WILL
HIGHER ENERGY PRICES IMPACT THE ECONOMY?
by Joseph Dancy,
LSGI Advisors, Inc.
Adjunct
Professor, SMU School of Law
September 8, 2004
With crude oil prices in the $45 a barrel range we hear conflicting
opinions as to what impact they will have on the U.S. economy and stock
market. Some argue the economy is much better insulated than in the past
from energy shocks as it uses less energy per unit of GDP, while others
argue that on an absolute basis we are more dependent on crude oil than
ever.
Stephen Roach, Chief Economist at Morgan Stanley, published an interesting analysis of this issue last month. He argues that the impact of higher oil prices depends on the vulnerability of the underlying economy.
When a weak economy is hit by higher energy prices a recession is the likely outcome, while a strong economy is better insulated. He claims today’s economy is vulnerable due to the weak recovery, and higher energy prices significantly increases the odds of a recession.
Historical Reaction to Oil Price Shocks
History tells us there have been three major oil shocks in the last 30 years -- all stemming from geopolitical disturbances in the Middle East. The Arab-Israeli Yom Kippur War of October 1973 and the subsequent oil embargo, the Iranian Revolution and related events in 1979, and the Iraqi invasion of Kuwait in 1990 that triggered a brief spike in oil prices. Roach notes the latest potential shock – number four - is the US-Iraqi war.
While on an inflation adjusted basis the recent run-up in prices is not as severe as in the past, Roach argues that if oil stays near $50 a barrel for 3-6 months it will qualify as a ‘legitimate oil shock’ in line with past experiences. While not at $50 a barrel prices are in a ‘danger zone’ he argues:
“The track record of oil shocks is close to perfect. In the case of the United States, each of the previous three oil shocks was followed by recession. OPEC I led to the deep recession of 1973-75. OPEC II was followed by a brief recession in 1980 and eventually set the stage for a severe recession in 1981-82. And the Gulf War Shock was followed by a mild recession in 1990-91.
These cyclical contractions all had one thing in common: The US economy was already vulnerable when it was hit by a shock. In the final three quarters of 1973, just before OPEC I, real GDP growth had slowed to a 2.2% average annual rate. In the first half of 1979, just before OPEC II, average annualized growth slowed to just a 0.6% pace. And in the three quarters prior to Iraq’s invasion of Kuwait, real GDP growth slowed to a 2.2% clip. In all cases the US economy was at or near its “stall speed” when the oil shock occurred.
. . . The closer to the [economic] stall speed, the thinner the cushion that is available to withstand the unexpected pressures of an exogenous disruption. Recessions are the rule, not the exception, in that context. That’s very much the risk today.
The current recovery in the US economy has been the most anemic on record. . . . America’s saving-short, overly-indebted, job- and income-constrained consumer looks as vulnerable as ever. Add to that the ever-mounting perils of outsize twin deficits and there is good reason to believe that an inherently vulnerable US economy could be hit hard by another oil shock.
. . All in all, it now appears that the world is being subjected to its fourth oil shock in 30 years. It’s quite possible, of course, that the geopolitical complications could unwind and oil prices retrace a significant portion of the recent run-up. But that’s pure guesswork at this point. . . . Under the presumption that such prices stick near current levels, the outlook is worrisome, to say the least.
Just as the previous three oil price disturbances led to recession, there is good reason to fear a similar outcome in 2005. For an unbalanced world that has run out of policy stimulus, there can be no mistaking the mounting perils of another energy shock.”
What About Energy Company Stocks?
In a recent Globe & Mail article Ross Healy, president of Strategic Analysis Corp., addressed the question of why oil and gas stocks are acting so poorly even though crude oil prices are unusually high. Like Roach, Healy turned to historical data for the answer.
The "last real commodity mania that we could recall" was gold bullion back in 1980 according to Healy. Early that year bullion jumped to slightly more than $800 an ounce, before falling back sharply. It rallied again, but not to the same level. In the initial market run-up gold stocks had only a tepid response to the sharp jump in bullion prices to $800 – four times the level a year earlier. But after bullion prices fell back from the $800 peak, the situation changed.
Globe & Mail journalist Angela Barnes writes:
By then, "the thought of high bullion pricing had seeped into the collective perceptive psyche of the market," Mr. Healy said. Once the setback ended, and bullion found a temporary solid footing and was clearly headed higher, possibly much higher, "gold stocks went berserk, and the gold and silver index more than doubled" in a very short time, he said.
"The market did not 'believe' the amazing gold price the first time around," he said.
Could the oil-and-gas sector exhibit a similar pattern? While cautioning that history does not necessarily repeat itself, Mr. Healy said he suspects it could. "It certainly is not only possible, but, indeed, would help make some sense out of what is otherwise a most peculiar phenomenon, and it would also fit the 'facts,' " he said.
As he sees it, oil and gas stocks are "very, very cheap."
© 2004 Joseph Dancy
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