Economics: Oil and the Economy
New York: June 06, 2004
By John R. Stephenson

With crude oil prices stubbornly close to $40 a barrel and no end in site to the worrying and prognosticating, it is high time we examined oil and its impact on the economy. Although we still live in a hydrocarbon age, we have done much to lessen our dependence on oil over the recent decades. In fact, analysts have determined that a $10 increase in the price of oil lessens overall consumption by approximately .8%. When consumers are faced with higher oil (hence gasoline prices) they tend to slow down their spending, particularly on durable goods. The effects of higher oil prices are most pronounced for those at the low end of the economic spectrum.

But the hysteria around the price of crude oil is not driven so much because of its effects on the economy but rather the fact that supply could be disrupted which in itself could lead to an economic recession. This fear has been heightened recently by the recognition that our oil-based economies have become increasingly dependent on an increasingly strained world oil supply. The basic problem? The oil supply outside of the OPEC producing countries and the former Soviet Union appears to be fully tapped out and the production volumes from the OPEC countries are by historical standards high and the likelihood of significant increases seems unlikely. Add to this the recent concerns over Saudi Arabian supply and the recent terrorist activities and you have ample cause for concern.

Demand for oil has never been greater as countries such as China and India begin to industrialize. With the US economic recovery in high gear and the summer driving season upon us, the world's number one oil consuming country (the US consumes 4 times more oil than China and 10 times more oil than India) is demanding more and more oil. But the real change in the demand over the last few years is not the US economic recovery but the rapid Asian industrialization. If you examine oil consumption on a nominal GDP basis you will find that the US consumes .65 barrels per $1000 of nominal GDP, whereas China and India consume 1.40 and 1.23 barrels respectively! The conclusion? The developing world, because of its reliance on industry (the western world is a services-based economy), is much more reliant on natural resources. Some 40% of the overall demand growth in oil this year can be explained by China alone.

With tight world oil supplies and ever more aggressive tactics by terrorists to disrupt oil supplies and infrastructure, the stage has been set for a possible energy crisis which in itself would be far more catastrophic than the mere rise in price of the commodity. A severe disruption in oil, particularly if it was prolonged, could bring on an economic recession. It is fear over supply rather than the concern over demand that in the short run is driving price escalation in the oil futures markets.

As a long-term call we like the prospects for energy companies. Partly on the basis of improving fundamentals and also as a hedge should a serious supply disruption materialize.