Commentary: Oil Prices and the Economy

The Global Portfolio Strategies Team has published an article exploring the prospect for a longer-term trend of rising oil prices to create headwinds for U.S. economic growth. The paper noted that:

• Every major recession in the U.S. since 1973 was preceded by a sharp rise in oil prices, and the latest one is no exception. As was the case 30 years ago, the spike in prices caused sharp declines in demand and a subsequent price collapse. 
• From a longer-term perspective, oil has alternated between multi-year periods of cheap oil and increasingly expensive oil. A long period of stability from the end of World War II was shattered by the Arab Oil embargo in 1973 and the economic power shift to the Organization of Petroleum Exporting Countries (OPEC). 
• Multiple recessions in global economic activity between 1973 and 1982, energy conservation induced by oil price spikes, increased non-OPEC supply and rampant OPEC cheating on production quotas combined to usher in another long period of declining oil prices that extended through the 1980s and 1990s.
• A new up-cycle in oil prices, however, took hold around 1999. In contrast to the period of rising oil prices during the 1970s, sharply rising demand in emerging economies and tight supplies, not politics, were the primary forces behind the price jump into last summer.
• We do not believe that the tumble in oil prices since then is the beginning of another long period of cheap oil. We doubt whether the production of oil will be able to keep up with potential demand on a secular (long-term) basis.
• We expect oil prices to rise faster than overall inflation in the years ahead so that alternative sources of energy become economical to produce, while demand is tempered through slower economic growth and increased energy efficiency. In our opinion, the weight of the evidence points to important supply constraints that will keep prices quite volatile around a rising trend.
• One implication of a long-term trend of rising oil prices could be that recessions would become more frequent. Rising energy costs can be likened to a tax increase, leaving less discretionary income for other purchases and reducing national wealth as money leaves the country and goes into the coffers of oil-producing countries.

Our View 

• Unlike the aftermath of oil price spikes in the 1970s, there has been surprisingly little inflation in the latest cycle of rising oil prices. As a result, increases in energy costs have tended to depress output and consumption instead of having an inflationary effect. 
• We are not too concerned about inflation rearing its ugly head anytime soon. Rather, a tendency toward deflation and a stubbornly weak consumer appear to be the more likely near-term problems facing the U.S.

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