The Unreliable Forecasts

As oil surges higher, oil price forecasts are revised upward no matter they are based on fundamental or technical analysis. This reflects that the attempts to accurately predict oil prices are futile because it is almost impossible to correctly grasp and analyze all the factors involved, especially the speculative elements. Nowadays, the doomsday prediction of $100 a barrel is gaining credibility quickly.

What have disjointed the economic growth and inflation forecasts? According to a survey conducted by the Wall Street Journal in August last year, seventeen out of fifty-two economists believed recession would be inevitable if oil prices had sustained between $50 and $59 for an extended period of time, with another fifteen believed the price range should be around $60 to $69. In that particular month, oil prices averaged $45 a barrel. But in the same survey done during August 5 to August 9 this year, economists revised their Q3 and Q4 US GDP forecasts upward to 4.2% and 3.6% respectively from the revised 3.5% and 3.4% in June. For the global economy, the latest IMF forecasts call for 4.3% and 4.4% real growth in 2005 and 2006, only moderating mildly from the fastest growth in thirty years at 5.1% last year. Although these forecasts were made before oil hit $68, they still suggest there is a big gap between higher oil prices and economic recession that most fear.

The same holds true for inflation. In the Federal Reserve's August 9 statement, it still states that core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained, suggesting that high oil prices have yet to trigger inflation fears. The consensus for the US headline inflation is also around 3% by the year-end. It is in this regard that the mainstream forecasts for the Fed Fund Rate target to be at 4.0% by the year-end and it will likely peak at 4.5% next year. The threats of recession and inflation seem to deviate from past experiences. What have contributed to the differences since the previous oil crises?

The Experiences of Oil Crises

On October 17, 1973, OPEC's oil embargo unveiled a global oil crisis. Oil prices surged from just under $3 a barrel before the embargo to almost $12 a barrel by March 17, 1974 when the embargo was lifted, an increase of a staggering 300%. Since then, oil prices had stayed above $10 level. The global economy experienced a period of stagflation. The US economy immediately contracted 2.1% in the third quarter of 1973. And between 2H74 and 1Q75, three quarters of recession ensued. Inflation reached double digits in 1974 and hit a record high of 12.3%. Such a combination of recession and high inflation proved to be the worst combo ever.

Another oil crisis took place at the end of the 1970s after oil has been permanently pushed higher earlier. The Iran Revolution and the US Hostage Crisis together with the Iran-Iraq War triggered another run in oil prices. Though OPEC was not involved this time and they even increased production to cut the supply gap to just 4%, panic was set off in global markets, driving oil prices from $15 to $35, an increase of 130%. The US was in and out of recessions between 1980 and 1982, with inflation reaching a high in 1980 at 14.8%.

The Gulf War arguably set off the third oil crisis in 1990. But it lasted only six months and the impacts were much milder than before. The crisis triggered by oil embargo proved to be the most damaging to the US as well as the global economies. Besides stagflation, oil crises also brought structural changes. The US Federal Reserve began its war against inflation by taking the lessons of stagflation to heart. Global oil production, exploration and energy conservative efforts were also intensified. The takeoff of automobile and electronics industries in Japan can also be traced back to then. But the question remains what makes the differences to respectable growth and benign inflation this time when oil prices also surging?

The Difference in the Trajectory

There could be many answers because since the 1970s and 1980s, the global economy and financial markets have undergone substantial transformations. Yet it is difficult to pin down a single answer.

Oil prices at $68 a barrel are record high by historical standards, much higher than those in previous crises. But this is only the nominal price. After adjusted for inflation, today's prices have not yet broken the record, which could serve as an explanation for the stable growth and benign inflation in the face of surging oil prices. In 1973-74, oil prices jumped from $3 to $12. Adjusted by the inflation differences of 4.38 times and 3.95 times, it equal to an increase from $13 to $47 in today's dollar, far from the new high. As for the increase from $15 to $35 during 1979-80, it is equal to rising from $40 to $83 in today's dollar if it is adjusted by the 2.68 times and 2.36 times inflation differences. Therefore. today's prices are still 18% below the inflation-adjusted record then. Such a comparison demonstrates that the new highs of oil prices in nominal or real terms are irrelevant to whether recessions will ensue.

But such calculations are flawed because they only compare the highs and lows of oil prices. Generally speaking, for oil prices to curb economic growth, there is a time lag and they have to sustain for a prolonged period. In this regard, it makes more sense to compare the average prices over those periods to assess the real impacts on growth. From 1973-74, oil prices surged from $3.05 to $10.73 on an annual average basis, a rise of 250% in twelve months. And from 1979-80, the increase was from $17.25 to $28.64, a rise of 66%. In 2004, oil averaged $41.47, and in the first seven months of 2005, it rose to $53.12. The increase therefore was 28.1% from a year ago, much muted than before. Also important is the trajectory of the increase. In previous crises, oil doubled or trebled in six to twelve months while today's increase is gradually unfolding, taking three and a half years to register a 200% increase. Obviously, the cumulative increases as well as the trajectory of increase are not as steep as the previous oil crises. This partially explain why the economy remains resilient today even though the nominal oil prices have risen to record levels.

