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By Dirk van Dijk, CFA

The following two charts (and the comments in between them) are part of a very interesting article by James Hamilton. The collapse in oil prices last fall acted as a key economic stabilizer and helped ameliorate the economic decline.

It showed up in two key places. The first was in the trade deficit numbers, which have shown a very dramatic improvement over the last year (see here and here). The other place it showed up was in retail sales, since a dollar spent at the gas pump is a dollar that can not be spent elsewhere.

Since last Christmas, prices at the pump have climbed sharply, as shown in the first graph. While prices are still far below the levels of a year ago, the current levels are high enough to start hurting, especially those who have seen their incomes drop due to the recession. Dr. Hamilton calculates that the current prices would be consistent with energy taking up over 6% of total personal consumption expenditures, up from 4.85% back in December.

As the second graph shows, that would be about the share of spending energy had back in the mid-1980’s. The mid-1980’s were not exactly the worst period of our economic history, so such a level in and of itself should not be a real problem for the economy. And we faced a far more serious problem with energy prices in the 1970’s than we did even at the worst energy price levels we saw a year ago.

Still, this is coming at a time when the economy is still very fragile. Retail spending on goods other than energy face strong headwinds from both the need for consumers to rebuild their personal balance sheets (pay down past debts and build up savings) and from much worse personal income statements (unemployment, hours and wages cut, lower interest rates on savings). This is just one more unhelpful factor that will pressure sales, particularly for stores that sell discretionary items, including clothing stores like The Gap (GPS) and appliance stores like Rex Stores (RSC) and HH Gregg (HGG). Higher oil prices are of course good news for the energy sector, but for the overall economy high energy prices are a significant negative.

The rise in oil prices does not seem to be consistent with the overall weakness of the world economy, but there are several reasons why it just may be sustained or extended, even in the absence of a global economic rebound. The first is that oil is a good hedge against future inflation, and given the expansion of the Fed balance sheet, that may be a very serious concern down the road. Currently the bigger threat is deflation, but it will be hard for the Fed to sop up all the liquidity that has been created to fight the deflationary fire.

A second and somewhat related reason is that China has been increasing its purchases of all sorts of commodities, trying to take advantage of the lower prices (note that the price of other commodities like copper have also increased sharply from the lows of last winter, but remain well off the highs of last summer). OPEC has also shown greater discipline this time around than they have in the past. How long that will last nobody knows, but so far they have been keeping it together.

The third reason is that the looming danger of peak oil has not gone away, it has only been masked by "peak demand" caused by the economic downturn worldwide. Any incremental oil is now coming from very expensive sources like the Canadian oil sands or the very deep waters of Brazil, both of which require oil prices in the mid-$60’s to be economically viable.

With oil prices rising above those levels, the drilling off Brazil should pick up steam. There are, however, very few rigs capable of drilling at such depths. Most of those are controlled by two firms, Transocean (RIG) and Diamond Offshore (DO), both of which will benefit enormously if oil prices stay high.

In short, the current levels of oil prices are not exactly fertilizer for the "green shoots," but will not kill them off either. Other developments, such as long-term interest rates, will have more of an impact. The very low prices at the pump in the first quarter may have been one of the key reasons why consumer spending in the quarter was higher than expected (but probably not as big a factor as increases in transfer payments). However, if they continue to rise towards the $100 level, the world economy could easily fall back into the abyss.

National average U.S. gasoline retail price. Source: NewJerseyGasPrices.com.

The 16% increase in gasoline prices between December and February resulted in an additional $37 billion spending by consumers at an annual rate on gasoline and fuel oil, increasing the share of energy purchases in consumer budgets from 4.85% in December to 5.17% in February. The additional 40% increase we've seen in the retail price of gasoline since February has likely brought that expenditure share back up above 6%.

Source: Will Rising Oil Prices Prevent a Recovery?