FSO Editorials

WILL HIGHER OIL PRICES
FUEL INFLATION?
by Ronald R. Cooke
The Cultural Economist
Author, "Oil, Jihad & Destiny" and "Detensive Nation"
April 12, 2005

A news story that compares the rising price of oil to the rate of inflation made the rounds of American media last month. Reporters, pundits and some economists repeated the parable without giving it much thought. The essential claim is that in 2005, higher oil prices will not drive up the rate of inflation as much as they did in the 1970s because oil consumption, as a percentage of GDP, has decreased by half since then. We have become much more efficient in our use of oil, claim the analysts, and therefore higher oil prices will only have a modest upward impact on inflation.

Rubbish.

Although the statement is true, the concept masks a lot of dirty little problems.

Here is why.

Economics

The historical relationship between the price of oil and the rate of inflation gives us clues as to what we may expect in the future. In 1974, the price of oil on the world market increased by 252 percent, from an average of $3.29 per barrel in 1973 to $11.58 per barrel in 1974. Inflation (CPI-U) rose sharply, from an average of 6.23 percent in 1973 to 10.97 percent in 1974, and remained high at 9.14 percent in 1975. In 1979, oil again made a dramatic 121 percent jump in price as it moved from $13.60 in 1978 to $30.03 in 1979. It gained another 19 percent in 1980. Despite the fact that Americans had become more efficient in their use of oil since the price increase of 1974, inflation also increased, by a chaotic 11.26 percent in 1979, 13.52 percent in 1980, and 10.37 percent in 1981. One could argue that conservation had not done anything to slow down the inflationary spiral. By contrast, a 48 percent decrease in the price of oil in 1986 was accompanied by only a modest decrease in the rate of inflation from 3.57 percent in 1985 to of 1.92 percent in 1986. Given the percentage decrease we experienced in the price of oil in 1986, the rate of inflation remained stubbornly buoyant.

If we generate a chart that shows the average annual nominal price of oil versus the average annual rate of inflation for the period 1970 through 2002, we can see � by inspection � there is a modest correlation between changes in the price of oil and concurrent or subsequent rates of inflation. We have to remember, however, that the rate of inflation is influenced by many other economic factors: the level of current economic activity, speculation in the commodity markets, interest rates, changes in productivity, and so on. None-the-less, history suggests that if the price of oil effectively doubles, there has to be an increase in the rate of inflation.

In doing the research for my book "Oil, Jihad and Destiny" I developed a formulae to replicate historical changes in the annual average price of oil versus corresponding changes in the rate of inflation from 1970 through 2002. I discovered that the formulae's accuracy was greatly improved if it also included the annual increase in oil consumption efficiency. Unfortunately, the model can only project the rate of inflation based on changes in supply and consumption. It cannot account for futures speculation or changes in the value of the dollar. Never-the-less, if we use the formulae to project future rates of inflation versus projected increases in the price of oil, we must conclude that even with liberal assumptions about the rate at which we increase the efficiency of oil consumption, the rate of inflation is going to accelerate.

When the Federal Reserve increased the fed funds rate to 2.75% on March 22, 2005, it noted that "pressures on inflation have picked up in recent months." With the computer modeling tools at its disposal, its extensive information resources, and its staff of very bright people, the Federal Reserve must certainly be aware of the relationship between the price of oil and its inflationary impact on economic activity. The Fed knows that its previous policy of easy money has sown the seeds of increased inflation. In addition, Federal Reserve Chairman Greenspan has already warned that America's heavy burden of public and private debt, as well as the cost of sustaining a presence in Iraq, homeland security, Social security, and Medicare are a troubling financial burden. The Fed is very much aware that these factors � taken in the aggregate - create an inflationary economic environment. Even with computer models and bright people, however, it is still difficult for the Fed to judge the timing of future inflation.

Unequal Distribution

There are gut wrenching reasons to fear the inflationary pressures of increased oil prices. Take the Law of Unequal Distribution. This law states there will be an unequal distribution of economic change among the economy's participants. We can classify these participants by various measures in order to make a comparison.

For example, increased oil prices will have only a marginal impact on organizations that use relatively little oil in the provision of goods and services. We can anticipate financial service, insurance, health care, education, government, and utility enterprises will experience little or no cost inflation as the price of oil increases. On the other hand � depending on their business model - transportation, retail, wholesale, agriculture, construction, and manufacturing enterprises may experience modest to sharply increased cost inflation. These costs, less gains in oil consumption efficiency and changes to the basic business model, will eventually have to be passed on to the ultimate consumer.

The Law of Unequal Distribution will be especially hard on consumers. I fired up my trusty spread sheet in order to determine how rising fuel costs would impact the finances of households making $25, $50, $100, $200, and $275 thousand dollars per year. Assuming one car per household that gets 18 MPG, and 10,000 miles of driving per year, each household consumes 555.6 gallons of fuel per year. Last year that fuel could be had for $1.44 per gallon. On average, households in this scenario would have spent .33 percent of their income on vehicle fuel. With gasoline prices moving up to $2.88 per gallon, the average household expenditure increases to .66 percent of income.

The trouble � as stated in the first paragraph of this article � is in the averages. The percentage change in vehicle fuel costs are relatively easy to absorb if your making $100, $200 or $275,000 per year. Households with $275,000 in annual income, for example, would only spend .58% of their income on vehicle fuel. However, lower income households take a terrific hit. Households with $25,000 in annual income would be forced to spend 6.4 % of that income on vehicle fuel. For households that make $50,000, their vehicle fuel costs would jump to 3.2% of their annual income. And it's important to note that these two groups, taken together, account for 56 percent of American households. Obviously, increases in the price of oil will have a serious impact on the available discretionary spending of the two lower income groups.

