Tuesday, March 8, 2011

Three Questions On Oil

Much of the financial press - and many of my recent discussions with clients - have centered around the oil market.

Oil, of course, is a hugely complex topic, so I will not attempt to address all of the implications of the events in the Middle East on world oil markets.

Instead, I want to try to briefly answer three questions that seem to arise frequently.

First: Will the recent jump in oil prices lead to broader inflationary pressures?

My answer: Maybe, but it's not as a straightforward as it was in, say, the mid-1970's, when the Arab oil embargo caused inflation in this country to soar. The reason is that oil as a percentage of the typical household expenditures has declined significantly from a generation ago.

This week's Economist has several good pieces about Libya and oil. Here' s an excerpt from their "Oil Briefing" in the March 3 issue:

Economists do not expect a repeat of the 1970s, when oil-price rises led to “stagflation” in the rich world. Olivier Blanchard, chief economist of the IMF, and Jordi GalĂ­, of the Centre de Recerca en Economia Internacional in Barcelona, point out that two recent oil-price rises—one beginning in 1999 and another in 2002—were of the same order of magnitude as during those turbulent years. But the effect on both inflation and unemployment in the rich world was much smaller: in America, for example, a rise in inflation of only 0.7 percentage points on average, whereas the 1970s shocks had caused a rise of 4.5 points in the two years after the shocks.

The rich world is less vulnerable now because it has substantially reduced the amount of oil used per unit of output. America’s economy in 2009 was more than twice as large in real terms as in 1980. Yet over that period America’s oil consumption rose only slightly, from 17.4m b/d to 17.8m. Europe actually used less oil in 2009 than in 1980, even though its economy had grown.


Next: Should the Fed and the European Central Banks raise interest rates in response to the rise in oil prices?

Again I turn to the Economist:

In recent years, with inflation expectations more stable, central banks have responded more moderately to higher oil prices. But in July 2008 the ECB raised short-term interest rates because it feared that a rise in headline inflation would feed a wage-price spiral. In retrospect, that was a mistake. The global economy was already slowing, and over the next year both headline and core inflation (which excludes energy) fell sharply in the euro zone. Although America's Federal Reserve did not tighten, it hinted at the possibility, which prompted markets (wrongly) to anticipate a rate increase. These hawkish signals may have compounded the slide in economic activity already underway.

Finally: Will the rise in oil prices weaken the economy?

This of course is the big question for investors, since shares of many companies have risen in anticipation of continued improvement in economic conditions.

I think for the time-being we remain in a muddling growth market, and that energy will not yet hurt economic growth. However, if oil prices continue to rise, it could very well choke off some of the economic improvement we have recorded over the last few quarters.