Tuesday, February 21, 2012

Should we be concerned about oil prices?

Economic reports from late 2011 and early 2012 indicate a recovery that is solidifying.  While many were concerned about a possible double dip late last summer, increasing optimism seems to be taking hold as more jobs are created and the unemployment rate declines.  As discussed elsewhere, some of these reports are probably a little misleading.  Nevertheless, the economy is on more solid footing than it was six months ago.  What could go wrong?  One concern mentioned in the post regarding the outlook for the new year was rising oil prices.  Less than two months later and more people are becoming concerned that we can see a repear of last year or worse.  Recall that the economy appeared to be strengthening as 2010 ended and 2011 began, but than a series of shocks hit the economy including a spike in oil prices.  As a result, economic growth was anemic in the first half of 2011.  Could it happen again?  Unfortunately yes.  The average price of gas is at a record high for the month of February and some forecasts suggest it could hit $5 by summer.  Barring a blow up in the Middle East, this seems unlikely (note that the record high average price is $4.13 reached in the summer of 2008 while it rose to $3.97 in May 2011).

Why are oil and gas prices rising?  There are many reasons that are beyond control in the short term.  One reason not discussed much is the "risk-on" trade.  Investors were quite nervous in Fall 2011, depressing prices of many assets including stocks and oil.  As investors became more confident and were willing to take on more risk, asset prices rose, including both stocks and oil.  Since reaching a low in October, the S&P has risen by almost 24%.  Over the same time, gas wholesale gas prices have risen by about 25% while Brent North Sea crude prices have risen by about 20%  thus, part of the reason for the recent run-up in oil prices is renewed willingness by investors to take on risk.  Of course there have been reasons for the willingness of investors to take on more risk including perceptions of a stronger US economy and less fear of a European meltdown, both of which led to rising stock and oil prices.  In addition, speculation has played a significant role in the behavior of oil prices in the last decade, driving it up to $157 per barrel in 2008 and back down later that year as the global economy collapsed.  Events in the Middle East, including the after effects of the Arab Spring and concerns about rising tensions over Iran's nuclear program are beginning to have an impact.

Though not much can be done about it in the short term, I suspect oil price may become a critical issue as the presidential campaign heats up this summer.  The Obama administrations "delay" of the Keystone oil pipeline  will be at the center of the debate.  For details about the merits of the pipeline, I'll defer to a respected economist that specializes in energy, Jim Hamilton, who tends to be objective without an ideological agenda.  Here are some of his recent posts in favor of the pipeline: