Larry DeBoer
Professor of
Agricultural Economics
Purdue University

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The Outlook and Oil

I wasn't looking at the price when I pulled into a gas station off I-65 last week. My gas tank was almost empty, and I wanted to get home. The pump spit out the receipt, and I did a double-take. Twenty bucks to fill up my little car. Gas was $1.99 a gallon.

Like everyone else, I didn't like that at all. But I'm an economist, so when big economic trends affect me personally, I find them just a little entertaining. It's an occupational hazard.

Oil price hikes are a hazard for the economy. The recovery was rolling, with gross domestic product (GDP) growing 5 percent above inflation from March 2003 to March 2004. Then, growth slowed to 3 percent in the second quarter. Almost all of that slowdown was because consumers spent less on goods and services. And the reason for that was that energy costs were up, and consumers had less left over to spend on everything else.

Oil prices have been rising. Crude oil has topped $49 a barrel -- a record price - and, by the time you read this, it may be over $50. In the past, big oil price increases have resulted from OPEC's production cutbacks. But that's not the reason this time.

The members of the Organization of Petroleum Exporting Countries benefit from high oil prices, of course, but they don't want the price this high. They remember the 1970s and 1980s, when high oil prices caused the oil-importing nations to conserve. That reduced oil demand and helped cause a collapse of oil prices in 1986. OPEC wants the price high, but not too high.

So OPEC members are producing flat out, pumping just about as much as they can. But the demand for oil is outpacing production. The world's largest oil importer, the United States, is growing pretty fast. The world's second-largest oil importer, China, is growing really, really fast. Growth increases oil demand, as more cars hit the road and more oil-fired factories are built.

Growing demand and production at capacity probably means that oil prices will remain pretty high for the foreseeable future. Not necessarily as high as $50 a barrel, though.

That's because there's a large dose of politics and speculation in that oil price. Russia's government is battling the giant Yukos oil company over taxes. The legal turmoil could interrupt oil production, though it hasn't yet. In Venezuela, political disputes between the Chavez government and its opponents have reduced oil production. Ethnic violence in Nigeria has cut production there. And oil exports from Iraq have not returned to prewar levels.

Oil buyers look at all this political instability and worry that future supply will be reduced, even as demand continues to increase. So, they try to build their inventories by buying now, and that increases demand more and raises the price.

The oil price is high partly because markets are worried. But, what if Russia and Yukos settle, the results of the recent referendum are accepted by the Venezuelan opposition or Iraq's new government finds a way to restore exports? Oil buyers may decide that supply is not threatened with further reductions. That could bring oil prices down, fast.

High oil prices take the edge off growth in the United States. If oil prices come down, consumers will have more income left over to spend on other things. Consumer spending will increase, and so will GDP. Factories that use oil for energy or as a raw material will earn more profits, so they'll expand production and employ more workers. Inflation will be less of a threat, which means slower and maybe smaller interest rate increases from the Federal Reserve. 

Unfortunately, the opposite could happen, too, if the politics goes wrong. What if Yukos stops producing, Venezuelan strife increases and Iraq's oil facilities are sabotaged? That would drive prices even higher, and growth would stay slow.

We look to economists to forecast the economy. These days, maybe the political scientists could do a better job.




Writer: Larry DeBoer
Editor: Olivia Maddox