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Would $100 oil slam the global economy?

/ Source: BusinessWeek Online

Economists have been surprised how little the current high price of oil has damaged the U.S. and world economies. After all, prices have already soared by 300% since 1999, yet nearly all regions of the world continue to chug along. That's a big contrast to the oil crises of the 1970s and 1980s, which sent economies into major funks.

What would happen, though, if the price of a barrel of oil topped the psychologically significant level of $100? The answer varies by region, with the worst likely impact in Asia and the least impact in Europe. But no question, oil prices one-third higher than they are now would sting everywhere.

Are we close to seeing oil selling for $100 per barrel? With conflict raging in the Middle East and the peak of the U.S. hurricane season just around the corner in August and September, reaching that triple-digit figure doesn't look out of the question. "If something goes wrong somewhere, and if it's big, and people think it is going to last a long time, prices could go up a long way," says Kevin Norrish, an analyst at Barclays Capital in London.

One scenario: If the fighting in the Middle East somehow produced cuts in the flow of oil from the Persian Gulf region — still an unlikely outcome — that would almost certainly drive oil prices above $100. Another major hurricane hit to refineries and producing installations on the U.S. Gulf Coast also could produce a sharp spike, according to Saad Rahim, an analyst at PFC Energy in Washington.

"If there is a repeat of last year and a major refiner is taken out, we could see $100," he says. Giants such as BP, Chevron, and Exxon Mobil operate facilities throughout the region and could feel the pinch. Rahim notes, however, that the U.S. markets weathered last year's big outages with less of a price runup than many analysts expected.

Indeed, the key difference today from the supply-driven oil shocks of the 1970s and 1980s is that the current price boom is mostly driven from the demand side, thanks to a powerful cocktail of global economic forces. Emerging markets, including China and other Asian countries as well as the Middle East, are coming into their own as major energy consumers.

Intense global demand
Why? Factories in Asia are running flat-out to supply the world with goods. And rising incomes are allowing people to buy more and more cars and other motor vehicles from the likes of Toyota and GM, even as governments are rushing to build highways to accommodate them. The demand for air-conditioning in many developing countries is also soaring, leading to more and more fuel being burned to generate electric power. At the same time, fuel consumption has been surprisingly feverish in the U.S., where $3-per-gallon gasoline has hardly fazed U.S. drivers.

Would $100-per-barrel oil be a different story? The answer is a cautious yes. One reason the U.S. economy has not been hit hard by rising energy prices is that the efficiency gains of the last two decades mean that energy costs were squeezed down to about 5% of disposable income, compared with 8% in 1980, the era of the last crisis, according to PFC Energy.

"You still have room to run before people start to cut back," Rahim says. He does think that $100 per barrel could be the point where there is a "widespread demand response." But that is by no means a sure thing. The "Fun Fun Fun" culture of carefree driving popularized in a Beach Boys tune more than three decades ago remains a powerful force in the U.S.

Winners and losers
Depending on the cause of the spike, $100-per-barrel oil could move gas prices in the U.S. to as high as $5 per gallon. Such levels, if reached suddenly, would contribute to a slowing of the U.S. economy—of which there are already signs, with retail sales slack and home sales falling. For people on tight budgets, another $2 per gallon takes away money they could otherwise spend on housing, at Wal-Mart, or Target.

Across the rest of the world, the impact of $100 oil would be uneven. Europe would most likely be the best buffered from price increases. For one thing, the strong euro takes some of the sting out of rises in the price of oil, which is sold in dollars. European industrial countries such as Germany also are highly efficient in energy use—even more so than the U.S. And much of the energy they consume comes from natural gas and nuclear energy, where long-term contracts dampen sharp swings in oil prices.

Moreover, taxes on fuels such as gasoline are so high in Europe that price increases in crude aren't felt as much by consumers as in the U.S. Europeans already shell out in the range of $7 to $8 per gallon for gasoline—higher than U.S. drivers would pay even if oil topped $100 a barrel.

Meanwhile, Russia, the big energy supplier to Europe through companies such as Gazprom and Rosneft, would make out like gangbusters, figures Peter Westin, chief economist at MDM Bank in Moscow. If oil prices topped $100 per barrel, Russian economic growth could surge from the expected 6% up towards 9%.

Efficiency matters
The impact in Asia would be mixed. Countries such as Thailand, Malaysia, Indonesia, and India, whose factories are inefficient energy users, would probably be hurt the most, though their high economic growth could act as a cushion. In India, for instance, an oil price of $90 per barrel would have slowed 2005 GDP growth from 8.4% to 6.3%, figures Subir Gokarn, chief economist of the New Delhi credit rating agency Crisil. Inflation would have more than doubled, to 10.3%, and the current account deficit would have nearly doubled, to 10.8%. Gokarn calls these effects "significant but not dramatic."

Though Japan is hugely dependent on imported oil, the country is also among the world's most efficient energy users, thanks to major investments made over the last three decades. Japan's heavy use of natural gas, the prices of which are regulated, also helps buffer consumers, as does the strong yen.

On the other hand, South Korea, another big oil importer, could see key industries such as auto production hurt in the event of a big price rise. So far, price increases have had "a marginal impact," says Han Ki Ju, senior economist at the Korea Institute for Industrial Economics & Technology. "But in view of the tight margins for the global auto industry, the impact on the car-making sector will become noticeable if energy prices continue to rise."

Much more than oil
And then of course, there is China, which is among the least efficient energy users in the world. Though its economy would feel some pain, high oil prices are not considered a top risk to the Chinese economy. Policymakers are more focused on the dangers of overheating or a falloff in U.S. demand for Chinese goods.

In the end, global economic performance is driven by a lot more than just the cost of oil. Even with the risk of price shocks, the Asian Development Bank is still predicting 7.5% growth this year for emerging Asian economies, followed by 6.9% in 2007. Meanwhile, the euro zone, with its relative immunity to oil price shocks, should see nominal GDP growth of just 3.8% this year and 4.2% in 2007, according to the OECD. Oil at $100 sounds scary, but the world won't stop.