It's no secret that gas prices are high. Here in Chicago, prices seem to be perilously close to $5 a gallon, and the cost of gas seems to be a constant topic of conversation even among those (like me) who don't even own a car.
The reason gas prices keep coming up in the national conversation is that the pain at the pump has profound economic consequences. I don't see gas prices falling anytime soon, and the consequences of these elevated prices is going to be a headwind to the recovery.
So why have prices risen so sharply? First off, global demand is increasing. Emerging economies have now almost completely shrugged off the great recession and are growing at very fast rates. As these economies expand, industry demands more fossil fuels (including oil) to keep the economy moving. And as consumer incomes rise, more people see buying a car as an important milestone. More cars on the road means more gasoline burned.
Certainly some of this increase in demand is offset by a slackening of demand for oil in slow-growing developed economies, but in aggregate, the demand for oil is rising. And this rise in demand might not slow down anytime soon. With strong sovereign balance sheets and burgeoning domestic demand, many emerging economies can still grow in the face of a flat economy in the developed world.
Unrest in the Middle East and North Africa is also playing a role in higher prices. So far, there have only been relatively small supply hiccups resulting from the conflicts in places like Egypt and Libya. But the concern remains that the unrest could spread and negatively affect production in one of the major producing countries such as Saudi Arabia or Iran. Although the regimes in those countries appear stable for now, so did the leaders of Tunisia and Egypt before they were suddenly forced out. This uncertainty in supply is contributing to the higher price of oil demand. And just as demand might not slack anytime soon, this uncertainty is not going to go away instantly. The NATO-led offensive in Libya is ongoing, and the turmoil in the Middle East is an entrenched reality.
And even beyond the turmoil, there isn't a rush of new oil or increased production to help ease the burden. OPEC is divided on whether to boost supply, and it isn't clear if member countries had the capacity to sharply reduce oil prices even if they wanted to do so. Add in summer seasonal factors pushing prices up, and it appears that high oil prices might be here for sometime.
So if expensive gasoline is here to stay for a while, what will some of the effects on the economy be?
Consumer Spending & Confidence
When consumers spend more money on gas they have less money to spend on everything else. Although miles driven will fall somewhat with persistently higher gas prices, the amount that Americans drive isn't going to suddenly drop off a cliff. People still need to get to work, go to the grocery store, and generally live their lives. It will just be more expensive to do that. Over a period of years, people can move closer to work and switch to alternative forms of transit but that is not an easy or fast process.
And given that most Americans don't have large amounts of excess income at the moment, they are going to cut back on other nonessential purchases. Consumer spending has been a major driver of the recovery, and a sustained drop-off in spending is going to have a ripple effect across the economy.
There is also the more intangible issue of higher gas prices affecting consumer confidence. Seeing the very high prices advertised on giant signs all across town and seeing the eye-popping total for filling up a gas tank is going to naturally make consumers even more nervous about inflation and the state of the economy. This means that some people will cut back on spending by an amount even larger than just the incremental amount they are spending because of higher gas prices. This effect will serve to magnify the impact of any consumer retrenchment.
The auto industry (and particularly the domestic carmakers) have seen a remarkable turnaround since the depth of the recession. And though auto-sales levels are not back at prerecession levels, General Motors' and Chrysler's bankruptcy proceedings along with Ford’s restructuring have brought cost levels down far enough that the firms are now profitable.
However, high gas prices could very well threaten this upward trajectory. Although the firms' are trying to ramp up production of fuel-efficient small cars, in many ways their bread and butter remains trucks and SUVs.
Filling up those huge tanks at more than $4 a gallon is not an appealing prospect, and if prices stay high for a long time, it will take a big chunk out of sales. Given the fact that these companies are just really getting on their feet again and finding their bearings, the timing could hardly be worse. Even though they are better-equipped today to deal with a large drop in sales, it is still going to be very painful.
Travel companies are some of the first to feel the pain of high gas prices. For firms with direct fuel costs such as airlines, the impact is immediate. Airlines have had a very good run lately. The industry has been very disciplined in not adding new capacity even has demand has begun to pick up; this has allowed ticket prices and profit margins to rise. High fuel prices threaten to derail the airline recovery as the thin profits get gobbled up jet-fuel costs. Airlines can add fuel surcharges and try to raise prices, but demand is still tenuous enough that huge costs increases will be hard to push on the market.
Hotels will also feel the pain. Lots of families that might have taken a road trip this summer could very well stay home. As a result, they won't partake nonessential driving, and that would make for an easy way to save some cash. High airfare will also keep vacationers away from farther-out destinations. Hotels that serve primarily leisure travelers will see themselves squeezed as long as gas prices remain at today's elevated levels.
As oil rises so does the cost of moving goods. In turn, this potentially increases the price of almost everything that we buy, as many goods have to be transported across the world before they end up on the store shelf. Firms will be forced to either swallow the higher cost or attempt to raise prices. Given the general weakness in the economy, hiking prices is an unattractive prospect, but with a fair amount of cost inflation for many inputs, it isn't easy to absorb the cost either. Any way you slice it, higher transport costs are going to hurt almost every industry that has to ship goods.
Oil prices have declined from their recent highs, but with a barrel of oil still hovering around $100, consumers and corporations alike are still feeling the sting. On its own oil isn't going to sink the recovery, but it is creating one more headwind to an economy that needs all the help it can get.
What do you think? Will oil stay high for the foreseeable future? Have you changed your purchasing or driving habits recently?
By Bearemy Glaser
Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of markets editor Jeremy Glaser.This guest blog was first published on Morningstar.
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