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The Wall Street Journal: How Economy Could Survive Oil At $100 a Barrel

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The Wall Street Journal: How Economy Could Survive Oil At $100 a Barrel

Compared to 1980, U.S.
Is More Able to Handle
Once-Unthinkable Rise
By PETER FRITSCH and KELLY EVANS
September 29, 2007; Page A1

The world economy has managed, with some indigestion, to swallow the rise of oil prices past $80 a barrel. How well could it survive $100 a barrel?

The answer is quite well — so long as several conditions still hold true. The price rise would probably have to be gradual. Inflation couldn’t get so bad as to force big interest-rate hikes. Oil-rich nations would need to pump their profits back into U.S. and European economies.
 
All of this has happened so far. The happy confluence may continue, though fears remain strong that high energy prices will tip the U.S. into recession.

A host of factors, including tight oil supplies and a weak U.S. dollar, suggest that oil prices have further to rise. Some analysts continue to believe that oil is destined to reach an all-time high, as measured in today’s dollars, of more than $101 a barrel. The record was set in 1980. On Friday in New York, the benchmark crude-oil futures price closed down $1.22, or 1.5%, to finish at $81.66, a little more than $2 off the all-time high, not adjusting for inflation.

High oil prices could lead to ugly consequences if they hit consumers’ pocketbooks — especially in the U.S., where the housing slump is already hurting the economy. Consumer spending has been the primary engine of growth in the U.S. in recent years.

Target Corp. was among the major retailers in the last week cutting sales forecasts. Target expects September sales at stores open at least a year to rise just 1.5% to 2.5%, down from an earlier expectation of 4% to 6% growth.

For all the concern, the world today is better equipped to swallow expensive oil than it was when Jimmy Carter was installing solar panels and a wood-burning stove in the White House.

The main reason has to do with what some call the Wal-Mart effect. For every extra dollar taken from drivers’ pockets at the pump in the form of higher prices in recent years, low-cost exporters from China and elsewhere have put roughly $1.50 back in the form of cheaper retail goods. Even at today’s near-record prices, U.S. households today spend less than 4% of their disposable income at the pump, vs. over 6% in 1980.

Current prices are also a reflection of a strong economy, not an oil embargo or war in the Middle East. Since a market-share war between Saudi Arabia and Venezuela flooded the market with oil and drove prices to below $11 a barrel in 1998, oil prices have risen nearly eight-fold. During that run, the global economy grew roughly 5% each year.

Strong growth in places like China helps take some of the edge off the oil-price blow for U.S. and European companies such as Detroit’s Big Three auto makers. Many emerging markets are hitting a “takeoff” stage, where per-capita income reaches a level that sparks serious auto demand, says Ellen Hughes-Cromwick, Ford Motor Co.’s chief economist. Growth in emerging markets is a “structural development” that is “less sensitive to oil-price changes,” she says.

“There’s a more relaxed attitude now,” said Daniel Yergin, a noted oil historian and chairman of Cambridge Energy Research Associates. At a recent event promoting Alan Greenspan’s new memoir, Mr. Yergin asked the former Fed chief on stage if $80 oil was a concern. “He basically shrugged and said, ‘Not so far,'” Mr. Yergin recalls.

Economists see global growth slowing but still chugging along at a relatively healthy 3% this year and next. High oil prices also mean more money for oil-producing nations such as Russia and Saudi Arabia to invest globally. “If resource owners are now getting a bigger piece of the pie to spend and invest, then $100 oil shouldn’t be a problem” in the absence of a U.S. recession, says independent energy economist Philip Verleger Jr. “And that investment is happening.”

Fundamental Shift

Such sanguine views, while they are far from universal, reflect a fundamental shift in economists’ understanding of how energy prices affect the economy.

Historically, oil prices have doubled or trebled in a matter of weeks because of sudden and sharp supply disruptions, such as those in 1980 following the Iranian revolution and the outbreak of the Iran-Iraq war. That prompted the Fed to raise interest rates sharply in an effort to head off a spiral of inflation.

Current Fed chairman Ben Bernanke has spent a lot of time trying to understand such shocks. In 1997, he analyzed the effects of sharp rise in prices during the oil shocks of 1973-75, 1980-1982 and 1990-91 in the Brookings Papers on Economic Activity. His surprising conclusion: The Fed’s cure for high oil prices was worse than the disease.

“The majority of the impact of an oil price shock on the real economy is attributable to the central bank’s response to the inflationary pressures engendered by the shock,” he wrote. Today, that view is fairly mainstream among central bankers.

Mr. Bernanke’s Fed recently responded to the subprime mortgage crisis by cutting benchmark interest rates for the first time in four years. By implication, the Fed was saying it was more worried about the fallout from credit-market gloom than about the risk of inflation. At a time of record energy prices, that’s a risky but educated bet.

Growing fuel efficiency could also blunt the blow of higher prices. James Barnes, a Union Pacific Corp. spokesman, says the railroad has bought more fuel-efficient locomotives and trained engineers to operate trains in ways that conserve fuel. “From a macro level, we would anticipate that rising oil costs will make us more competitive [with trucks] and potentially drive more business our way,” Mr. Barnes says.

Engine of Growth

In China, the engine of growth on which many are counting, other energy sources can make up for oil. China uses oil for only 21% of its energy needs, with most of the rest coming from coal. Unlike in the U.S., where imported oil goes to fill people’s gasoline tanks, China mainly uses oil in industrial settings, where coal may be an alternative. Greater coal use, however, would also exacerbate China’s already serious pollution problem and speed up emissions of gases that contribute to global warming.

Still, some fear the impact of $100-a-barrel oil would be too powerful for the U.S. to overcome. “If we aren’t already headed for a recession, it could push us in that direction,” says Bill Zollars, chairman and chief executive officer of YRC Worldwide Inc., a large trucking company based in Overland Park, Kan. “With a very fragile economy like we have now, this could be another burden for the consumer and the business community.”

Mr. Zollars says shipment volumes at YRC, which serves many retailers and manufacturers, have dropped to 2003 levels. “We are not seeing the kind of volume we would normally expect” ahead of the Christmas retail season, he adds.

Fall in Demand

Higher oil prices could hit the beleaguered auto and airline industries. Detroit is still digging out from the fall in demand for sport-utility vehicles caused by the climb in gasoline prices. Paul Ballew, General Motors Corp.’s top sales analyst, explained sluggish industry sales earlier this month by citing in part high fuel prices, which he called “effectively a tax on U.S. households.”

For now, most economists expect oil prices will stay high through next year. An unexpected hurricane in the Gulf or a sudden disruption to oil flows from a big producer like Iran or Mexico could push oil to $100, they say.

Demand is chugging along. The Paris-based International Energy Agency sees world oil demand in the fourth quarter rising by 2.8%, or 2.3 million barrels a day from a year ago, to nearly 88 million barrels a day.

Of course, those forecasts could go awry if the U.S. economy tanks and brings Europe and Japan along with it. Then demand would likely ease, and oil prices could fall, perhaps significantly. And then, the world would have something else to worry about.

–Daniel Machalaba, Shai Oster, Susan Carey and Mike Spector contributed to this article.

Write to Peter Fritsch at [email protected] and Kelly Evans at [email protected]

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