Running on Black Gold
As goes oil, so goes the economy. That hasn't always been the case--during the 1990s, the price of oil was low enough to be taken for granted. Now, because the world slurps up nearly every drop it produces and grows thirstier by the day, the tiniest sniffle in Saudi Arabia or Russia sends financial markets into a fever and brings aches and pains to the world's economies.
Both the level and the volatility of oil prices have risen significantly over the past year. The former acts as an ongoing drain on economic growth, but the latter is where the real danger lies. "When supply and demand are tightly matched and inelastic, as they are now, we're subject to an oil shock," says Federal Reserve governor Edward Gramlich.
Oil prices rose above $50 a barrel for just a month last fall and have since receded 22 percent off their highs. Yet that brief spike, on top of higher prices leading up to it, prompted economists to dramatically revise their forecasts for 2005. Strong Capital Management chief economist Jay Mueller estimates that high oil prices cut U.S. economic growth by a half point last year. If prices linger in the mid-$40s through 2005, as many predict, that will shave off another half point of growth, or more than $50 billion, he says.
Still, the economy should grow about 3.5 percent in 2005, and it is more energy efficient today. The energy needed to generate a given level of output has declined nearly 40 percent since 1980, because of the shift toward services. Yet because the economy is also much larger, total oil consumption has risen 20 percent since 1980. And since consumer spending makes up 70 percent of the economy, and SUV s and other gas guzzlers are popular, higher pump prices tend to drag down growth in GDP.
Then there's the relationship between oil and inflation. Since oil is used in products such as drugs and clothing, soaring petrochemical costs directly affect the price of many goods. So far, though, there is little evidence of widespread inflation.
Fearful. The psychological impact of rising oil prices can also cow consumers and companies into a cautionary stance. "If you are anticipating higher gas prices in the near future, you could change your spending decisions now," says Strong's Mueller. As for companies, "the worry about higher energy prices can affect investment and hiring decisions."
Rising prices are not just a U.S. problem. Every $10-a-barrel rise in oil's price subtracts $300 billion from the world economy, even after allowing for the massive transfer of wealth from oil importers like the United States to oil producers like the Organization of Petroleum Exporting Countries, says Fred Bergsten, director of the Institute for International Economics. "Even if prices level off in the mid-$40s, there is a significant price to pay," he adds.
Some of the costs of high oil prices are unseen by consumers, playing a role in the nation's burgeoning trade deficit and weakening dollar. Because the United States imports nearly 60 percent of the oil it consumes, a rise in its price widens the trade gap. That pushes down the already drooping dollar. In turn, because oil is priced in dollars, oil producers might be tempted to raise prices further to offset the weak greenback. One need only look back to the 1970s, a decade of economic angst in the United States, to see how an oil shock can create havoc.
Adjusted for inflation, today's prices are well below those that followed the Iranian revolution, and the U.S. economy is expanding. But to those who remember the 1970s, the tight oil market offers little comfort. "There is no single better predictor of recessions," says Bergsten, "than an oil shock." -Matthew Benjamin
This story appears in the January 10, 2005 print edition of U.S. News & World Report.
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