Oil prices are rising again: benchmark crude oil futures finished last week at $75.57 a barrel, up 50% since early 2007. This sharp rise in oil prices suggests several questions: what is driving this increase in prices? How much higher will oil prices go? What is the relation between high oil prices and the weakening US dollar? Will high oil prices hurt US and global economic growth? Let us consider the possible answers to these questions.
 

First, the reasons for this increase in oil and energy prices are by now well known: demand is rising rapidly as the global economy is growing at a sustained rate and as the BRICs and emerging market economies are growing at a very rapid rate. At the same time, the supply/production of new oil is not rising as rapidly as demand: concerns about how permanent the increase in oil prices are, geostrategic and political constraints to greater investment in exploration and production in a number of unstable countries, constraints to refinery capacity in the US and elsewhere are keeping both oil and gasoline prices high and rising. Also, while rising demand is most driven by economic fundamentals, the possibility of a bubble in oil prices cannot be ruled out: speculative demand for oil and other commodities is high (based on CFTC net speculative long positions) and a potential additional driver of higher prices. 

Second, how far higher will oil prices go? The simple answer is that we do not know. However, considering the economic fundamentals is likely that oil prices will rise further for the rest of the year and beyond as conditions of strong demand and tight and inelastic supply are likely to persist. A Goldman Sachs analyst famously predicted in 2005 oil to get to $100 by 2009.  This blogger discussed the potential for a secular sharp increase in oil prices towards $100 in a 2005 note. A number of analysts are currently arguing that oil prices may soon rise above $80 (as suggested by Richard Berner of Morgan Stanley today) or even reach $100 this year (as suggested by other analysts and by a variety of prices on oil option contracts; see for example the recent analysis by Jeffrey Rubin at CIBC). The main factor that could lead to a meaningful fall in oil – and other commodity - prices ahead would be a sharp US economic slowdown that leads to a global economic slowdown. While such a US slowdown cannot be ruled out, the issue of whether the rest of the world would decouple from such a US slowdown remains open.

Third, what is the relation between high oil prices and the weakening US dollar? This is a complex issue that has many angles to it. Brad Setser has recently discussed this question pointing out that while oil exporters’ asset preferences are still biased – if less than before – towards dollar assets, their spending/consumption preferences are biased towards European rather that US goods. So, the effect on the US dollar of higher oil prices depends on how much of the oil windfall is saved rather than spent.  Richard Berner suggests three channels of interaction between the US dollar and oil prices: a lower dollar reduce the purchasing power of oil exporters over non-US goods; second, oil producers facing such a loss of real income may decide to restrict their production of oil to push up the oil prices (see also today's FT on this point); third, oil exporters may be diversifying their portfolios away from dollar assets, partly because of return consideration, partly because of the geopolitical risk of directly holding US assets. As he puts it: “we believe that the interplay among oil prices, the dollar, and the responses of oil producers may create a vicious circle in which both oil prices and the dollar overshoot.  Brent crude may rise past $80/bbl and the dollar may continue to weaken, and those moves could elevate US inflation.  While US Treasuries are rallying as investors focus on the meltdown in credit, the oil-dollar link may limit or reverse the attractiveness of US bonds.  Here’s why. The oil-dollar link is impossible to prove because the evidence for it is only circumstantial.  However, the logic for each of the three parts in the circle is solid, in our view.  First, the orderly decline in the dollar is reducing the non-dollar value of oil producers’ receipts, and thus of their purchasing power.  Second, Eric Chaney and I think oil producers are trying to offset that purchasing power lost to a weaker dollar by restraining crude supply, thus keeping prices high.  Finally, we and Stephen Jen believe that oil producers likely are diversifying portfolios away from the dollar to hedge returns and, for some, in response to worries about the possibility that USD assets might be frozen or confiscated.”

Indeed, given the rising political constraints in the US towards inward FDI or strategic equity investments, it looks like the Chinese and the Middle East official investors and sovereign wealth funds are now showing greater preference for non-US assets: China and Singapore are financing a chunk of the Barclays acquisition of ABN-Amro; Qatar is planning to increase its strategic investment in a leading UK retailer; Dubai just agreed to purchase a controlling stake in Auckland International Airport. Note that significant diversification by sovereign wealth funds into assets with higher yield than government bonds (such as equities) does not affect the value of such countries’ currencies relative to the US dollar only as long as such diversification still goes into dollar assets or US assets. Conversely, diversifying away from dollar assets will put further downward pressure on the US dollar, for any given rate of reserve accumulation.
 

Finally, will high oil prices hurt US and global economic growth? The conventional wisdom is that high oil prices are consistent with sustained global growth – as they have been in the 2004-2006 period – if they are driven by high global demand growth. Also, the income windfall of high oil prices for oil exporters – if mostly saved – will keep global interest rates lower than otherwise as the excess of savings of such oil exporters (their current account surpluses) will tend to rise; then, lower real interest rates support global demand.  

Those points are correct subject to two caveats that suggest a risk of a US economic slowdown following this spike in oil prices...