Oil Rises, Economies Decline?

The week was all about oil – again.  Prices rose as Tropical Storm Katrina threatened oil production in theGulf of Mexico.  On Wednesday the price of a barrel of crude rose to $67.32, a new record.  Today as Katrina heads into the Gulf, it trades at $67.55.  Global demand for oil is now so high that any previously inconsequential disruption can threaten the supply of the irreplaceable energy source, at least in the fears of traders.

But it’s the high prices and the duration of them that threaten our economy.  WalMart has already blamed the ‘oil tax’ for their weaker-that-expected sales results.  But Target and JC Penny’s did better than expected.  High gasoline prices may have played a part, but maybe, just maybe, Target and Penny’s out-executed their larger competitor.  At any rate, high oil prices have traditionally been a drag on economies a year later.

Energy prices last peaked in March of 1981 with a barrel of crude costing $90.00 in today’s dollars and a gallon of gasoline costing an average of $3.03 in today’s dollars.  According to the Lundberg Survey of 7,000 gas stations around the country, an average price for all three grades was $2.53 a gallon.  We still have a ways to go to reach the 1981 peak, but the speed with which prices have risen this time are unprecedented.  Retail prices have risen an average of 70 cents since the beginning of the year and are up 62.7 cents from last August, Lundberg reported.

The effect on our economy so far has been muted, but will it last?  In the four quarters that followed the energy spike of 1981 gross domestic product grew an average of 2.6%, but it declined an average of 2% in each of the four quarters following, from March 1982 through December 1982.  Stocks as measured by the S&P 500 declined by 24% from March 1981 to August 1982 (while the economy was still expanding) in anticipation of the recession, but began a 66% rally in August 1982 (the month of the worst decline in GDP) that ran until June of 1983.

But, there are other significant differences between then an now that could support the argument that this time may be different, or less severe.  First, energy plays a less significant role in the economy now than it did then.  According to theNationalEnergyInformationCenter, energy consumption per dollar of GDP has fallen from 15% in 1981 to about 9% today.  Second, inflation in 1981 was raging at 11% while today it is at 3.2%.  The Federal Reserve was also very busy back in 1981 trying to reign in runaway prices.  The Fed Funds target was 16% in March of 1981 and rose to 20% in May.  They began to ease after that to a low of 9.5% in August of 1982.  That’s a far cry from interest rates today.  The Fed Funds target rate is now 3.5% and will likely rise to 4% before the Fed begins easing.  Finally, productivity is considerably better today than it was back then.

While it is too early to know the fallout from higher energy prices we are already seeing the effects in some areas, such as consumer confidence.  Today, the University of Michigan confidence survey dropped from 92.7 to 89.1 as consumers felt the pinch of rapidly rising gasoline prices.  Demand for long-lasting goods made inU.S.factories dropped 4.9% in July, the biggest decline in 18 months, according to the Commerce Department. The report was far worse than economists expected.

We are taking a conservative approach in anticipation of a slowing economy.  But we do not expect a recession to follow, based on all the information out there and on the opinions of the numerous experts we follow.

Sam Bass
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