I then developed a second model, making suitable adjustments for the probable average mileage per vehicle (assuming wealthy households would retain their 15 and 18 MPG vehicles while lower income households migrated to vehicles getting 22, 27 and 33 MPG). If the price of vehicle fuel is $2.88 per gallon, the average percentage of household income spent on vehicle fuels would only be .42 percent of income. That's the kind of figure the media likes to quote in its "sound bite" news broadcasts. The average expenditure doesn't appear to be too bad. But unfortunately for a household having an annual income of $25,000, the cost of vehicle fuel actually increased from 1.75% of income in 2003 to 3.49 % of income in 2005. That's over $870 ! And households with an income of $50,000 will have to spend over $1,000 on vehicle fuel.

And how about the guy who wants to keep his beloved pickup truck that gets 15 MPG? If his household is in the $25,000 bracket, he'll have to pony up almost 8 percent of his household income for vehicle fuel.

Sorry.

But vehicle fuels are only part of the inflation story. These 112,000,000 households also heat their homes and buy other products made where oil is either consumed as a raw material or used in the production process. The big nut is heating oil and its natural gas equivalent, followed by oil intensive products (fertilizers, chemicals, lubricants, and so on) and products whose manufacture uses relatively small amounts of oil. Taken in the aggregate, America's economy consumes 3,450 gallons (or 82.1 barrels) of oil per year per household.

Non vehicle oil costs probably add over $1,000 (or 4 percent) per year to the budget of a household making $25,000 per year. They will add over $1,800 (but less than 1 percent) to the budget of a household making $275,000 per year. For households making $50, $100, and $200,000 per year, the percentages are 3, 1.5, and less than 1 percent, respectively.

The bottom line. If we add the annual cost of vehicle fuel oil consumption to the cost of non vehicle oil consumption, and if oil prices hold at the levels experienced during the first quarter of 2005, then American households � on average � will spend just over one percent of their income on oil. That's the figure we will see in the media. It's the same logic described in the first paragraph of this article. But for households making $25,000 per year, that number jumps to more than 8 percent of their annual income, and it's almost 6 percent for households in the $50,000 income bracket. The Law of Unequal Distribution shows us that at these prices, households in the lower two income groups (56% of American households) will be forced to make serious adjustments to their spending habits.

The Impact

Still think oil price increases aren't inflationary?

Well, here is another reality. Any claim that an increase in the price of oil will not drive up inflation is based on the implicit assumption there is no shortage of oil. Bad assumption. Shortages are coming. Competition for available fuel will drive up the price (as it has already done in 1974 and 1979). For manufacturers and retailers, supply chain and distribution costs will increase faster than other business costs. Transportation links will be less reliable and more expensive. Suppliers of both goods and services will be forced to develop business models that use less transportation. Logistics productivity will decrease.

It's all inflationary.

For a country like the United States, there will be an outsized impact. This economy, and the business models of its individual enterprises, has been built on the assumption of readily available and low cost fuel. Both assumptions are now false. Depletion induced oil shortages will occur. Higher fuel prices are inevitable. Decreasing transportation flexibility translates into higher production and distribution costs. Just-in-time delivery will gradually migrate to local warehousing operations. Production will move closer to the consumer. Inventory costs will increase. Retail consumer traffic patterns and buying habits will change. Food costs will go up. The list of probable change is very long. Oil dependent enterprises will be forced to make significant changes to their business model

� or perish.

But the real change will be at the consumer level in the chain of distribution.

Productivity will decline. That drives up inflation. In an effort to drive down their costs, suppliers will attempt to accelerate their use of computer based inventory management systems and the Internet for consumer distribution. On-line transactions can be tracked in order to tighten the distribution channel and reduce the need for excess inventory. Consumers will be encouraged to make their purchases from the suppliers WEB site, rather than drive to the store. Home delivery services will proliferate. Companies such as Wal-Mart, Federal Express, Ford, and McDonalds will be forced to make a fundamental change to their business models.

Unfortunately, there is a limitation to the substitution of on-line transactions for in-person shopping and distribution. Because the Internet suffers from the imbedded faults of an inadequate architecture, defective software, and a deficient network, America lacks the communications infrastructure to fully substitute on-line interaction for travel. Why? Congress has thus far failed to establish a credible communications policy. Our representatives refuse to recognize the realities of the economic and cultural challenges that face us.

Too bad. If Congress was on the ball, we could avoid a lot of headaches.

Based on an average annual price of $41 per barrel, my model projects that the year-over-year change in the consumer price index (CPI-U) for 2005 will be a modest 3.1% because deflationary pressures are also working their way through our economy. Higher interest rates, a decrease in the rate of economic growth, and our policy of exporting jobs in exchange for low cost goods and services all tend to retard inflation. If oil continues to sell for more than $50 per barrel, however, the rate of inflation will be higher and the Fed will be forced to accelerate its pace of interest rate increases. (Please note: the economic impact of oil production, consumption and pricing on inflation, unemployment and GDP is detailed in my book "Oil, Jihad and Destiny").

Speculation and shortages will push up the price of oil. Speculation and surpluses will drive the price down. But the impact of oil depletion guarantees that the long term price trend is UP. Obviously something has to give. The consumer will have to make choices. Shoes for the kids or gasoline for the car? Meat on the table or fuel for heat? Make an impulse purchase at Wal-Mart or pay the rent? It's going to be rough. Tight spending control for two thirds of American households.

Or go broke.

They aren't going to be happy.

And a final note. The model I developed for the American economy can be applied � with some revision of the assumptions � to the economy of any industrialized nation. Japan, France, Australia, South Korea � it doesn't matter.

Inflation knows no borders. It will be everywhere.

© 2005 Ronald R. Cooke
The Cultural Economist
Author, "Oil, Jihad & Destiny" and "Detensive Nation"
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