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Oil Fears Could Be More Devastating Than Oil Prices

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

As the price at the gas pump continues to creep higher, and turmoil in the Middle East continues to dominate news headlines, I'm checking in with Morningstar's Bob Johnson, director of economic analysis, for his take on the effect of oil prices on the economy.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: So, let's put this in perspective first and get a sense of how much of the economy is related to oil in the U.S.?

Johnson: Well, let's talk about it just in term of oil usage in the United States--that's consumer, business, things that may be stored. We have approximately 7 billion barrels usage a year, and at $100 a barrel, that's about $700 billion a year. Compared to a GDP of about $1.4 trillion, that's 5%. So it's a significant number, but it isn't like it's half or three quarters.

Stipp: So, another important thing is that we do get a good amount supply from overseas, but it's not like it's all coming from overseas. So when people hear about disruption, and they worry about oil skyrocketing, there are some other countervailing forces there as well?

Johnson: Absolutely. About half of oil is produced in this country, and we import the other half of it. I was surprised by that; I was just talking to our oil analysts this morning, and they were telling me that the import percentage was at 50%. I would've guessed it was probably slightly higher than that. So obviously, that's money that flows back to the U.S. In other words, if gas or oil prices go up, money goes away from the consumer to the oil companies who may reinvest it in new shale projects and other new things--invest it back in the economy. It's not like it's all going overseas--wasted and disappeared.

Stipp: So, I want to get a sense about the components of the oil price right now. So we had been seeing it go up a bit even before some of the turmoil had happened overseas. So to what extend do you think that $105 or so, where oil is trading right now, is due to this premium because of fear about contagion and more turmoil in the Middle East versus where oil might be had the Middle East conflicts not happened?

Johnson: One way to think about that is, the world economy was in relative equilibrium in terms of oil, and we're producing and using about 85 million barrels per day of oil across the world, and supply and demand were pretty much in line. So now, when there is any type of a disruption that number tends to jump rather violently.

So we had been as low as $42 a barrel in terms of oil; we've been as high as $147 for a barrel of oil, and now we're right around $105. So we're clearly high. Where would it have been without the disruptions? My guess is around $90, because we'd seen it come up at the end of last year as economic growth kicked in. The more economic growth you have, the more oil you tend to use. So I would expect it would have been higher than say midyear last year, because the growth expectations have really come up rather dramatically. So $85-$90 a barrel oil make sense to me. Anything beyond that I believe has to do with threats in the Middle East.

Stipp: So there is a component of actual supply disruption that's occurred in Libya, but then there is also a component of that extra premium, that fear that turmoil might spread. Can you give a little sense on where those things might be falling in the price of oil?

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Johnson: Egypt caused some price situations already, and Egypt doesn't produce any oil. There was some worry about the Suez Canal, but that caused one jump up in the price. Then Libya came along, and that caused an even bigger move in the price of oil.

But believe it or not, Jason, Libya is only 2% of the world's supply. So it's not like its massive, but what people are worried about is if it moves on from Libya to say Saudi Arabia ... and I say this number again and again, we use about 85 million barrels a day. 10 million of that comes from Saudi Arabia. So that's a big deal. If that were to disappear overnight, that would cause a huge acceleration in the price of oil.

Stipp: So certainly part of that jump that we're seeing right now is due to the fears of what might happen next in the Middle East.

OK. So, let's talk a little bit about the consumer and how prices are affecting the consumer right now. So we have seen that jump from maybe around $89-$90 level to over a $100 now. What have you seen, if anything, on how this has affected the consumer so far?

Johnson: So far--and I want to be very cautious to say--so far so good. Consumers have really rolled with the punches on the oil price so far.

Right now I look at weekly retail sales, monthly retail sales. February was a very good month for retail sales--much better than anticipated. So they certainly haven't backed off, especially at the high end--the Nordstroms and Saks, luxury goods manufactures are all doing particularly well. The discounters--the Wall-Marts, the Targets--not so much. So maybe it has some impact more on the low end than the high end.

Cars is another area where we thought maybe sales would fall apart the last week of February, because that's when the Libyan situation really heated up, and cars are really big and important purchases, but we had one of our best Februaries in a long, long time. It beat expectations right through the last week of February. So, so far the consumer hasn't gotten scared, but I think the articles about gas prices have really started to show up, and that may spook them.