The Difference in Economic Resilience

Besides the relatively moderate trajectory has enabled corporations and consumers to digest and prepare for the oil prices run-ups, the added economic resilience could also explain the still rosy growth forecasts.

First of all, the recent run-ups in oil prices were driven mainly by demand factors instead of supply disruptions as before. According to the IEA, the current demand and supply of oil is relatively balanced. It is due to the limited capacity to increase production that any incidents may set off shocks to the vulnerable balance. However, there has been fear instead of real shortage so far, which is vastly different from the past oil crises when oil supply was artificially suspended and economic activities were forced to stall. The global economy is still running at normal pace albeit having to pay premiums for oil. Besides, corporate earnings are still robust. Against the original projection of only 6.6% increase in the S&P 500 companies' Q2 earnings, the actual earnings were up 14%, suggesting that higher energy costs were more than offset by increases in sales. Therefore, production and consumption remain largely unaffected. Higher oil prices are prevented from spilling over to the consumption sector, which forestalls significant monetary tightening and supports economic growth.

The transformation of the US as well as the global economies could be the explanation. It is well known that since past oil crises, the US, Europe and Japan have transformed into matured and services oriented economies. Combined with the technological improvement and popularization in energy saving, the US economy is believed to be half as depend on oil as before. If so, even if oil prices surge to $80 or above, matching the inflation-adjusted record in the 1980s, the economic impacts should be relatively muted than before and real crisis might brew only when oil prices double from that level. Nonetheless, the developing countries which are manufacturing oriented could be hard hit and be the first to fall under high oil prices environment.

In July, vehicle sales in the US were up 16% over last year, which was unthinkable given how high oil had risen. Even the sales of gasoline guzzling SUVs were up 25%. The reasons are that the automakers introduced employee incentives again to combat the market share slump and the US consumers are not daunted by higher oil prices. It is true that the gasoline price per gallon has increased by 40% in the twelve months before August. But it is also true that real estate prices have also run up by double digits, the stock and bond markets up by single digits, and salaries also up moderately in the same period. The income growth more than offsets the high oil prices practically and psychologically. Before such balance is destroyed, private consumption in the US is not likely to slow down markedly.

Where Will the Test Come From?

Even so, dismissing the higher oil prices too easily or being overly optimistic about the growth prospects is unwise. Although oil crisis will not be repeated in the same way as before, it can still shock our economy in many ways.

Higher oil prices are undoubtedly negative because they act like a tax on corporations and consumers. The major beneficiaries, such as oil exporting countries and oil companies, are unlikely to help other economic sectors withstand the crisis with their higher incomes. A widely accepted rule of thumb for assessing oil impacts is that: a ten-dollar rise in oil prices, if sustained for an extended period of time, will weaken the US and the global economies by 0.4-0.6 percentage points. According to Greenspan's own assessment in June, he claimed that oil prices increase since 2003 could well shave 0.5 percentage points from last year's US economic growth, and the impacts this year would likely amount to 0.75 percentage points. Using annual average prices, oil did increase by $13.4 in 2004 and another $11.7 in the first seven months this year, corroborating Greenspan's calculations using the rule of thumb. It is because the potential growth of the US economy is higher than originally expected that higher oil prices have not reached the critical point to trigger recession. But their continuous surge will sooner or later threaten the economy and this explains why governments and central banks should not take things for granted.

Other ways oil can impact the economy are to push up inflation, force central banks to hike rates or trigger capital flights, thereby resulting in the same shocks to the economy. The latest US core CPI and core PCE were 2.1% and 1.8% respectively, underlining the still contained inflation. And that is why consensus still calls for the Fed Fund Rate to peak at around 4.5%. But this is probably due to competition as well as the still decent corporate earnings. Once profits are insufficient to offset higher energy costs, US corporations could pass the costs on to their consumers. Inflation will heat up and interest rates hill be raised. In this scenario, economic growth will eventually become the victim of higher oil prices.

Besides the unforeseeable factors, such as geopolitical events, terrorist attacks, and natural disasters, etc, which could disrupt oil supply, favorable factors, such as assets price appreciations and income growth, could also taper off and unable to offset higher oil prices. The negative impacts could surface rather rapidly.

Another issue worth examining but without a concrete answer is whether the end result will be the same if higher oil prices are primarily driven by speculations or real demands. As the derivatives markets become more popular and sophisticated, oil companies and end-users are inclined to use them to hedge higher oil prices. This could be part of the reason why there has not been much spillover from higher oil prices yet. But it is also believed that speculations from institutional investors and hedge funds are behind the recent oil run-ups. This drives both the prices and volatilities higher. Although it is impossible to account for the proportion of such activities in the oil run-ups, there is little doubt that they magnify the response in prices to tighter demands. But the impacts are simply too difficult to pin down and analyze.

In view of these, complacency is not warranted because the balance of oil demand and supply is vulnerable. Once broken, the results could be disastrous because recessions are most likely to be accompanied by higher inflation as demonstrated in the 1970s and 1980s. Governments and central banks' hands will be tied because they have to sacrifice one of the goals between growth and inflation. If history tells us anything, it is likely the growth will be sacrificed, using recession to bring down inflation and oil prices. As oil is surging higher today, such a threat cannot be ruled out completely at any time.