February 2, 2003

Price of oil, not cost of war, is the key to America’s way

By James W. Coons

It’s all about the price of oil. The real key to the economic outlook will be what happens in Iraq. But not because the U.S. military might fail. The scale and complexity of the operation do create the potential for terrible losses on both sides, but achievement of the immediate military objective is not in doubt.

More to the point, the $10 trillion U.S. economy is not vulnerable should the fighting go poorly. Even an extended and expensive war would not impede the economy’s advance for long. The Vietnam War was drawn out, costly and divisive. Yet the economy prospered during the 1960s. Probably not because of the war, as is commonly suggested, but apparently despite it.

Then why the hesitancy among businesses and consumers? Why the reluctance to invest in new plant and equipment? Why the decline in consumer confidence to a new cyclical low in January? It’s not the bear market in stocks; that’s old news. It’s not dismay over corporate governance; the crooks are headed to jail and effective reforms are in place. It’s all about the price of oil.

A huge jump in the price of oil played a key role in each of the five recessions of the last thirty years. At the simplest level, a higher price hurts the economy, because the United States uses more oil than it produces. Greater expenditures for petroleum-based products leave consumers less income to spend other ways. Businesses cut back on investment, because the higher cost of operating equipment reduces expected financial returns.

The price of oil began rising shortly before the 1973-75 recession. Within a year it was 205% above its low-point during the preceding two years. The price climbed 105% before of the 1980 recession and 178% one month into the 1981-82 recession. The price was 162% higher three months after the start of the 1990-91 recession, and the 2001 recession was preceded by a 205% increase. No other triple-digit increases occurred during the period.

Of the other five post-war recessions that occurred before 1973, all but the 1960 episode were preceded by what at the time was a substantial increase in the price of oil. A price spike of a given size disrupted economic activity more then than it would now, because we used energy less efficiently and energy markets were less flexible.

The war question is really an oil price question. If Hussein spoils the oil fields, if a backlash leads to an embargo, or if any other complications produce a significantly and sustainably higher price of oil, the short-lived economic expansion of 2002 will fade quickly into a new recession.

Although the prospects are good for a strengthening economy this year, we’re on the edge. Already, the price of West Texas Intermediate has increased more than 80% from its average in December 2001. The effect is similar to a new tax of $50 billion or more annually. An additional rise of as little as $5 per barrel would push the cumulative price rise to 107%, which is uncomfortably close to recession territory.

The consensus is that the price of oil will be back down to a manageable level by spring. The futures market anticipates a 10% reduction by year-end and a 12% reduction in 2004. That seems likely. The price of oil was already down 40% from its peak by the time fighting started in Gulf War I. It fell another 15% during the next year.

The problem with relying on a projected decrease in the price of oil, though, is that the consequences of it being wrong are so costly. Expansion plans that look like winners based on the assumption of a falling price of oil can cause financial ruin if the price rises instead.

Therein lies the primary obstacle to faster economic growth. It is the uncertainty of the event, coupled with the severity and certainty of the result, that is holding the economy back. Not until the confrontation with Iraq is resolved will economic growth increase to its potential.