Rapidly Accelerating Oil Price Gains

May 20, 2008

The first forecast I ever heard that oil prices would climb above $100 was made by T. Boone Pickens when prices were only about half that high. Today’s new prediction by him that we’ll see oil at $150/barrel later this year doesn’t sound so non-sensible after seeing that earlier projection come true. Rising costs for energy and other raw materials have been superimposed upon a world economy already trying to cope with a huge reassessment of risk in global credit markets and have in fact supplanted the subprime mortgage crisis as the source of greatest downside risk to growth in the future. The price of oil on August 9, 2007 when the credit crunch began looked high at $71.59/barrel but in fact was 6.2% lower than a year earlier. In the first half of 2007, oil prices had averaged 8.3% less than in the first half of 2006. By 4Q07, oil prices had risen to 50.7% above the mean level in 4Q06. On-year oil price growth continued to climb in 2008 to 67.5% in the first quarter and 76.6% in April. So far this month, they are 95.2% greater than the average price in May 1-20, 2007. A new record of $129.46 was touched today in the wake Pickens’ forecast. These levels easily represent historical peaks in inflation-adjusted terms as well.

Reduced energy dependence enabled the global economy to cope very well with rising oil prices from the mean of $26.08/bbl in 2002 to last year’s average of $72.44. It helped too in this period that oil prices were extremely volatile both upward and downward. For example, oil slumped from a then-record high of $78.40 in July 2006 back to $49.90 six months later. Such retracements lent an element of impermanence to the elevation that is not sensed in the latest relentless upleg of oil costs. The suddenness of the rise in oil since last August and the extremely high levels that now prevail will depress economic growth more visibly than their climb from $30 to $80 did.

Central banks cannot offset this new growth risk the way they counter-punched the credit crisis. U.S. interest rates are much lower now than back in August. Also, higher raw material costs pose the biggest threat in 25 years to hard-won low inflation expectations. Today, Germany reported a 0.9% jump in its April PPI, which also increased 7.6% saar over the first third of this year. A few hours later, the United States announced that its PPI that same month rose just 0.2%, but the year-to-date advance at a seasonally adjusted annual rate was even slightly above Germany’s pace. Moreover, core U.S. PPI inflation rose 0.4% m/m and to 3.0% y/y from 2.7% in March and 2.4% in February. Worst of all, U.S. producer price strains are significantly greater at the intermediate (+0.9% m/m and 10.5% y/y) and crude levels (+3.2% m/m and +34.3% y/y). The worst part of the bulge in U.S. inflation lies still ahead, and the story is the same in many other economies, too.


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