The Gas in Our Tanks
Wall Street Journal
May 11, 2004

The U.S. once again finds itself grappling with high energy prices. Oil has jumped to nearly $40 a barrel, pushing gasoline to record levels. Natural gas has been selling for more than $6 per million BTU, pricey for this time of year.

Nine of the 10 U.S. recessions since World War II followed spikes in oil prices, so many Americans might worry that today's energy prices have risen enough to scuttle a recovery that has just begun creating a significant number of jobs. Paying more for oil and natural gas can sap growth, but this time around the recovery appears robust enough to withstand the higher energy bills. Rising prices without recession isn't unprecedented: The oil markets gave four false signals during the 1980s and '90s.

There's little mystery in the link of energy prices to recession. Consumer spending takes a hit as budgets stretch to pay more for filling up at the gasoline pumps and heating homes. Just as important, oil products and natural gas are key inputs for electricity, airlines, trucking, petrochemicals, fertilizer and a host of other industries. Those vulnerabilities haven't gone away, and that's why the recovery slows.

How much depends on what happens to energy prices. Take the outlook suggested by futures markets— oil prices 35% higher than previously forecast and natural gas prices about 30% above their historical relationship with oil. That puts oil at $30 to $32 a barrel and natural gas at $5 to $6 per million BTU.

Under this scenario, Dallas Fed research suggests GDP would suffer a one-time reduction of 0.9%— not all at once but spread out over several years. An economy racing forward at 3.5% to 4% annually can weather the loss of several-tenths of a percentage point. A decade or two ago, a similar run-up in oil and natural gas prices would have done more damage to the economy. Three factors explain why we've become less sensitive to energy-price shocks:

• First, shifts in the composition of output and investments in more efficient plants, equipment, homes and vehicles have cut the energy-to-GDP ratio by more than 50% since the early 1980s. In the airline industry, for example, the average fuel per passenger mile has fallen by about 25%.
   
• Second, today's price hikes aren't as severe as many of the past episodes. Adjusted for inflation, for example, today's crude prices would have to rise to $75 to $80 a barrel to get where they were in 1981, which would mean gasoline prices of $3.50 per gallon or higher.
   
• Third, the economy benefits from experience gained over the years in dealing with higher energy prices. Companies that survived past episodes are less likely to misjudge the impact of expensive oil and natural gas on their own businesses and on others with whom they trade.

An economy less susceptible to energy price volatility comes as a blessing because prospects aren't good for the kind of price busts that in the past brought relief from expensive oil and natural gas.

Oil prices are high because demand is growing, largely from the U.S. recovery and China's rapid industrialization. At the same time, OPEC has resisted increasing production because it has concerns about seasonal slumps in demand and greater supplies from non-OPEC nations and Iraq. The declining dollar, moreover, has contributed to upward pressure on oil prices because it has reduced OPEC's willingness to supply oil at lower dollar prices and boosted foreign dollar-denominated oil demand.

Like oil, natural gas has become more expensive—as its increased usage to produce electricity has boosted demand. On the supply side, a recent National Petroleum Council study reports that North America is becoming increasingly reliant on higher-cost sources of natural gas.

Oil and natural gas prices likely will retreat from their current heights, but market fundamentals point to prices that will continue to run high by the standards of the past few years. Fortunately, more expensive energy will only muffle the recovery, not snuff it out.

Recognizing that high energy prices are not a risk to this recovery doesn't mean Americans can be complacent about energy. Many of the factors behind the recent surge in prices—for example, China's rising demand for oil, and rising production costs for natural gas—will be with us for a long time. Substantial world-wide investments in oil production, liquefied natural gas facilities, pipelines and the electricity grid will be needed just to keep energy prices on their present path.

About the Author Mr. McTeer is president and CEO of the Federal Reserve Bank of Dallas. Reprinted with permission of The Wall Street Journal © 2004 Dow Jones & Company, Inc. All rights reserved.