March 23, 2012

Economics Group Special Commentary John E. Silvia, Chief Economist [email protected] ● (704) 374-7034

Eugenio J. Alemán, Senior Economist [email protected] ● (704) 715-0314

Azhar Iqbal, Econometrician [email protected] ● (704) 383-6805

Here We Go Again: Oil Prices and the U.S. Economy “It’s déjà vu all over again.” Yogi Berra Another spring has brought another gas price surge at the pump. The most recent surge in the price of crude oil raises questions that seem to have been answered many times over the past 40plus years: how much do higher oil prices hurt the U.S. economy and is it enough to generate a recession? The answer to these questions is clear: yes, there is a negative effect on the U.S. economy, but we estimate that it is not enough to generate a recession. Even though the U.S. economy is, today, much more efficient in its use of oil than it was back in the 1970s, the magnitude of the recent increase in oil prices remains a concern to an economy that continues to recover from the worst recession since the Great Depression.

A Similarity with a Difference

During the previous run-up in oil prices, just before the start of the Great Recession in the summer of 2008, the conditions of the U.S. economy were very different from today. Thus, any comparison between these two periods has to be assessed against a different backdrop. Back then, the economy had serious imbalances, with the housing bubble bursting, a very large current account deficit, a financial meltdown in the works, an extremely leveraged consumer, etc., that made the economy, especially the consumer, extremely vulnerable to the type of shocks that could ensue due to a surge in petroleum prices. Today, however, while the U.S. economy is still working its way out of the Great Recession, many of the previously mentioned problems are not as serious as they were in 2008 and thus, the potential effects of this run-up in petroleum prices may have a diminished effect on economic activity today than what they had back in 2008. Of course, the effect of any rise in the price of energy depends on the severity (i.e., supply and demand) and duration of the events that drive the price of oil higher. If oil prices top $127 per barrel for West Texas Intermediate (WTI), the price of gasoline will approach $4.00 per gallon; that price will start to have an effect on consumer behavior. 1 Back in 2008, Americans began cutting down on miles driven per month to adjust their expenditures to the higher price of oil. Even if consumers do that today, the effect of higher oil prices on the economy could likely be less than in 2008, as the initial conditions of the economy are different. However, the transportation industry’s problems will start to become severe, as there is very little that can be done to reduce the number of miles driven to deliver goods across the United States. For the airline industry, a run-up in oil prices could also mean a significant blow to their efforts to reign in expenditures and this could have a major effect on the feasibility of many carriers that are already experiencing tough economic times. Again, the consequences on the economy will depend on the severity of the increase, as well as on the duration of the increase, as firms could take the hit in the short run. But in the long run they will have to adjust to the new situation. 1

See the next section for an explanation of the relationship between WTI and gasoline prices.

This report is available on wellsfargo.com/economics and on Bloomberg WFEC.

The conditions of today’s U.S. economy are different from those in 2008, and thus today’s run-up in oil prices may have a different effect on economic activity.

The impact of a rise in energy prices depends on both the severity and the duration of the event.

Here We Go Again: Oil Prices and the U.S. Economy March 23, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

As is always the case, there are many unknowns that prevent analysts from forming a precise number for the economy as a whole, as it depends on the reaction of consumers, firms, governments, etc., and how they deal with the new oil-price environment. However, we have made some calculations, in nominal terms, that could shed some light on the potential strains on U.S. consumers’ pocketbooks if the situation worsens.

U.S. Consumers’ Pocketbooks: Some Simple Calculations 2

Given that gasoline is a byproduct of crude oil, an increase in crude oil prices lifts retail gasoline prices, but the precise rise in gas prices for a given change in crude oil remains flexible. As such, consumers need more money to buy the same amount of gasoline than they did before, all else equal. From the spending side, personal spending is a major part of GDP, roughly 71 percent; thus, a persistent rise in oil and gasoline prices could lead to reduced economic growth through its effect on personal consumption expenditures on other goods and services that will have to be sacrificed for consumers to buy gasoline at higher prices. Alternatively, consumers could reduce the number of miles driven per month in order to attempt to keep other expenditures constant as gasoline prices increase. We say that consumers will need to adjust quantities, i.e., the number of miles driven per month, in order to keep other types of expenditures constant. Of course, this is easier said than done. But we saw this type of response from consumers the last time the national retail price of gasoline approached $4.00 per gallon back in 2008. During the last two weeks of February, WTI crude oil prices increased $8.62 to $107.18 per barrel. Over that same time period, the average national price of retail gasoline increased roughly 20 cents to $3.72 per gallon.

Ten Percent Gets You 15 cents

A 1.0 percent increase in the cost of WTI boosts retail gasoline prices by 0.4 percent.

