Effects of Oil Surge Confound Forecasts

Imagine that an impeccable source had assured you on Jan. 1 of this year that crude oil would be near $55 a barrel by mid- October. Your investment assumptions most likely would have been dour.

The stock market? It would be trashed for sure.

The bond market? Long-term interest rates would have to be dramatically higher on inflation concerns.

The economy? Probably careening toward recession.

But oil is indeed near $55 a barrel -- up from $32.50 at the start of the year -- and neither the financial markets nor the economy seems too distressed.

The Dow Jones industrial average, at 9,933.38, is down 5% for the year, which is annoying but no disaster. The broader Standard & Poor’s 500 index is off a mere 0.3%.

Long-term bond yields are down, not up. The 10-year Treasury note was at 4.06% Friday, compared with 4.25% on Jan. 1.

And if a recession is on the way, nobody told consumers in September: Retail sales jumped 1.5% last month, the biggest gain in six months, the government said Friday.

The reaction, or lack of reaction, to record oil prices is partly a testament to the human spirit. People learn to cope with adversity; otherwise, a lot less than $55 oil would have ended civilization long ago.

But there is another reason oil’s ascent has failed to generate certain logical responses: No one has a good answer for why, exactly, the price is where it is.

And without a good answer, each additional gain in crude’s price is greeted with as much disbelief as fear.

Hope is involved too -- the hope that the faster oil rises, the faster it will come down. In free markets, price spikes usually end with a crash rather than with a gradual descent or a plateauing. (Think Nasdaq in 2000.)

As for the economy, analysts can’t agree on the longer-term implications if oil fails to fall back soon. For example, are higher energy prices inflationary -- or deflationary? Or maybe both?

By now, everyone who fills up a gas tank a few times a month knows, generally, why oil has surged this year. Global demand, and particularly Asian demand, has been stronger than expected.

On the supply side, meanwhile, for much of the year every week seemed to bring another threat of a production disruption in key supplying nations including Norway, Russia, Nigeria and Venezuela.

After Hurricane Ivan swept through the Gulf of Mexico in September, fear of supply interruptions turned into the real thing, as many drilling rigs and pipelines were damaged.

And ever present in the oil market is the fear of a terrorist attack in the Middle East that would severely curtail production from that crucial region.

But what would the price of oil be without that fear premium built in? Pick any number and your guess might be as good as that of any veteran oil trader.

“I don’t think anybody on this Earth really understands the dynamics of the world oil market now,” said Ed Keon, chief investment strategist at Prudential Equity Group in New York.

If trading in oil futures markets were limited to petroleum processors alone (i.e., actual users of the commodity), it’s possible that the current price wouldn’t be near $55 a barrel. But any speculator also can buy an oil futures contract -- and nothing attracts speculators like a hot market.

“Why are you buying?” was asked of many investors during the dot-com stock bubble of 1999 and early 2000. The honest answer was, “Because they’re going up!” That mentality is necessary for a speculative frenzy.

Evidently, oil traders believe the world will be a significantly less dangerous place in a year. Oil futures for delivery in November 2005 are at $47 a barrel.

That discount also could reflect the belief that the global economy will have slowed sharply by then, reducing oil demand.

So far, however, predicting the economic effects of record oil costs has been as difficult as figuring what’s really driving the price.

The cost of gasoline nationwide declined for much of the summer but has been soaring again since early September. Yet that failed to keep consumers out of the stores last month. The government’s retail report Friday said demand was robust for cars, appliances and clothing, among other goods.

Susan Sterne, head of research firm Economic Analysis Associates in Greenwich, Conn., said rising energy prices couldn’t have the same effect on consumers as 10 or 20 years ago, because energy is a much smaller share of the typical family’s total spending -- 3% to 4% now, compared with 8% to 10% in the early 1980s, based on government data.

What many consumers saved refinancing their mortgages in recent years far surpasses the extra expense they are incurring at the pump, Sterne noted.

Some analysts are more worried. Spending was surprisingly strong in September, but “the question persists: Can consumers keep it up in the face of rocketing energy prices and anemic job growth?” Merrill Lynch & Co. economists asked in a report sent to clients on Friday.

Federal Reserve Chairman Alan Greenspan, in a speech on Friday, said the effect of higher energy costs on the economy was “noticeable” but “likely to prove less consequential to economic growth” than in the 1970s.

Ever the perfect hedger, however, Greenspan also said that the economic risk would grow if oil prices were to move “materially higher.” Not surprisingly, he didn’t quantify “materially.”

The Fed’s view is important, of course, because the central bank controls short-term interest rates. Frightened that soaring oil prices in the mid-1970s and late 1970s would stoke already-high inflation, the Fed rapidly tightened credit in both periods -- driving the economy into recessions.

This time, another view has been widely circulated: Instead of fueling inflation, perhaps higher energy costs could lead to deflation. The logic here: As the price of energy rises, consumers and businesses might cut back on other spending, putting downward pressure on the prices of many other goods.

Is it a viable thesis? Sterne says no: “There is no historical precedent for that.”

David Wyss, economist at Standard & Poor’s in New York, said the “core” U.S. consumer price index -- which excludes direct food and energy costs -- would rise 2.1% in 2005, up from an estimated 1.7% this year, as companies raised prices on myriad products and services to recoup some of their higher energy costs.

But the action in the bond market this year, as long-term yields have fallen, suggests that some investors believe oil just might prove to be deflationary. If you’re betting on deflation, amid a slowing economy, you’d probably want to lock in current yields on the assumption that the Fed might be in the mode of cutting interest rates in 2005 instead of raising them further.

In any case, bond yields today certainly don’t suggest there’s much fear of rampant inflation from oil’s persistent advance.

Maybe the bond and stock markets are convinced that oil trading has become one absurd speculative frenzy -- and that a sharp reversal in price is inevitable, and sooner rather than later.

Consumers can only hope that the markets have it right.

Tom Petruno can be reached at tom.petruno@latimes.com.