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Jeremy Siegel, Ph.D. The Future for Investors

Oil’s Not Well in the U.S.

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Very Good (613 Ratings): 3.623158/5

Posted on Friday, May 30, 2008, 12:00AM

What seemed virtually impossible just six months ago has turned into a harsh reality. Oil has crossed $130 a barrel and could be headed much higher. We know that oil price increases benefit oil producers and hurt oil users. But how does this all balance out and what is the overall impact of this spectacular rise in the price of crude oil on the US economy?

Since the US is a net importer of oil, higher oil prices hurt our economy. The United States produces about 8 million barrels of oil a day, but we consume over 20 million barrels. That means that we are net importers of 12 million barrels of oil a day, which, at $130 a barrel, comes to about $1.5 billion. This is the amount that we fork over to foreign oil producers every day. At current prices our yearly oil purchases will total $570 billion this year and account for the lion's share of our trade deficit.

Because US GDP, the total value of what we produce in a year, is about $14 trillion, the cost of importing oil at current prices is just over 4% of our total output. Since a year ago oil was about $70 a barrel, the extra amount we pay for oil will eat up an extra 2% of our GDP.

To put this in perspective, the long term rate of productivity growth in the US is just over 2% a year, so rising oil prices will negate a whole year's improvement in our standard of living.

Worse Than the Housing Slump

This loss in real output is significant and exceeds the drop in the housing construction since the real estate boom ended. At the end of 2005 the US was spending over $600 billion on residential construction. That has now shrunk to less than $400 billion and has been a major contributor to the slow growth of GDP.

But there's a critical difference between housing and oil that makes the impact of higher oil prices much worse. The housing bust is due to a slowdown in the demand for housing, not in the supply of a critical commodity, such as oil.

This means that many of the resources that had previously gone into the housing industry, such as labor and materials, can now be released to other sectors of the economy. In contrast, rising oil prices are an outright cost that does not release other resources into the economy.

Adjustments to Estimate

The above calculations are a "first round" estimate of the cost of rising oil prices to the US economy and assume that we consume the same quantity of oil at $130 a barrel as we did at $70. This is unlikely, as higher prices will encourage many to cut back on oil. Economists call the response of the quantity purchased to a change in price, the elasticity of demand. The higher the elasticity, the lower the impact of rising oil prices on the economy.

Unfortunately, the elasticity of demand for oil is small, especially in the short run. First, there are not good substitutes for oil, and many of the substitutes that do exist have also shot up in price. Even those who are lucky enough to be able to use natural gas instead of heating oil to warm or cool houses have seen prices rise more than 40% over last year. The rising cost of all forms of energy reduces the ability of consumers to avoid higher energy costs.

Furthermore, there are also factors that increase the impact of oil costs beyond the $1.5 billion that we pay to oil producers every day. Even if the US were lucky enough to produce enough oil so we didn't have to import oil, there will be short-term negative effects from rising oil prices.

Although the extra costs to consumers of rising oil prices will be offset by the higher returns earned by oil producers, there is still a painful adjustment that the economy must make to the change in relative prices.

Certain industries, such as the auto, trucking, airline, and transportation would bear the brunt of higher energy prices. Not only would these firms realize lower profits, but there would be a significant loss of jobs.

It's true that other industries, such as those involved in extracting, exploring, and conserving oil would see higher profits and likely seek out more workers. But it would take considerable time before all the workers laid off in, say, the auto industry to be absorbed by energy producers.

In the meantime, total output would slump and unemployment would rise. This adjustment means that the total cost of a sharp increase in oil prices is higher than the amount we pay to foreign producers. In short, the oil price shock could keep the economy growing at a snail's pace through the rest of the year.

What Can be Done?

For many of us, the use of oil is a necessity over which we have little choice. Nevertheless, we can minimize the impact of rising oil prices by taking shorter trips, using public transportation and carpooling, among others actions. In fact, Americans have already changed their behavior. The US Department of Transportation just reported that in the 12 months ending in March the number of miles driven has fallen for the first time in 25 years.

If oil prices continue to rise, I recommend that the government release some oil from its strategic reserve and perhaps raise the margin requirements on oil future markets to reduce speculation. I certainly do not blame speculators for the surge of oil prices, as I believe there are many fundamental forces at work raising energy prices. Nevertheless, such moves could break the inflationary psychology and warn speculators that the price of oil can go down as well as up.

Summary

The rise in oil prices has shocked Americans into realizing that fossil fuels are not unlimited. In the long run I am optimistic that conservation and alternative fuels will significantly blunt the impact of rising oil prices and not constrain economic growth. But getting to that long run will require painful adjustments in the short run and, to that end, higher energy prices may be a blessing in disguise.

