The Economic Impact of Higher Oil Prices

Crude oil is rapidly closing in on the 100 dollar mark, most analyst believe it will break through the barrier in 2011. The impact of this on global production and economic recovery, is a slackening of consumer demand, according to future and commodity expert Ole S. Hansen at Saxo Bank.

“In other words, the only cure for higher oil prices is higher oil prices!”

Ole S. Hansen

The commodity shock and subsequent financial crisis back in 2008-09 led to a dramatic reduction in the global demand for crude oil. Demand from OECD nations fell off a cliff. This initially resulted in a 110 dollar collapse of the price of WTI Crude oil from 2008 to the early part of 2009.

Over the past two years the price of oil has steadily recovered half of that collapse on the back of continued strong demand from non-OECD members, especially China. OECD nations began seeing a pick-up in demand during the second half of 2010. According to the IEA, total global demand reached an all time high of 88.7 million barrels per day during 3Q10, a rise of 3.3 million bpd year on year.

“Given the continued positive growth assessments among emerging market nations and the boost that the US economy is receiving from the second round of quantitative easing and the new payroll tax break, global oil consumption is expected to expand by 1-1.5 million bpd in 2011. A rise of this magnitude will mean tight supply lines and the risk of higher prices,” Hansen writes in his latest analysis.
The average price of WTI crude during 2010 was just under 80 dollars per barrel after having traded in a relatively tight range for most of the year. Only in the last quarter did we see a sustained rally above 80 dollars a barrel on the back of the strong pick-up in demand. Most of the major research houses now predict average prices above 90 dollars for 2011 with the risk pointing towards a move above 100 dollars during the year.

“What kind of impact will this have on the still fragile economic recovery among OECD nations? To answer this question let us have a look at the U.S., which consumes approximately 22 percent of global production, of which nearly half goes to gasoline consumption.”

Above is the chart of the U.S. daily average gasoline price compiled by the American Automobile Association. The annual average price has moved higher over the last two years after the price shock back in 2008.

Prices during 2010 were relatively stable as the supply and demand situation on WTI crude was relatively balanced. Towards the end of the year the gasoline price began to move higher in line with crude oil and is currently sitting some 32 cents above the 2010 average.

“The annualized economic impact for every one cent rise in gasoline prices in the US is approximately 1.5 billion dollars, so US consumers are faced with a bill of an extra 48 billion dollars this year (approximately 0.3% of GDP) if gasoline prices stay at their current levels. And even if crude oil prices remain the same, gasoline prices will likely rise at least another 10-15 cents due to the shift to more expensive summer blends that occurs every spring. Even a rise of that magnitude would put us back at the 2008 average price, and a rise above 100 dollars a barrel would put us above that level in the spring and summer.”

A one dollar increase in the price of gasoline from the 2010 average to 3.78 dollars per gallon would result in 150 billion dollars less to the consumer and would be the approximate equivalent of a one percent reduction in GDP.

According to Saxo Bank, is the biggest risk of higher prices is a squeeze on margins and the relative in-elasticity of demand means a higher percentage of consumer spending goes to gasoline expenditures – particularly in the US, where taxes make up a much smaller percentage of the price, relative to other developed nations. Oil increases will come straight out of the bottom lines of corporations with energy intensive inputs, because their pricing power is still relatively modest considering the hangover and output gap from the last recession.

“This would put a huge additional burden on local authorities, whose budgets are already very hard pressed (school buses, city buses, etc..) and road construction activity would have to slow unless budgets are expanded to compensate for higher costs,” Hansen points out.
Adding: “Hardest hit by any increase would be emerging markets, however, as their use of oil per unit of GDP is still far higher than in the developed world. It will be interesting to see how the superior emerging market growth story will function of crude oil trades above 100 dollars a barrel for any significant period of time.”

Ole S Hansen

“Eventually, the only cure to higher oil prices is higher oil prices, which experience shows us do eventually crimp demand and bring supply and demand back into balance. During hurricane Katrina in the US, for example, the spike in gasoline prices saw year-on-year gasoline demand fall as much as -3% in the absence of a recession. As prices rocketed well above 100 dollars per barrel and the US lurched into a recession, demand fell even further. We would suggest that any further rise in prices from here will begin to see a slackening in demand,” he concludes.

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