To help answer the question and quantify the relationship between WTI, gasoline prices and personal spending, we conducted a regression analysis. 3 We then estimated the elasticity between WTI and retail gasoline prices to look at what is the percentage change in the price of retail gasoline that can be explained by a percentage change in the price of WTI, everything else equal. Based on our statistical analysis, a one percent increase in WTI boosts retail gasoline prices by 0.4 percent. 4 Specifically, a 10 percent increase in WTI, from its current price of $107.18 to $117.9, would boost gasoline prices from its current level of $3.72 to $3.87 a gallon. We also know that a specific round number, such as $4.00 per gallon, is considered a psychological threshold for consumers. Therefore, breaking above this higher price point may accelerate declining consumer confidence. For instance, the first time retail gasoline prices hit $4.00 back in June 2008, consumer confidence, as measured by the Conference Board, dropped more than seven points during the month. Today, in order to hit this psychological threshold of $4.00 per gallon, WTI would need to increase to roughly $127.00 per barrel from its current level of $107.18 per barrel.

All statistics are available upon request. We used the price of WTI for this example, but a similar result can be found using Brent oil prices. 4 This result is statistically significant at a five percent significance level. 2 3

2

Here We Go Again: Oil Prices and the U.S. Economy March 23, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

Figure 2

Figure 1 West Texas Intermediate Spot Price

U.S. Retail Fuels

Monthly Average Cash Spot Prices, Dollars per Barrel

$140

$140

$ per Gallon

$5

$5

WTI Spot: Feb @ $102.26 $120

$120

$100

$100

$80

$80

$60

$60

$40

$40

$20

$20

$4

$4

$3

$3

$2

$2

$1

$1 US Retail Diesel: Mar @ $4.14 US Retail Gasoline: Mar @ $3.92

$0

$0 98

99

00

01

02

03

04

05

06

07

08

09

10

11

12

$0

$0 01

02

03

04

05

06

07

08

09

10

11

12

Source: IHS Global Insight, U.S. Department of Energy and Wells Fargo Securities, LLC

The best available proxy for consumer spending on gasoline is provided by the Bureau of Economic Analysis’ measure of personal consumption expenditure on gasoline, fuel oil and other energy goods. The relationship between this measure of gasoline purchases and gasoline prices is statistically significant. According to our analysis, a one percent increase in gasoline prices would require 0.86 percent of additional expenditures in personal consumption. In other words, a 3.72 cent increase, which is one percent of $3.72, would necessitate an additional $3.53 billion (0.86 percent of $410.602 billion, which is the current level of PCE gasoline purchases). Moreover, $3.53 billion is roughly 0.2 percent of nominal GDP. That is, a one percent increase in gasoline prices would reduce nominal GDP by 0.2 percent, all else remaining constant.

A 1.0 percent increase in gasoline prices would reduce nominal GDP by 0.2 percent.

Two important points to take into consideration here: first, a persistent rise in gasoline prices may have a more significant effect on consumers and the economy. For instance, gasoline prices were above $3.00 a gallon for six consecutive months between November 2007 and April 2008. During that same time period, consumer confidence dropped more than 25 points. Our analysis also points to a statistically significant relationship between consumer confidence and gasoline prices. In fact, a one percent increase in gasoline prices is associated with a 0.2 percent decrease in consumer confidence, with a one-month lag. Second, a change in gasoline prices typically generates two effects: (a) an income effect and (b) a substitution effect. The income effect may reduce gasoline consumption in response to a rise in gasoline price, all else equal. That is, we will probably start to see a reduction in the number of miles driven by American drivers, something we experienced back in 2008 when gasoline prices hit the $4.00 per gallon mark. The substitution effect would probably be negligible, at least in the short to medium term, as it is very difficult to substitute out of gasoline consumption in a short period of time. However, in the longer term, the substitution effect will become more important as consumers find other alternatives.

Effects on Real GDP 5

Higher oil prices are negative for economic growth as it acts as a tax on consumption. The tax on consumption has a direct and an indirect effect. The direct effect is the obvious increase in what consumers pay for gasoline at the pump. The indirect effect includes the increases in transportation costs and their effect on higher prices of all those goods that are transported. Apart from the obvious effects on consumers and the purchasing power of income, an increase in oil prices and gasoline prices tends to contribute to lower real economic growth. In fact, all of the last recessions in the U.S. economy have been, at least partially, led by a large increase in oil and gasoline prices.

Higher oil prices act as a tax on consumption.

5 For a regional report on the effects of higher oil prices in the United States, please see “Regional Impact of Gasoline Prices” available on our website.

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Here We Go Again: Oil Prices and the U.S. Economy March 23, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

Thus, this latest run-up in oil and gasoline prices will have a negative effect on economic growth. The problem is to know how persistent and how large this run-up in gasoline prices is going to be. The fact that the economy is showing signs of strengthening will help to minimize the effect of higher oil prices, though the strengthening economy will have a limited effect. Consumers adjust to economic shocks over time, such as reducing the number of miles they drive.

