January 7, 2008

Oil at $100 a barrel? No sweat

The price of today's crude may sound frightening, but the U.S. economy should be able to absorb it, many experts insist.
NEW YORK (Fortune) -- Crude's surge last week took its price to an eye-popping $100 a barrel. The rise comes on top of a 57 percent jump for 2007 and puts oil within reach of its all-time inflation-adjusted high above $102, hit back in 1980.

The latest jump means that Americans can expect to pay more for everything from gasoline to food and clothes. Those rising prices threaten to constrict consumer spending, which is repsonsible for more than two-thirds of domestic economic activity.

A sharp consumer slowdown would be bad news indeed, because the economy is already showing signs of strain. The government reported Friday that only 18,000 jobs were created last month, a mere fraction of the number needed to keep up with population growth. The Institute for Supply Management's factory index dropped below 50 in December, a sign manufacturing work is contracting.

So will $100-a-barrel oil be the straw that breaks the economy's back? Probably not.

After all, growth has persistently chugged along now for four years despite ever-increasing oil prices. Obviously, another huge rise in oil prices this year wouldn't help the economy - but it's not at all apparent that it would break it either. "We must accept the notion that at some point there's a price people won't pay" for oil, says Howard Simons, an oil industry veteran who has been measuring oil's impact on the economy for 30 years. But crude oil has seen its price rise fivefold in just six years, he adds, and "we haven't even approached the point of crimping consumer spending."

Simons notes that unemployment, at 5 percent, remains historically low, and that consumer spending hasn't fallen off a cliff even as foreclosures spike and house prices plunge. Moreover, history shows that trying to predict a recession is daunting.

Simons notes that just four years ago, a spike in oil prices took the price tag on a barrel of crude oil to $40 - a level many observers viewed as unsustainable. Voices predicting imminent recession grew louder as crude surged past $50, $60 and $70 a barrel. Yet as weak as parts of the economy now look - house prices are in free fall in much of the country and wage growth has been anemic - a sharp pullback in economic activity has yet to manifest itself.

Indeed, despite Friday's weak labor report, "These jobs gains indicate the economy did not enter a recession in the fourth quarter of 2008," writes Peter Morici, an economist at the University of Maryland's Robert H. Smith School of Business.

The economy's resilience is due in part to gains in energy efficiency over the past quarter-century, since the last oil shock. Ken Medlock, a fellow in energy studies at the Baker Institute for Public Policy at Rice University in Houston, also notes an energy-saving shift from a manufacturing-led economy in the 1970s and 1980s to today's service-oriented economy. He says that the price of crude oil would need to soar to $140 a barrel in order to bring the per-mile cost of driving, for example, back to 1980 levels.

Efficiency gains and economic flexibility are two reasons Medlock, for one, doesn't expect to see triple-digit crude prices throw the economy into contraction. "I don't think we're going to see a pullback like in the 1970s and 1980s," he says. He adds that while the housing and auto markets are showing clear signs of an economywide slowdown, he believes the United States will avoid a deep recession unless there's some sort of unexpected shock.

For his part, Simons believes the rising price of crude will come to be seen as a footnote in a history of this era. He expects coming years to be dominated by the cleanup of the housing mess. Even aside from the foreclosures sweeping the nation and wiping out homeowners, he points to billions of dollars of bad loans that threaten the health of the banking system. Banks that are busy raising money to sop up their losses will be inclined to tighten the reins on lending, possibly starving business expansion.

"We dodged one deflationary recession" after the tech bubble burst in 2000, he says. "Now the question is whether we can dodge another."

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