What Do Rising Oil Prices Mean for U.S. Economic Growth?

In late January, I envisioned several scenarios for oil prices -- the worst being that oil could more than double if Saudi Arabia, which produces 25% of the global oil supply, went the way of Egypt.

Since then, the popular uprisings have spread in deadly fashion to Libya, which has declared force majeure on oil contracts. Libya accounts for a mere 0.5% of U.S. imports -- although it's easier-to-refine so-called sweet crude, so this should have a limited effect on oil prices in the U.S. -- especially since Saudi Arabia could pump "an additional 1 million to 1.5 million barrels in a matter of days," according to Tom Kloza, chief oil analyst at the Oil Price Information Service, quoted in The New York Times.

But with oil nearing $100 a barrel, the question that must be concerning economic forecasters and politicians who depend on economic growth is this: How much will higher oil prices cut into economic growth? According to the International Monetary Fund, a $10-a-barrel increase in the price of oil reduces U.S. GDP growth by 0.5 percentage points. Based on that relationship, forecasters need to go back to the drawing board to estimate how much oil prices could rise, what that might mean for GDP growth and how policymakers ought to respond.

While the rising price of gasoline at the pump is the most visible economic effect of higher oil prices, the reality is that oil and its byproducts are a bigger part of the economy. Here, according to NPR, are some examples of that cascading economic effect:
  • Airlines are likely to add fuel surcharges to the price of tickets -- they've raised fares four times since the start of 2011, according to the New York Times, boosting the lowest ticket price 10% since last January.
  • Delivery companiessuch as Federal Express (FDX ) and UPS (UPS) are likely to raise rates.
  • Food priceswill reflect the higher costs farmers incur to run their tractors and other equipment. Transport costs would also rise.
  • Plastic goodsmight increase in price, since plastic is derived from oil.
  • Crowding out-- since consumers' real incomes are already down 8.1% in the last decade, those higher prices will limit what consumers can spend elsewhere.
Three Possible Scenarios

Nobody knows what's going to happen with the price of oil, but here are three scenarios for oil and unleaded gasoline and the impact on 2011 GDP growth -- most recently forecast by the Federal Reserve to be between 3.4% and 3.9%.

Under the "optimistic scenario," the price of oil would drop back to $89 a barrel, where it was in December 2010 before unrest in the Middle East kicked off. This would cause the price of gasoline to decline to $3 a gallon and would lead to GDP growth of 4.1%, a roughly 0.5 percentage point increase.

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The "most likely scenario" would result in the price of oil rising to $100 a barrel and the price of gasoline climbing to $3.50 a gallon due to ongoing instability in the Middle East, but with Saudi Arabia continuing to control its oil supply. This would cause a roughly 0.5 percentage point decline in U.S. GDP growth to 3.1%.

Under the "pessimistic scenario," crude would rise to $150 a barrel, and the price of gasoline would surge to $4.50 a gallon as political instability in Saudi Arabia caused a severe contraction in energy production. This would lead to a roughly 2.5-point decline in U.S. GDP growth, down to 1% for 2011.

With Saudi Arabia pouring more money -- including a recent $36 billion injection -- into its economy, it's no doubt hoping to forestall this worst-case scenario. Unfortunately, unexpected surprises have a habit of happening. But it's somewhat comforting to point out that a few months after oil hit $147 a barrel in 2008, it plunged as low as $33 a barrel as global demand plummeted in the wake of the financial crisis.

And that self-correcting market for oil gives me some hope that this pessimistic scenario, even if it does occur, won't last long.

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