Stipp: So, if we are rolling with the punches right now, when do you start to get worried that the price of oil is really going to start to have an impact on the consumer. At what point does the oil price level really concern you?

Johnson: Well, the magic number is $120 per barrel in my mind, and let me tell you how I get there. Right now, we've come up to $100 a barrel, and each $20 increase in per-barrel price affects the economy by about a $140 billion. So, we've come from the average oil price last year of $80 per barrel to about a $100 right now. That's $20, and so that's $140 billion taken out of the economy.

Well, we had a little help. The payroll tax cut also equals about that same amount. So, we've kind of offset the effect of oil so far. Now, I think if we move from $100 to $120, now we are way beyond the tax cut. And now I think we start to run in the trouble when we get to that $120 level.

Stipp: We have seen, when oil was really high back in 2008, consumers actually did start to pull back their demand, which I think helps to keep oil from just going out of control on the upside. What factors do you think might keep oil prices under control and maybe commodity prices under control in general this time around? Will we be able to consume less? Are we better equipped to consume less if we need to?

Johnson: Well, I think we continue to kind of cut back. When I was talking to our oil analysts today, I said something like, last time I talked about oil, it was about 20 million barrels of usage in the United States per day, and I said I'll boost that up a little bit when I talk about it today. But actually the number has come in a little bit.

So, the oil consumption by the U.S. economy really is pretty stagnant, which is good news, and I think as we use more electric cars and more hybrids, be more energy conscious, over time there is certainly room for that to come down, but that unfortunately doesn't happen in the short run. People do park their cars once a while and take public transportation; it helps a little bit. So, that will keep a little bit of a lid on the price of oil. And if the world economies, especially China, starts slowing, then you'll really see an issue in oil, and when we slowed in 2008, even China slowed way down. Everybody thinks China will keep us up. Well, it sure came down in 2008, the demand from China.

Now in terms of other commodities, that's a very interesting question. I think if oil trickles up $1 a month, or a little bit more than that, like it had been until we got into the real crisis situation, it tended to inflate what I call the whole commodity complex. It was the idea that India and China will have this insatiable demand, and the U.S. was beginning to pick up again, and these would collide and everybody bought any commodity that moved. And QE2 certainly didn't hurt that either.

Now with the price of oil suddenly up and everybody is fearful now we're going to have a slowing economy and now people are going to shift from buying one product to another product. You're going to have to buy more gas and less clothes. Now maybe there is room for cotton to come down. Maybe now that China is talking less growth and less loans, maybe the copper comes down and so that type of thing is happening. The price of oil, when it goes violently up, may actually prove to be deflationary longer term.

Stipp: Especially for other commodities?

Johnson: For other commodities.

Stipp: We've also seen that natural gas, which sometimes is going to be moving in the same direction as oil, there are some other forces that are causing those to kind of move in different directions as well, or at least natural gas is not moving up as much as we've seen oil move up.

Johnson: Yes, I think one of the problems with the energy complex is commodities moving up [together] over time; oil goes up, and because you can use natural gas instead of oil, or you can use coal instead of oil, things tended to be tied to each other a little bit. And so when we saw a big jump in oil prices, all the other stuff moved up. And this time we're seeing something a little different. Natural gas is actually still relatively flat, and that's because we've had large discoveries here in the United States, new drilling techniques and so forth. So this time, it's just the gasoline part of it. The home heating part of it is really not nearly as drastically affected as it's been in other big oil price runups, so that's one bit of good news in this whole thing.

Stipp: Last question for you, Bob. From what you're saying to me, it seems that at least if we're around this level, around $100 to $105, it seems to me that what you're saying is that the fear potentially of higher gas prices in the future, which might cause consumers to pull back preemptively, is probably a bigger threat than the actual oil price that we're seeing at around $100.

Johnson: Right, I think it's pretty neutral, and again, if things blow up in Saudi Arabia, for example, and we get a big price rise, then all bets are off. Then prices of oil will go up, and it will affect the consumer.

But right now, the consumer and the price of oil--it's not devastating, but it's the fear that more is to come. And I think the papers were relatively quiet on the oil issue for a long time, and I can tell you this week, all the headlines--"all pumped up" I saw that headline this morning on the way in to work. The stories about that are starting to get out there. I worry that could panic people a little bit. That fear is more devastating than the actual reality.

Stipp: All right. Well, Bob, thanks for your insights and the context on oil, and for joining me today.

Johnson: Great to be here.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.