As we saw in 2008, the U.S. consumer is quite savvy and can adjust over time to economic shocks. The latest recession is one of the best examples of consumers adjusting to new economic realities. For example, by 2006, U.S. per-capita miles driven per month was close to 850; however, at the lowest point during the middle of the U.S. economic recession in November 2008, that number dropped to 780 miles, a decrease of more than eight percent. By the end of 2011, U.S. drivers were driving close to 800 miles per month once again in per-capita terms. However, the number of miles driven has not yet returned to the peak achieved during the housing boom. Figure 4

Figure 3 Vehicle Miles Driven

Vehicle Miles Driven Per Capita

12-Month Total, Billions of Miles

3,250

3,250

Monthly Miles Driven

900

900

Per-Capita Miles Traveled: Dec @ 800.45 3,000

3,000

2,750

2,750

2,500

2,500

2,250

2,250

2,000

2,000

1,750

1,750

1,500

1,500

1,250

850

850

800

800

750

750

700

700

650

650

600

600

1,250

550

550

1,000

500

Vehicle Miles Traveled: 2011 @ 2,962 Billion 1,000 1970

1975

1980

1985

1990

1995

2000

2005

2010

500 80

82

84

86

88

90

92

94

96

98

00

02

04

06

08

10

Source: U.S. Federal Highway Administration, U.S. Dept. of Commerce and Wells Fargo Securities, LLC

It could be argued that U.S. drivers have less degrees of freedom today than what they had before the last recession, as they have kept the number of miles driven per capita relatively low compared to the previous peak. Thus, there is less margin to adjust further down in travel today than when the crisis hit. Of course, the reduction in miles driven was not only a result of the high price of gasoline but also a consequence of the severe recession.

Consumers are becoming more versatile in adjusting to gasoline shocks.

We also conducted a regression analysis to see the real effects of higher real gasoline prices on the U.S. economy and observed that the real effects on GDP take a while to appear, perhaps because individuals and firms try to adjust as much as possible, i.e., by reducing miles driven, by changing consumption patterns, by using public transportation, by substituting away from more expensive goods and services, etc., to increases in the price of gasoline. This is, perhaps, another explanation of why inflation has been relatively muted during the last episodes of higher gasoline prices compared to the 1970s and the 1980s. The results seem to indicate that consumers are more versatile in adjusting to gasoline shocks today than they were previously and a similar increase in gasoline prices has a diminished effect on real economic activity. The effect is also probably a matter of magnitude. Back in January 1974, oil prices increased by 135 percent, from $4.31 per barrel in December 1973 to $10.11 per barrel in January. It is clear that 135 percent is a shock in any league and in any country and since we were so dependent on oil in the 1970s it is no surprise that the effects of this shock were so damaging to the U.S. economy. Today, we are much more efficient in the use of oil and have more energy alternatives than we had back in the 1970s and 1980s.

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Here We Go Again: Oil Prices and the U.S. Economy March 23, 2012

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

Furthermore, oil prices have been hovering around $100 per barrel for several years and we seem to be more adapted to these prices today than we were back in 2004 when oil prices started this latest period of ever higher oil prices. At the same time, the U.S. economy is showing signs of recovery and this momentum could be sustained if, as we said before, there is no further shock to oil prices. A conflict between Iran and Israel could produce such a shock, which would probably take the economy into a recession. However, barring such a military shock, we believe that current oil prices will still allow the U.S. economy to grow, albeit not at an optimum, potential, pace.

We believe that current oil prices will still allow the U.S. economy to grow, barring a conflict between Iran and Israel.

Summary

Higher oil prices and higher gasoline prices have negative effects on the U.S. economy. In this piece we measured some of these negative effects. The U.S. economy today is not the same economy it was in the 1970s or 1980s and it seems clear that the present economy is more adaptable to higher oil prices. This does not mean that higher oil prices will not be detrimental to economic activity—they will. Current oil and gasoline prices will slow down consumption and may even lead into a recession, as consumers feel the pinch of this tax in consumption. The current situation is not the same as it was in the mid-1970s, when oil prices increased by 135 percent from one month to the next. Today’s situation is like the story of the frog: if you throw a frog into a boiling crock pot, it will jump out immediately. However, if you put the frog in cold or temperate water and start boiling it, the frog will cook without complaining. As long as oil prices continue to increase and there is no “shock,” we may be able to survive as we adapt better than the frog.

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Wells Fargo Securities, LLC Economics Group

Diane Schumaker-Krieg

Global Head of Research (704) 715-8437 & Economics (212) 214-5070

[email protected]

John E. Silvia, Ph.D.

Chief Economist

(704) 374-7034

[email protected]

Mark Vitner

Senior Economist

(704) 383-5635

[email protected]

Jay Bryson, Ph.D.

Global Economist

(704) 383-3518

[email protected]

Scott Anderson, Ph.D.

Senior Economist

(612) 667-9281

[email protected]

Eugenio Aleman, Ph.D.

Senior Economist

(704) 715-0314

[email protected]

Sam Bullard

Senior Economist

(704) 383-7372

[email protected]

Anika Khan

Economist

(704) 715-0575

[email protected]

Azhar Iqbal

Econometrician

(704) 383-6805

[email protected]

Ed Kashmarek

Economist

(612) 667-0479

[email protected]

Tim Quinlan

Economist

(704) 374-4407

[email protected]

Michael A. Brown

Economist

(704) 715-0569

[email protected]

Joe Seydl

Economic Analyst

(704) 715-1488

[email protected]

Sarah Watt

Economic Analyst

(704) 374-7142

[email protected]

Kaylyn Swankoski

Economic Analyst

(704) 715-0526

[email protected]

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