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Oil-Price Volatility Bedevils Business and Consumers

Energy prices may be partly to blame for driving the global economy into recession, but it’s the uncertainty surrounding price direction that prevents a sustained recovery from taking hold, analysts say.

CNBC.com

Indeed, since July 2008, the price of crude oil has fluctuated between a record high of $145 and $30 per barrel, hovering today at around the $100 mark.

The resulting yo-yo effect on fuel prices for the last three years has made it hard for consumers and businesses to loosen their purse strings enough to jump start the lackluster economy, says Kay Smith, head of macroeconomic analysis for the U. S. Energy Information Administration, EIA.

“There’s a lot of headwind in the U.S. economy right now, but I think we’re just really uncertain,” says Smith . “It’s the volatility of oil prices that will impact the economy more than any particular pricing point.”

The same is true abroad, she notes, where the volatile cost of energy is compounding economic angst over the European debt crisis, theearthquake in Japanand social unrest in the Middle East.

And the stability the markets crave is nowhere in sight.

Chris Lafakis, an economist with Moody’s Analytics, expects oil prices to hold at around $100 a barrel for the rest of the year, but expects them to rise in 2012.

“We think that oil right now is trading close to its fundamental price and we expect that price to persist for the rest of the year before rising by up to $5 per barrel in 2012,” says Lafakis, cautioning that prices could climb “appreciably higher” if oil producers don't increase production and the conflict in Libya persists.

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The Organization of Petroleum Exporting Countries, OPEC, which controls 40 percent of the world’s oil supply, failed to agree earlier this month to increase production quotas, a move that would have offset the short-term loss of supply from Libya and potentially driven down prices.

“At present, we’re operating with 2 percent less crude oil production than we had prior to the Libyan civil war and we’re reaching peak seasonal demand in Europe and the U.S. as the summer driving season begins,” says Lafakis. “We’re going to need some extra production out of OPEC to fill the gap that Libya has left.”

The Economic Equation

Rising oil prices impact the economyon multiple fronts.

For starters, it increases the cost of production inputs, which effects energy-intensive industries like agriculture and manufacturing, especially companies that make chemicals, paper and glass.

Over time, if the cost increase cannot be passed along to consumers, businesses start laying off workers and idling plants, which reduces economic output.

Higher oil prices, of course, also drive up prices at the pump, since gasoline is a byproduct of crude oil. That increases the cost of transportation, making it more expensive for consumers to travel and businesses to ship goods (including groceries) to end-users.

“Gasoline is one of the few commodities where consumers can actually see the price changes every week so they’re reminded constantly of how much a gallon of gas costs,” says Smith. “Certain trigger points, such as when the price of gas reaches $4 a gallon, have a negative impact on consumer confidence.”

Indeed, a number of consumer surveys — national and regional — support that, affecting both psychology and behavior.

Energy and You - A CNBC Special Report
Energy and You - A CNBC Special Report

“Once you get to $4 a gallon for gasoline it starts to amplify the effects of the rise in oil,” says Lafakis.

For every $1 that oil prices rise in the U. S., he notes, gas prices rise by 2.2 cents per gallon. Thus, a $10 rise in the price of crude oil translates into a 22-cent increase in prices at the pump.

That takes a bigger toll on the economy that it might seem.

According to Lafakis, every one-cent increase in the price of a gallon of gas decreases consumption by $1.25 billion over the course of an entire year.

A $1 increase in gas prices over a 12-month period would sap $130 billion off of consumption – slightly more than the cost of the payroll tax reduction passed by Congress in late 2010.

“The economic stimulus package was a big reason why we expected the economy to perform better in 2011, but suddenly with higher fuel prices it’s taken a large bite out of the recovery in the consumer sector,” says Lafakis. “Consumers have less money to spend on other goods and services or to save or pay down debt so it really acts like a tax increase on the U.S. consumer.”

The impact of higher oil prices in countries outside the U.S., however, many of which are struggling to keep inflation in check, could be more, according to the International Energy Agency.

The IEA's forecast calls for world oil prices to remain high, at about $110 this year, compared with $80 in 2010.

“There are real risks that a sustained $100-plus price environment will prove incompatible with the currently expected pace of economic recovery,” it states in its latest monthly oil market report.

New Demand

But a prolonged period of elevated oil prices would also likely weaken demand among industrialized nations, which could help bring energy prices back down to earth.

Preliminary data suggest demand is already starting to wane.

According to the IEA, growth in world oil consumption slowed to 2.6 percent in the first quarter of 2011, compared with 4.1 percent in the last quarter of 2010.

The agency also predicts that total oil product demand in industrialized nations will fall this year by 0.5 percent, while total oil consumption in North America will fall by 194,000 barrels per day in 2011.

In contrast, oil product demand in North America rose by 609,000 barrels per day in 2010.

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“The surest remedy for high prices may ultimately prove to be high prices themselves,” the IEA notes.

Emerging Market Demand

Demand from the emerging markets and developing nations, however, shows no signs of slowing — the reason global demand for oil is projected to remain flat or slightly higher for the foreseeable future.

Historically, the 34-developed countries that comprise the Organization for Economic Cooperation and Development, OECD, which include the U.S., and Europe, have accounted for the largest share of world energy consumption.

But in 2007, energy use among non-OECD nations exceeded that of OECD nations for the first time, according to the EIA.

By 2035, the agency projects China and India, both non-OECD countries, will account for 30 percent of total world energy consumption, and energy use throughout non-OECD Asia will rise 118 percent between 2007 and 2035.

Energy use is also expected to rise 82 percent in the Middle East during the same period, and 63 percent in Central and South America and Africa.

By comparison, the U.S. share of world energy consumption is projected to fall from 21 percent in 2007 to about 16 percent in 2035, the EIA reports.

Energy and You - A CNBC Special Report
Energy and You - A CNBC Special Report

According to Lafakis, much of the decline in U.S. demand for crude oil stems from a shift in consumer behavior.

“As prices rise, consumers are more sensitive,” he says. “People are moving closer to their jobs, walking to work or using more public transportation.”

They are also buying more energy-efficient cars.

“Over the last two or three years, when the price of gas hit $4 per gallon, consumers were buying fewer trucks and sport utility vehicles (with lower gas mileage) and more cars,” he says, noting the same purchasing pattern emerged during the most recent spike in prices at the pump. “Most of the oil used in this country is used for transportation purposes. If oil prices continue to rise, then I would expect to see the same response from consumers.”

As such, he notes, the biggest impact of the recent spike in oil prices may not be the toll it took on the world economy, but a permanent change in how the U.S. and other industrialized nations manage their dependence on oil.

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