Jeremy Siegel, Ph.D. The Future for Investors

The rising price of oil and other commodities continues to bedevil the economy and is the major reason for the decline of stock prices. In my last column I showed that if oil stays at $130 a barrel, the US would pay over one-half trillion dollars to foreign oil producers over the next year, a sum that could reduce US economic growth by two percentage points or more. Given the continued weakness in the housing market, rising oil prices could still send the US into the recession, although second quarter growth will come in around 2%, buoyed by consumer tax rebates.

I, like others, hoped that soaring oil prices would be temporary. Earlier this year, the Federal Reserve, along with other forecasters, predicted that the slowing world economy would break the upward spiral of commodity prices. But it has not. Part of the reason is that outside the US, the economic slowdown has thus far been slight and the developing countries have continued to devour energy supplies. Now that oil has crossed $140 a barrel, the implications of permanently high oil prices must be addressed.

Energy's Impact on Corporate Profits

Higher oil prices negatively impact US corporate profits since we are a huge importer of oil. The higher energy price acts like a tax, but is even worse. If higher prices came from increased taxes, the revenue collected by the government could be used for public works, debt reduction, or to lower other taxes. But the proceeds from higher oil prices go directly to foreign oil producers, siphoning a large amount of spending power from consumers without any offsetting benefit.

Higher energy prices will reduce corporate profits even when firms devise contracts to try to insulate themselves from energy inflation. A trucking company, for example, may institute a "cost plus" pricing schedule, linking the price directly to the cost of diesel fuel.

But the higher costs will encourage some to ship their goods by other methods, such as trains, which are more energy efficient. Or buyers may try to purchase goods produced closer to home, or not buy them at all. In all these cases, higher prices will reduce the demand for truckers' services. To offset this loss of demand, truckers will find that they cannot increase their total prices by as much as the increase in energy costs and retain the same volume of business. As a result they will find themselves discounting the base price to partially offset cost-plus contracts, lowering their profits.

Some believe that firms can neutralize the impact of higher energy prices by buying oil in the futures market, thereby hedging against future price increases. Much has been made of Southwest Airline's success with hedging the cost of jet fuel, thereby neutralizing some of the impact of oil price increases.

But airlines should only hedge against airline seats that have already been sold but have not yet been flown, not against seats that are still available and over which they still have pricing control. If airlines hedge by buying oil contracts against seats not sold and oil prices drop, then airlines will be forced to honor its commitment to buy at a higher price and will be at a competitive disadvantage to those carriers who did not hedge and can buy fuel at lower prices. Over-hedging can be a risky as under-hedging.

The Dollar Impact on Corporate Profits

If current oil prices remain high, American will be spending almost $300 billion in extra oil costs over last year. These higher oil prices will hurt workers and well as firms. About three quarters of our national income is paid to workers in the form of wages, salaries and bonuses, and one quarter is paid to shareowners in the form of dividends and profits. If one quarter of the increased cost of oil fell on corporate equity, this would reduce corporate profits by about $75 billion dollars per year. Since before-tax corporate profits are about $1.5 trillion, these higher prices will cause a 5% reduction in profits.

Yet this sum is apt to underestimate the short-term impact of higher prices on profits. Firms are only now beginning to pass through higher energy costs. Furthermore, many American firms are geared to produce goods and services based on cheap energy, such as SUVs, boats, and trucks, which have been hurt badly. The sharp shifts in demand away from energy using production could double or even triple the short-run impact of higher energy costs on corporate profits.

Longer Term Outlook Much Brighter

In the longer run, the profit impact of higher oil costs will be greatly mitigated. Both consumers and businesses will shift resources towards conservation and alternative energies, and first movers in those areas stand to make good profits. As real wages and other capital costs adjust, I believe the longer term impact of the doubling of oil prices on corporate profits will be much less than 5%.

Nobody knows how high oil prices will go. The soaring energy inflation is the dominant economic issue in today's economy. And it is a hot issue not only in the U.S., but worldwide. In the short-run higher energy costs will hit corporate profits, but in the long run new industries will arise with good profit potential. However painful, higher prices are the best mechanism to force the world to conserve and find and develop alternative energy sources.