Are Higher Oil prices good News or a sign.

Are Higher Oil Prices Good News or a Sign of Another Downturn?

There’s a school of thought that says the Great Recession may have been caused not by sudden losses in the subprime mortgage market but by an oil shock.

A 2009 report from the University of California, San Diego, theorizes that high oil prices in 2007 and 2008 reduced domestic spending and auto purchases so significantly that "in the absence of those declines, it is unlikely that we would have characterized the period (from the fourth quarter of 2007 to the third quarter of 2008) as one of economic recession" for the United States.

A report from the U.S. Energy Information Agency seems to support this idea: "Most of the major economic downturns in the United States, Europe, and the Asia Pacific region since the 1970s have been preceded by sudden increases in crude oil prices."

Of course, you’ll find no shortage of experts who would dispute the notion that high oil prices made the difference between an ordinary recession and the deepest downturn since the Great Depression. But it would be safe to say that oil prices are critical to the health of the economy and play a key role in the business cycle.

Now here we are again, with oil prices fluctuating around $100 a barrel. Gasoline prices rose 15% during the 12 months ending in January. Even Federal Reserve Chairman Ben Bernanke has said he is closely watching gas prices, which could hurt growth and ignite inflation if they get too high.

What are the causes of the recent price increases, and could they lead to another downturn? Unfortunately, the world oil market is subject to a range of disruptions, so it’s no longer easy to draw a line between a particular event and rising or falling prices. As you’ll see, there may be many reasons for the recent run-up in oil prices.

Increased Economic Activity

The International Energy Agency (IEA) believes that rising prices are due to the increased demand from higher-than-expected economic activity, primarily from Germany and other euro-zone economies.

Another oil and gas report found that strong global economic growth in late 2010 was responsible for the second-biggest demand spike in the past 30 years.

In January, the IEA, which represents major energy-consuming countries, called on OPEC to boost output to keep pace with rising demand, saying that if oil rises to $100 a barrel in 2011, global oil expenditures could rise to 5% of gross domestic product, a level that has a history of causing economic problems.

Supply Concerns

• In Alaska, a key pipeline that supplies 12% of total U.S. crude output was offline for several days because of a leak.

• In China, for the first time, demand surpassed 10 million barrels a day in November 2010. However, the demand spike was due to centrally imposed energy savings targets. The government temporarily shut coal-fired plants and shifted production to diesel-powered generators to meet its efficiency and emissions

targets. Although oil demand was not expected to remain at 10 million barrels a day, China remains one of the world’s top consumers and producers of oil.

• New drilling regulations enacted in the wake of the Deepwater Horizon oil spill in the Gulf of Mexico have slowed the pace of exploration. As a result, the number of new wells drilled on public lands in 2010 was the lowest in a decade.

Dollar Weakness

The value of the U.S. dollar can affect oil prices because the world oil market is priced in dollars. Other countries must exchange their own currencies for dollars in order to buy oil. If a country’s currency is strong against the dollar, oil becomes cheaper for the buyer, who is likely to buy more. This additional demand can in turn send oil prices higher. In the United States, when the dollar weakens, it can take more dollars to buy a barrel.

The Fed has been criticized for its recent attempts to stimulate the economy by expanding the money supply, which is seen as contributing to dollar weakness. Bernanke has responded by noting that the dollar has been fairly stable in recent months and the main reason for rising oil prices is more likely due to rising demand in emerging markets.

Although it would be encouraging if the economic recovery was causing rising oil prices, it’s worth noting that the IEA expects 2011 oil-demand growth to be lower than in 2010.

1–2)

3–4, 6, 8, 10–11)

5) Oil Price Information Service, 2011

7) Reuters, January 10, 2011

9)

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright © 2011 Emerald Connect, Inc.