Why $80 oil hasn't impacted our economy, but why $162 oil will
With oil north of $80 a barrel it seems appropriate to revisit another conundrum facing economists, which is why high energy prices have yet to derail the economy. Many economists and analysts have estimated that high oil prices would lead to demand destruction and dent economic activity. Back in 2005 oil jumped to $60 a barrel and then even over $70 a barrel with hurricanes Katrina and Rita, and yet the resilient U.S. economy continued chugging along.
Last year we saw West Texas Intermediate Crude (WTIC) oil rise to $79.86 a barrel, kissing the $80 a barrel mark and again analyst were expecting demand destruction that never materialized. Oil retreated towards the end of last year before bottoming near $51.03 a barrel in early January of this year. Since then oil has risen 64% to new all-time highs at $83.76 a barrel. The question then becomes, if the economy survived $70 dollar oil and $80 dollar oil, how high can it go before oil prices impact the economy?
Looking back to the late 1970s and early 1980s energy crisis, where sky rocketing oil prices contributed to the twin recessions in 1980 and 1981, provides a comparative example with which to determine how high energy prices can go before the economy cries 'uncle'. There have been several suggestions as to why high oil prices have not impacted the economy as they did during the 1970s and 1980s, one being inflation. Correcting crude oil for inflation does reveal that we have not risen to the inflation adjusted high of $102.53 per barrel seen on March 31st, 1980, as we are currently more than 20% below that high.
Figure 1
Source: TheChartStore.com
However, price is only half of the equation as demand is equally important. Though the inflation adjusted price of crude oil is below the levels seen in the previous energy crisis, demand for crude oil is most certainly not. Demand for oil peaked at 18,909,000 barrels per day (BPD) in November 1978 as oil prices skyrocketed northward while demand for crude reached 20,630,629 barrels per day at the end of last year.
To determine the total petroleum cost to the economy one needs to multiply consumption (quantity) by price. Sky rocketing petroleum costs are often associated with recessions as seen in the figure below. A spike in the total petroleum cost to the economy was associated with the 1973 recession, 1980 recession, 1990 recession, and also in the 2001 recession. What is also glaringly obvious is the spike in petroleum cost to the economy currently, yet with no associated recession.
Figure 2
Source: Moody's Economy.com
The reason why high petroleum costs have not stopped the economic expansion is that the energy intensity of our economy is no where close to that of the 1970s and early 1980s, as consumption has not kept pace with either GDP or incomes. For example, since the low in oil consumption in 1983 of 15,094,850 barrels a day, oil consumption is up 37% as of December 2006, while nominal GDP is up over 300% over the same period. This indicates that oil consumption has not kept pace with economic activity over the last three decades resulting in a decrease in the energy intensity per economic activity. Oil consumption has also not kept pace with consumer incomes, which have increased by 294% since 1983, close to the same increase seen in nominal GDP levels.
Figure 3
Source: Moody's Economy.com
Figure 4
Source: Moody's Economy.com
Another way of looking at this relationship is the amount of consumer incomes being spent on energy. Even though crude oil prices have risen 635% since the low in 1998, energy spending as a percent of disposable personal income (DPI) has only risen from roughly 2% to 3.5% currently. The price of oil has increased more than six fold while the spending on energy as a % of DPI has only increased roughly one and a half fold and is well below the 5.3% peak seen in 1980.
Figure 5
Source: Moody's Economy.com
As shown above, energy consumption intensity per economic activity and consumer incomes has not kept pace, but why? The answer lies within the shift in manufacturing�s relative importance to the U.S. economy, which has steadily declined after World War II when the manufacturing base represented nearly half of total U.S. employment. Since WWII, the U.S. has shifted from a manufacturing economy to a service economy as is seen below. Service employment now makes up nearly 84% of total employment and manufacturing now makes up only a fourth of the share of total employment that it once did back in the 1940s.
Figure 6
Source: Moody's Economy.com
The result of the loss of our manufacturing employment as we have transitioned into a service economy is that we have also transitioned from an exporting country to an importing one. The trade balance sharply deteriorated at the start of the current economic expansion that also saw our manufacturing base gutted.
Figure 7
Source: Moody's Economy.com
One thing we have exported in this expansion is our manufacturing jobs with China being the net importer. This has led to a deteriorating trade balance with China as we now import that which we once exported.
