Oil Back at $100

I am between flights and have been traveling for a few days, but wanted to get off a quickie on current oil prices.

In hindsight, perhaps I was not aggressive enough with my predictions for 2011. My predictions covered two themes: Next generation biofuel producers whose business models would begin to collide with reality, and oil prices that would head back over $100 per barrel. Less than two months into 2011, there has been big news on both fronts. We have already spent a few weeks discussing the Range Fuels debacle, and now oil prices have once again breached $100. In fact, many markers such as Brent crude have been above $100 for several weeks, and they recently approached $120 per barrel. Here in the U.S. we tend to pay closer attention to West Texas Intermediate (WTI), and now it too has crossed back over the $100 threshold.

What does this all mean, and should you be worried? For one, it means higher fuel prices and strained budgets. The average person is going to spend more of their income on fuel, and/or they will have to slash their discretionary driving. Incidentally, ethanol prices aren’t immune; they tend to track gasoline prices and are also sharply higher.

It also reiterates that global economies remain at the mercy of unstable regions of the world, and implies that there is very little spare capacity out there (although Saudi is reportedly putting more oil into the market to compensate for potential supply disruptions from Libya). I think we all recognize that our level of oil imports keeps us in a precarious position, but we just don’t have the collective will to say “I am prepared to sacrifice in order to remove that threat.” After all, we could eliminate oil imports, but we would all have to get by with less oil. That’s the only way to address oil imports in the near term.

If oil remains at current prices, it is likely that the world will be right back into recession. The Wall Street Journal weighed in on this scenario:

Rising Oil Prices Threaten Recovery

The biggest risk to the economy from climbing energy prices stems from U.S. consumers, says James Hamilton, an economist at the University of California-San Diego. Collectively, they use about 140 billion gallons of gasoline a year, he notes, so the roughly 30-cents-a-gallon increase in pump prices over the past three months adds up. “That’s a significant drain on consumer budgets that could put a drag on the recovery,” he says.

To reiterate, this is a scenario I call The Long Recession. Oil prices are historically high even though the economy is weak, because there isn’t a lot of spare capacity in the system. A strengthening economy puts upward pressure on oil prices, which puts the brakes on recovery. Ultimately, it becomes very difficult for the economy to gain much momentum when there is very little spare oil production capacity in the system.

If prices remain at these levels, one of the first industries to get hit hard will be the airline industry. When oil prices surged in 2008, we saw a number of airlines declare bankruptcy; an extensive period of high oil prices will severely strain the airline industry. Industries that are dependent on trucking will suffer. Food inflation is likely to surge, and this will be worsened by high corn prices. In short, because so many sectors of the economy are dependent upon oil, high oil prices will put the squeeze on the economy and the longer this situation persists the more likely we will slide back into recession.

Now imagine that the situation in the Middle East gets worse. If the demonstrations spread to Saudi Arabia, we could see $200 oil overnight. That price level is probably not sustainable though, as that would certainly push us back into recession very quickly.

But even if the situation in Libya is resolved soon and tensions across the Middle East ease, isn’t it unsettling to know just how vulnerable we are? As an individual, you can take reasonable steps to limit your own fuel consumption and ease the strain on our personal budget. But as a country we need to take this issue much more seriously and recognize the threat as entirely unacceptable. Then we need to get serious about fixing the problem.