By Desmond Lachman

Friday, May 30, 2008

Filed under: Economic Policy, World Watch

Oil prices cannot keep rising forever, despite what many of today’s market participants seem to think.

Rudi Dornbusch, the renowned economist, once said that he did not understand how Mexico’s central bank board members could make the same mistakes time after time. Looking at the ongoing frenzy in the global oil market, one appreciates what Dornbusch meant. Once again, many market participants appear to believe that oil prices can only go up. It seems that the painful lessons of the 2001 dot-com bust have been forgotten, as have the lessons of the much more recent U.S. housing crash.

In their state of forgetfulness, many pension funds and insurance companies have built up very large open positions in the oil futures market. These positions are now estimated to total over $200 billion, roughly the equivalent of a full year of Chinese oil demand. They have contributed to the recent spectacular run-up in oil prices.

To be sure, there are many reasons why global crude prices have doubled over the past year from $65 a barrel to an all-time record of $135 a barrel. For starters, it has become increasingly apparent that world oil production is stubbornly stuck at around 85 million barrels a day; new oil production coming on stream is approximately offset by the depletion of the world’s major and aging oil fields. This depletion is occurring at a time when emerging market economies such as China and India are growing rapidly and their citizens are becoming increasingly energy-intensive in their consumption habits.

Sky-high oil prices pose a serious threat to global economic growth, and a global slowdown would undermine the very basis of those prices.Yet by focusing exclusively on supply limitations and on the emergence of China and India, the market is overlooking a key point, namely, that oil price increases are qualitatively different from other commodity price increases. Unlike other commodities, oil is an essential industrial input and it forms a vital part of every household’s consumption basket. As such, large increases in oil prices can and do have highly deleterious effects on the global economy.

The degree to which oil can affect the global economy is brought home when one considers that the United States, Europe, and Japan each have to import approximately 15 million barrels of oil a day. This means that oil price increases should be seen as the equivalent of a consumption tax levied by foreign governments on the major industrialized economies at a most inopportune time.

The market is also ignoring the fact that the recent increase in oil prices is not occurring in isolation. Rather, it is occurring at a time when the U.S. economy is suffering from the biggest housing market bust of the past 70 years. The housing crisis has contributed to a sharp decline in U.S. consumer sentiment, which has plunged to its lowest level since the early 1980s. Worse still, the recent oil price spike is experiencing “the mother of all crises” (in the colorful words of former Federal Reserve chairman Paul Volcker).

Past experience suggests that if the recent run-up in oil prices is sustained, it alone will subtract more than a full percentage point from U.S. GDP growth in 2008. That experience also suggests that, over the longer haul, the recent doubling in oil prices will subtract another full percentage point from U.S. GDP growth beyond 2008. Since these oil price increases have occurred in the context of a housing bust and a credit crunch, one must assume that the U.S. economy is facing the real risk of a recession that is both deeper and more protracted than the postwar average. And if the recent spike in oil prices threatens to tip the U.S. economy into recession, just imagine what a further run-up in prices—say, to the $150 to $200 a barrel range—would do.

But here’s the catch: if soaring oil prices were to push the United States and other industrialized nations into recession, is it plausible to think that the export-oriented Chinese economy could continue to grow at its present pace and make up for the lower oil demand in the West? No. In other words, oil prices cannot keep increasing without ultimately triggering a significant reduction in demand, which, in turn, would bring prices back down.

Of course, one should not exclude the possibility that oil prices could experience a further supply-induced spike. Nor should one minimize the world’s long-term energy challenge. However, we must avoid being carried away by the current hysteria. Sky-high oil prices pose a serious threat to global economic growth, and a global slowdown would undermine the very basis of those prices. No, oil prices cannot rise forever, despite what many of today’s market participants seem to think.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

Image by The Bergman Group.


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