Figure 8
Source: Moody's Economy.com
The result of China's industrialization and the exporting of U.S. manufacturing jobs overseas is an explosion in the energy consumption of China, as a manufacturing economy is inherently more energy intensive than a service economy. The normal pattern in U.S. corporate hiring in response to economic activity abruptly came to an end during the 2001 recession and was the catalyst that led to the surge in Chinese energy demand.
Instead of revamping its manufacturing base when emerging from the 2001 recession, corporate America continued to gut its manufacturing base, exporting jobs overseas as manufacturing employment has been on a one-way-street, down.
Figure 9
Source: BP Statistical Review (2006)/ Moody's Economy.com
As shown in Figure 9 above, with China's transition into a manufacturing economy comes increased relative energy intensity. Conversely, the steadily declining share of manufacturing employment to total employment in the U.S. has led a decline in energy intensity as measured by oil consumption per dollar of GDP. Since the 1970s, oil consumption has not kept pace with economic activity as current oil consumption per dollar of GDP has fallen 89% since 1970. The declining relative share of manufacturing employment and oil consumption per dollar of GDP are highly correlated with a correlation coefficient of 91%, supporting the notion that a declining manufacturing base results in declining economic energy intensity.
Figure 10
Source: Moody's Economy.com
With understanding why oil hasn't derailed our economy as our energy intensity per level of GDP has declined, the question still remains, at what price will oil derail the economy? Figure 2 above shows the cost of oil consumption over the past forty years, but the chart is really an apples- to-oranges comparison as consumption levels and the price of crude has not remained constant, nor has GDP. A more true apples-to-apples comparison is seen through ratio analysis, similar to the PEG ratio (price/earnings to growth) that normalizes PE's by the growth rate, when taking the petroleum cost and normalizing it by the GDP level. The result of this calculation is shown below, which illustrates how crippling and severe energy prices were during the inflationary period seen in the 1970s.
Figure 11
Source: Moody's Economy.com
We are currently above the first Persian Gulf War price shock and near the levels of the 1973 OPEC oil embargo, though roughly half of the 1980 price shock. As shown in the figure above, given current consumption and GDP levels, the price needed to equate to the same petroleum cost per dollar of GDP seen in 1980 would take $162 a barrel oil, more than double today's levels. Oil at $162 a barrel may seem unlikely in the near future but with razor thin spare capacity and rising developing world demand, $100 oil may be right around the corner as commented on in a recent report from CIBC World Markets ($100 Oil, July 18, 2007).
The two arguments against $100 oil, the ability of technology to raise new supply and the ability of price to limit demand, are falling quickly by the way side. Gone are Big Oil's smug assurances that their technical prowess will untap huge hitherto undiscovered reserves of cheap crude. What we hear instead through the voice of the US National Petroleum Council are warnings of depletion and steadily rising prices.
Why haven't soaring prices shackled demand? They actually have in some places like the carbon conscious economies of Western Europe, where crippling gasoline taxes and subsidies for alternatives like biofuels have reduced oil consumption for two years in a row. But such reductions have become a footnote to the world demand curve, which is no longer shaped by energy consumers in the OECD economies, but by the seemingly insatiable appetite of newly empowered consumers in developing countries whose economies are industrializing at breakneck speeds.
It's far from obvious who will fill that supply gap. What is obvious is that if that gap isn't filled, not only are triple digit oil prices on the horizon, but even more problematic, they will be here to stay.
Today's Market
The markets extended yesterday's losses due to several negative economic news reports. The Institute for Supply Management reported that their service sector index fell to 54.8 from 55.8 in August as expected, while mortgage demand fell as seen by the Mortgage Bankers Association who said mortgage application volume fell 2.7 percent in the week ended Sept. 28. Also weighing down the markets was news that Germany's Deutsche Bank AG said it would book charges totaling about $3.1 billion in the third quarter due to losses on loans, leveraged loans and structured credit products resulting from the subprime mess.
The best performing sectors were consumer discretionary (+0.25%) and health care (+0.13%), while materials (-1.25%) and industrials (-1.03%) were the sectors putting in the worst performance on the day.
The Dow Jones Industrial Average fell 79.26 points to close at 13968.05 (-0.56%), the S&P 500 declined 7.04 points to close at 1539.59 (-0.46%), and the NASDAQ shed 17.68 points to close at 2729.43 (-0.64%).
Treasuries fell with the yield on the 10-year note rising 1.4 basis points to close at 4.543%. The dollar index was up on the day, rising 0.33 points to close at 78.64. Declining issues represented 60% and 59% for the NYSE and NASDAQ respectively, reflecting a fairly broad decline.
