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Is Oil at the Tipping Point?

By Robert Samuelson

WASHINGTON -- It's been a minor miracle: The presumed power of soaring oil prices to cause an economic crisis has turned out to be more myth than reality. We Americans have grumbled loudly about rising gasoline prices while tanking up as if almost nothing has happened. Over the Fourth of July holiday, a record 40.7 million Americans took trips of more than 50 miles, up 1.2 percent from a year earlier. In June, gasoline consumption exceeded 9.5 million barrels daily, a monthly record. Meanwhile, the economy seems strong. The jobless rate of 4.6 percent is surely close to "full employment.''

The fighting between Israel and its neighbors -- which immediately sent crude prices to $78 a barrel -- poses this question: Is our good fortune about to expire? Although the tentative answer is no, it cannot be delivered with complete confidence. Economist Nariman Behravesh of Global Insight thinks the economic expansion will continue even though oil prices may drift up to $85 a barrel. But he quickly qualifies his prediction. A major Persian Gulf supply disruption could cut oil output by up to 5 million barrels a day (out of a total of 85 mbd). Prices could go to $120 a barrel. The economic effect would be "devastating.'' For every $10 a barrel, gasoline prices rise by about 25 cents a gallon.

Oil markets are operating on fear. The gap between demand and productive capacity is tiny, perhaps 1 million or 2 million barrels a day. Because oil demand is what economists call "inelastic'' (meaning that consumers see fuel as essential and curb their buying only slightly as prices rise), even modest threats to supply can create big price increases. Rebels in Nigeria have cut that country's sales by about 600,000 barrels a day, says Mary Novak of Global Insight. Prices have risen. The Middle East fighting creates many grim, if long-shot, possibilities: Iran might curb output to put pressure on Israel; terrorists might block tankers from using the Strait of Hormuz; the Israelis might bomb Iran.

"Everyone's buying because they're fearful of supply disruptions,'' says Mark Zandi of Moody's Economy.com. Geopolitics isn't the only danger. "If another hurricane blows through the Gulf of Mexico and damages rigs and refineries, that will send prices way up.''

There's also a mismatch between available crude supplies and the kind of oil that refineries want, notes Novak. The most desirable oils are "light'' and "sweet'' crudes that are highly liquid and have low sulfur content. These crudes are easily refined into gasoline, jet fuel and diesel oil. By contrast, "heavy'' and "sour'' crudes (thick, with high sulfur content) aren't easily refined. They're relatively plentiful. The scarcity of sweet crude is putting upward pressure on prices.

But until now, the economic impact has been muted. Why? Three reasons stand out.

First, adjusted for inflation, oil and gasoline prices have remained below previous peaks. This may no longer be true: The earlier highs occurred in 1980 and 1981, when gasoline averaged almost $3 a gallon (in 2005 "constant'' dollars); that's roughly where prices are today. Second, gasoline spending has represented a smaller share of household budgets because over the years Americans have gotten richer. Although that's still true, the gap is shrinking. In 1980 and 1981, gasoline spending equaled 4.3 percent of disposable personal income. In 2002, that was about 2.1 percent; now it's 3.7 percent. Finally, most businesses -- oil companies obviously excepted -- haven't passed their higher energy costs along in prices. Some economists worry this may soon happen.

What's worse, oil prices may be moving up just when other signs point to weaker economic growth. Since June 2004, the Federal Reserve has been raising short-term interest rates. The cumulative increases now seem to be having an effect. Borrowing costs are rising. The real-estate market is softening. It's harder for homeowners to sell and extract huge profits from their homes -- profits used for other spending. Higher gasoline prices may also erode confidence. "No single factor influences consumer sentiment more consistently,'' say economists Jochen Hitzfeld and Roger Kubarych of the HVB Group.

So, is oil at a tipping point? Could higher prices trigger a recession? Well, yes. But they'd probably have to rise much higher than $80 a barrel. No one really knows. What we do know is that the American economy has consistently confounded powerful reasons for it to falter. It has shown itself to be remarkably resilient. If we are lucky, it will prove so again.

(c) 2006, The Washington Post Writers Group


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