Video: What's driving oil prices?

By Martin Wolk
msnbc.com
updated 8/15/2005 9:47:44 AM ET 2005-08-15T13:47:44

Talk about a conundrum. Over the past year oil prices have blasted through the $40 barrier to $50 a barrel, then $60 and now $65, yet the economy continues to hum along, with growth outpacing expectations, driven largely by strong consumer spending.

With gas pump prices heading closer to $3 a gallon, there are growing signs the rising cost of energy is about to take a bigger bite out of economic growth. But so far consumers, businesses and the economy in general have remained surprisingly resilient.

The stock market fell sharply Friday on a widening U.S. trade gap and concern over oil prices, which hit a record of nearly $67 a barrel, up more than $4 a barrel or 7 percent for the week. Also, a University of Michigan survey showed that consumer sentiment has dropped more than expected this month, with several analysts blaming the decline on the surge in oil prices.

The rising cost of crude is about to become a lot more visible: The AAA motorists group warned that drivers will see pump prices rise another nickel a gallon in coming days.

“I think the combination of the rise in the price of oil, the trade numbers and the consumer confidence numbers conspired to send a very strong message to investors,” said Hugh Johnson, chairman of Johnson Illington Advisers in Albany, N.Y. “They got the sell signal. Oil has reached a price where it will impact consumer spending, the economy and earnings, and it’s time to put that in the forecast.”

So far rising oil prices have been largely offset by growing employment and rising wages. The global bond market also has been accommodating, keeping long-term interest rates relatively low despite rising short-term rates, leading to what Federal Reserve Chairman Alan Greenspan labeled a “conundrum” earlier this year.

Even so, oil prices have had an impact: If crude had dropped back to the level of $40 or $45 a barrel, as many analysts had projected, growth in the first half of 2005 would have been much stronger, analysts said. As it was, the economy grew at a rate of about 3.5 percent, in line with its historic trend.

“The economy’s resilience, given the relatively high level of prices through July before the latest upswing, has been very impressive,” said Lynn Reaser, chief economist at Banc of America Capital Management. “It speaks to the improving efficiency of the U.S. economy over the past two or three decades, and also the move more toward a service-oriented economy.”

But she and other analysts said oil could have more of an impact blunting growth in coming months. For one thing, while crude oil prices have risen more than 50 percent this year, much of that increase has come in the past three months. Higher oil prices generally do not affect growth seriously unless they persist, forcing companies either to pass on the higher costs or accept lower profit margins.

“Firms are trying to find ways to offset higher energy costs, …but there are limits to those kinds of efficiencies,” said Scott Brown, chief economist at Raymond James. “Eventually you will see consumer inflation higher.”

The rising cost of oil is being compounded by the Fed’s determination to move short-term interest rates steadily higher, as it did this week with its 10th straight quarter-percentage point hike. That is another trend that has had little impact so far but will soon as consumers and businesses feel the pinch of higher costs for everything from credit card debt to adjustable-rate mortgages.

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“The real risk is ahead of us when higher energy prices bump up against higher interest rates,” said Mark Zandi, chief economist at Economy.com. He said the impact will be felt particularly harshly by lower-income households who have no savings and may face high heating bills this coming winter.

So far consumers have neither changed their driving habits nor cut back on spending.

In fact, quite the contrary. Overall retail sales are up about 10 percent from year-ago levels. That outsized growth can only mean that consumers are taking money out of savings, drawing down their home equity or going deeper into debt.

Ironically, much of the growth in sales has been related to cars, trucks and the fuel that goes in them.

With automakers falling over each other to offer discount deals, vehicle sales are up 18 percent on a year-over-year basis. Gas prices, at an average $2.37 a gallon, are up about 20 percent over year-ago levels, and gasoline sales also are up 20 percent, indicating consumers and businesses have not cut back on their usage, said Reaser.

But ultimately the combined impact of higher energy costs and higher interest rates will have a negative impact on growth — not only here but around the world.

Joseph Quinlan, chief market strategist for Bank of America’s Investment Strategies Group, points out that Asia is particularly vulnerable to higher oil prices and already is showing evidence of a squeeze.

In Japan, workers are being urged to forgo their jackets and ties to cut the cost of air conditioning. Indonesia has ordered television stations to stop all overnight broadcasts with the exception for European soccer matches, Quinlan said.

And an “arc of instability” has emerged in the Middle East, with tensions simmering in Iraq, Iran, Saudi Arabia and Israel, he said in a note to clients this week. “Given this tumultuous backdrop, we believe these risks could turn the oil squeeze of today into an oil shock tomorrow,” Quinlan said.

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