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178 Comments

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Yahoo! Finance User - Monday, July 7, 2008, 2:15PM ET Report Abuse
- Overall: 1/5
This is in response to the gentleman who posted two messages ago: You're an idiot. Here's why: First of all, I could easily invest in securities in the market that have the potential for 20-30% returns like your supposed gas station, but in order to have that possibility, I must accept more risk in the market; just like opening a gas station is risky. It's not as simple as "oh, I'll open a gas station and beat the stock market" and it's not as simple as "the stock market has historically averaged a 10% yearly return so that's the best I can do." Furthermore, your argument for "why the rich stay rich" is absurb. While it IS easier to earn higher returns when you have a larger capital base to work with, YOUR argument is that .5% of a larger number is greater than .5% of a smaller number, thus the rich stay richer. And as if only the rich know the secrets of percentages, you go on to show us an example of a gentleman who can earn enough to grow his portfolio at the inflation rate while taking out a certain % to spend for himself. This example is perfect for showing how ANYONE (poor, middle class, rich) can grow their portfolio so long as they only spend a certain %age of their portfolio each year. Again, ANYONE can do that, not just the super rich. It all depends on how much you spend; and I'd bet most individuals with a 100 million dollar portfolio aren't spending only $500,000 each year--again, it comes back to percentages. While $500,000 would be an enormous amount of money to someone who has a $50,000 portfolio, it isn't as significant for someone who has a $100 million portfolio. Finally, why should I start "trading" not "investing" when in the long run I will "always perform with the market or below the market" ?
Yahoo! Finance User - Monday, July 7, 2008, 12:07PM ET Report Abuse
- Overall: 3/5
stopy crying about the rich and how you will always be poor. If you're that worried about it get off of your computer and get to work
Yahoo! Finance User - Thursday, July 3, 2008, 3:27PM ET Report Abuse
- Overall: 1/5
Look you People. You guys need to understand the simple little lives of the Rich folks. The poor will always be poor and the rich will continuing amassing wealth. No matter what happens in the economy, the market will not drop below a point where total expected return (dividends plus expected rise in earnings) will fall below the inflation rate (assuming long term horizon here). Moreover, the middle class and poor folks need not bother trying to amass wealth in the stock market by investing. In the long run you will always perform with the market or below the market. Why is it that a gas station owner can pull ROI's of 20-30%, and make a living, while investing in the stock market gives you a paltry 8-10%? Wow you would need to invest $1 million just to make a decent living. Here's why the market will always keep providing for the filthy rich and not give anything to the average person. BECAUSE THE RICH ONLY REQUIRE SO SMALL OF A RETURN TO LIVE OFF OF AND STAY RICH!!! Here's an example to open up your eyes. The filthy rich have millions. Suppose a rich person has $100 million in liquid assets (mutual funds). Now over the long run this guy can average anywhere from 8-10% returns in an index fund. Well, hold on, letâs make it a little more conservative. How about a safe, diversified portfolio consisting of stocks and bonds, and cd's. So this guy now averages about 6% return a year. After paying taxes (assume average rate of 25%; taking into account interest taxed at 35% and qualified dividends and cap. gain taxed at 15%) this guy's after tax return is 4.5%. Now take out 4% to add back to principal so that way the principal can grow at the average inflation rate. Wow, now we have a minimal .5% return leftover. What can the rich do with this ant-size return. THEY CAN SPEND IT ALL!!!!!! Yes, that means the rich can just blow off $500,000 every year. Why is this okay??? Well because the guy's got his original $100 million growing at the rate of inflation, he's got a conservative stable portfolio; this means he'll be enjoying a 6% return on $100 million forever. Ha, ha, ha, sorry middle class and poor class, it'll take a more than a lifetime just to get to a $100 million in todayâs dollars. So, donât worry about building wealth, just live your lives, and let your upcoming generations live theirs. No need to build wealth for you future generations, just have enough for your own retirement, and have your children do the same, and their children too, until someone in the future strikes it big, such as a lottery, maybe finding the next starbucks,google,facebook, you now what I mean. QUIT INVESTING AND START TRADING DAMMIT!!!
phillynet2002 - Wednesday, June 25, 2008, 3:10PM ET Report Abuse
- Overall: 3/5
In general I agree. It shocks me that some of the commentors on here have an attitude like the American people are getting what they deserve, or like they did something wrong. I like my truck. I will continue to drive it. It's my choice as American. You drive what you want I'll drive what I want. It no one elses business really. Market forces will make the adjustments necessary going forward. They always do. All industries require will have upheval and adjust. The US is the one of the most efficient users of energy in the world because it affects the businesses and stock holders. American citizen are the most dynamic citizens in the world. They will make the adjustment. They are the market force. They determine what is bought and sold all over the world. There is more than oil supply and demand here. It a perfect storm of political instability, foreign government controlled oil that are not are friends, falling dollars, speculation and supply and demand. They laugh when Paulsen and Bush leave the room and suck down another martini. Oil doubled in 6 or 7 mos. the supply and demand picture did not change that much in 6 mos. What changes is the taste for money and people realize they can get it. Just like housing, banking, Dot com era, agriculture and every other bubble that pops. Every so often imbalances exist and correct. Unfortunately the corrections are usually quite painful and rather sudden. Necessity is the mother of invention. This energy situation will create a new wave of technology advancement for the next secular business cycle. The goal is not to trash or flush the American way of life its to preserve it and make it better. To innovate that is what us Americans do best. That will happen through energy policy that includes, innovation, drilling (pronto, i we don't go get someone else will), change in individual attitudes. Commodity market that involve people actually in the oil business. Not just swapping paper. Rule were put in place for this and investors found away around with the ETF. All that said the internal combustion engine will be around for a long long time because there is oceans of oil down there.
Stephen M - Saturday, June 21, 2008, 8:58AM ET Report Abuse
- Overall: 5/5
I merely wish to second the remarks of "eloamsdown." A brilliant assessment of our situation.

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