3.9% rate in the third quarter - the strongest quarterly rate so far this year, even as oil prices kept rising.

"We've been surprised at how well consumers have hung in there," Wyss says. "We keep saying it's going to show up in consumer spending," and it hasn't happened. Wyss expects U.S. consumer spending to grow by about 3% in 2007, but growth is expected to slow to about 2% in 2008, due to higher oil prices, as well as falling home prices.

Inflation hasn't become a problem yet either, Wyss says, because the economy is less oil intensive than it was three decades ago. Businesses are passing along their higher costs, he says, but the increase has not been very noticeable because, as with consumers, oil represents a fairly small share of the total cost base.

"Energy is not that huge an element in most of the things that we buy. So we're talking relatively small changes," Wyss says. Manufacturers rely more on natural gas now than they did in years past, and natural gas hasn't risen as much as oil. And while all businesses use electricity, very little of the U.S. power supply is generated from burning oil products, so power prices haven't been pushed higher.

Some businesses, however, will be affected more than others, particularly those that are transportation intensive. "It's a negative for car sales, it tends to be a negative for food, especially restaurants, and travel is more expensive," he says.

U.S. automakers, such as Ford Motor (F) and General Motors (GM), are vulnerable to rising oil prices since they derive a large share of their profits from gas-guzzling sport utility vehicles. Transportation stocks, such as those tracked by the iShares Dow Jones Transportation Average (IYT) exchange-traded fund, and shares in restaurant chains could also feel pressure from the increase in prices.

For some, the rise in oil prices is a major boost. The economies of the oil-rich Middle East, Russia, and Venezuela will benefit from the gains, giving them increased political clout. So much money is pouring into some countries that it cannot all be invested locally. That drives up bond prices and helps keep interest rates low.

Still, if oil prices keep rising, they will eventually take a toll. Oil prices "are important, but not as important as they were 30 years ago," Wyss says. "That doesn't mean they can't cause a recession, it just means they have to go higher to cause a recession."

If other pressures on economic growth gain strength, the rising price of oil will only increase the chance of a recession down the road. "We are already being hit by the housing problems, we've got worries about financial market issues, how many shocks can we take at one time?" asks Wyss. "It may just be a straw, but if you throw enough straws onto the camel's back, it eventually breaks."

S&P chief technical strategist Mark Arbeter believes oil prices will top out near $100 per barrel, but he sees a significant correction afterwards, bringing prices back down into the $70 to $80 range. Global Insight, which forecasts energy prices, estimates the average cost for a barrel of oil throughout 2008 will be $74.67.

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