Oil on the Rise: Cause and Effect

High oil prices (left picture) have always been a source of social and economic anguish and with an average savings rate of below one percent, American citizens are not budgeting for expensive energy costs. Today, oil soared to $108, leaving many wondering how the future will unfold. Preliminary evaluations suggest consumption patterns will dramatically change and a larger percentage of household incomes will be devoted to food, housing, utilities, and other basic necessities. For example, gas is expected to reach an average of $3.40 in the coming months, up from the current average of $3.22. Consequently, the shift in consumption will result in depressing an already sagging U.S. economy. President Bush recently requested an increase in crude output to help prevent additional hikes in oil prices; however, OPEC stringently refused to raise production until the "market justifies it," implying their belief that, because of the global economic slow down, consumption rates have fallen below expectations. Unfortunately for Bush, prices have soared, not due to fundamentals, but because of speculative and uncertain times.

The threat of high inflation has prompted analysts to search for alternative investments to companies on U.S. indices and instigated a fervent plunge into commodities, ironic since investors play a significant role in increased oil prices. Non-Profit Radio spokesman, Adam Davidson, claims that world demand and expected shortages account for prices "up to $80 a barrel." Recent surges, however, can be attributed to pension and sovereign wealth funds, to name a few, dispersing over "$250 billion into oil futures in the last few years, the equivalent to several months of world consumption. Additionally, inflation has reduced American purchasing power and made it difficult to compete in an oil market where OPEC prices its barrels in dollars. Therefore, countries such as France and Britain are capable of placing relatively higher bids in the commodities market because of their stronger currency. Given recent trends, oil prices will most likely continue to rise and pessimists predict a peak as high as $200 a barrel within twelve months.

Kenneth Rogoff, an economist at Harvard University, says "the effect of high oil prices today could be the difference between having a recession and not having a recession." After the speculative burst in the housing market, Americans are attempting to reduce consumption of luxury items. Increase in crude oil costs will prevent this excess cash from being conserved and a larger proportion of income will have to be allocated towards subsistent goods. The consumer price index rose 0.4% in January largely due to the 0.7% increase in both food and energy, giving a rough estimate of inflation. The lethality of this situation is the inability to save. Under normal circumstances, a woeful economy triggers frugal behavior and consumers as well as businesses hoard liquidity to invest in recession proof assets. Theoretically, this should lead to growth and allow the economy to pull up from its downturn. However, investing in oil futures creates a complex problem. Sparked by a weakening economy, speculative oil bids raise prices and further depress growth, threatening stagflation. In turn, the financial gurus of Wall Street are even more eager to invest in "inflation protected" commodities and dump more American equity into oil funds. As a result, oil becomes more expensive and once again there is more inflation. This cyclical process prevents people from making the required transition to saving and investing as it forces money that could be used for such activities to be spent on basic goods.

Fortunately, in the past, dramatic increases in energy prices have been followed by shifts in consumer demands. Hybrid vehicles are a perfect example of a change in habits due to a rise in crude oil prices (right picture). Sparked several years ago, sales of hybrids are still increasing and were up 27% in January. Similar changes in energy conservation and demand for alternative fuels can be expected if the price of oil continues to go up. Given the rate of current technological advancement, and using the hybrid as evidence, rapidly implementing alternative energy sources such as solar power in a majority of American homes appears feasible. If this were to happen, the value of oil would quickly come under scrutiny. Furthermore, even with a lack of options, consumers will only be willing to pay a limited amount for goods. Given a theoretical cap, this prevents speculators from creating a severe, long term discrepancy from fundamental prices.

However, the oil bubble is very different from the 2001 dot-com bust or the recent housing burst and much more difficult to predict. Steven Forbes believes "soaring oil prices will lead to a crash that could make the hi-tech bust of 2000 'look like a picnic.'" Typically, this occurs when investors realize a commodity is overvalued and begin a sell off which sparks a chain reaction. One can not apply the same rule to oil. Unlike land or virtual sites, oil inherently retains productive worth because of its use as a power source. An energy commodity is generally much more practical compared to real estate or advertisements hubs, granted that one has the capability of conversion. Given current, global economic problems and the amount of energy required for countries to sustain growth and function, hording oil could potentially turn out to be a shrewd strategy. As a country weakens, oil also becomes fundamentally more valuable. The reduction of economic power makes it more difficult to compete for scarce resources and therefore necessitates stockpiling reserves, offsetting the artificial value of oil. Assuming prices were ridiculously out of sync, the bubble would burst, but the drop in price would presumably stop above market (consumption) forces.

The unique nature of speculative oil bids presents an interesting and unprecedented problem for contemporary economists and investors. Within a year, market developments should reveal predictable indicators as to the consequences of large oil funds. Contrary to Forbe's beliefs, I foresee a steady rise in prices. Technological innovations will counter exponential hikes, but there is no escape until energy demands are successfully distributed amongst numerous power sources. Nuclear energy, solar power, wind farms, and other alternatives will provide a dynamic solution to a monochromatic problem. I suggest diversifying one's energy portfolio.