Jeremy Siegel, Ph.D. The Future for Investors

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.