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Oil price spike has wide economic impact

If runaway oil prices go much higher, the damage to the U.S. economy will be deeper and wider than the fallout from the run-up so far. By's John W. Schoen.
Image: oil pump near refinery
“We're already in a mild recession,” says economist Lakshman Achuthan. “I think if we go towards $150 (a barrel), we start talking about something worse than a mild recession.”Matt Slocum / AP
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As dire forecasts about runaway oil prices become reality, it’s impossible to know how much higher they’ll go. But the impact of the price surge already is  being widely felt. And if prices go much higher, the damage to the U.S. economy will be deeper and wider than the fallout from the run-up so far.

Oil prices have doubled in the past year and have shot up nearly 50 percent since January to a record $135 a barrel. Much of the rise appears to be driven by speculators betting that tight supplies — or outright shortages — will push prices even higher.

Consumers — already hit with rising prices and flat wages — are being stretched further. As the Memorial Day weekend kicks off the summer driving season, gasoline prices are at record levels, reaching a national average above $3.83 a gallon. Some analysts predict the average will break past $4 as early as next week. In some parts of the country, prices are already closing in on $5.

“We're already in a mild recession,” said Lakshman Achuthan, an economist at the Economic Cycle Research Institute. “I think if we go towards $150 (a barrel), we start talking about something worse than a mild recession.”

The surge in oil prices is hitting some parts of the economy harder than others. Companies that use lots of oil have already been hurt; the recent surge will only make matters worse.

Airlines have been struggling to make a profit, even as they cut jobs and flights. American Airlines became the latest to announce it was tightening its belt another notch, saying Thursday that it plans to shrink capacity by as much as 12 percent and cut thousands of jobs.

To offset the rapid rise in jet fuel prices, the airline also said it plans to start charging passengers $15 to check the first bag of luggage for each passenger. United Airlines said it’s considering a similar move. The carriers already charge $25 for a second bag.

“(Higher oil prices are) going to send some smaller airlines into bankruptcy," said Nick van den Brul, an airline analyst at the French investment bank, Exane BNP.

Surging gasoline prices are further dampening sales at U.S. carmakers, whose product lines are more heavily oriented toward higher-profit, lower-mileage trucks and SUVs than their foreign competitors.

Ford Motor Co. said Thursday it’s cutting production by 15 percent in the second quarter of this year and another 15 to 20 percent in the third quarter.  Ford now says it won’t hit its target of getting back in the black by next year and may have to lay off more workers and close more plants.

Some parts of the economy will hold up relatively well; companies and regions that produce oil will do better. Oil companies are enjoying a spike in profits because production costs have not risen nearly as rapidly as market prices. Those higher profits could help boost local economies in regions where oil and natural gas are produced.

But those benefits will be more than offset by the negative effects of the surge in energy costs. Higher oil prices have already begun to spill over into higher costs for a variety of products and services, including food prices.

The threat of higher inflation makes life even more complicated for policymakers at the Federal Reserve, who have been slashing rates for nearly a year to try to offset the fallout from the housing slump and turmoil in the credit markets.  

The surge in oil prices could force the Fed to reverse course and begin raising rates — before the benefits of those rate cuts have had time to take hold. Minutes of the Fed's April policy meeting, released Wednesday, indicated that the central bank could start raising rates in the fall.

The biggest concern is the potential impact on consumer spending, which accounts for about 70 percent of U.S. economic activity. Consumers have already been hit by the slump in housing prices — eliminating the equity "piggy bank" that many homeowners tapped as prices were rising. Home prices fell 3.1 percent in the first quarter of 2008 compared with last year, according to data released Thursday by the government’s Office of Federal Housing Enterprise Oversight.

Another widely followed reading, the Standard & Poor’s/Case-Shiller index, has shown even larger declines for major U.S. metropolitan areas.

Rising gasoline prices are one more burden on consumers. Economists estimate that every additional penny at the pump takes roughly $1 billion out of overall spending. Taxpayers getting rebate checks designed to revive spending and get the economy moving again have already spent much of that bonus to gas up their vehicles.

So far, there seems to be enough oil and gasoline to go around: Refineries are still adequately supplied with crude, and gas stations aren’t running out of fuel.

Prices are surging as  traders see an increased risk of that happening. But that so-called panic buying could quickly reverse, sending oil prices sharply lower.

“This is all about psychology, and we are not very good at oil companies about forecasting the  psychology of prices," Jeroen van der Veer, CEO of global giant Royal Dutch/Shell, said on CNBC Thursday. “So we'd better prepare ourselves for more volatility because if this is psychology, it can change very quickly.”

The spike in oil prices also has brought calls for government action, despite the limited short-term impact those responses could have. The Department of Energy has suspended purchases of oil for the Strategic Petroleum Reserve.

But Energy Secretary Samuel Bodman said Thursday he did not support the idea of selling oil from the reserves to try to drive down oil prices.

The petroleum reserve "is meant to deal with ... the physical interruption of the flow of oil to our country. We don't have that issue today," Bodman told a House hearing.

The last such move came in September 2005, when the U.S. released millions of barrels of oil from its reserves as part of a coordinated effort by the International Energy Agency to head off possible shortages. But the amount conrolled by the United States is a relative drop in the global barrel and would likely have little impact on market prices.

The price surge has also revived debate on U.S. energy policy. Some longer-term proposals that have failed to win the support of the majority in Congress, like opening up new areas of the U.S. for oil drilling, may now get another look.

“We have to expand domestic exploration, we have to add additional new refineries, we have to add nuclear power into our electricity grid portfolio, we have give rewards for conserving energy and have to  continue to invest in research  and development,” Rep. Adam Putnam, R- Fla., said Thursday. “We have to have an ‘all of the above’ energy policy.”