“Toto, I’ve got a feeling we’re not in Kansas anymore”
       — Dorothy, in The Wizard of Oz

With oil prices stuck in the $90’s per barrel range, the official story is that the U.S. economy has shrugged off this year’s price increases. National Public Radio’s High Oil Prices Not Harming the Economy Yet  (November 12, 2007) duly reports that “while the price of oil affects just about everything that is made, transported, eaten and sold in the United States the cost hasn’t had the impact on the economy many people expected.” And it is true—the world has not ended yet, the economy has not ground to a halt. Things appear to be going swimmingly now, but the warning signs are there for all to read. What do the longer term trends tell us about the future?

Transportation accounts for about 66% of America’s oil consumption. Oil prices may skyrocket, but unless consumers feel the pain at the pump, there is little immediate effect on people’s everyday lives. As summer turned to fall, it seemed mysterious that gasoline prices did not rise as oil costs rose. Market conditions did not permit refiners to pass through their increased costs, so their profit margins—measured by the crack spread, the price differential between a barrel of oil and the refined products made from it—had dipped recently to about $5. This was not a situation that could go on forever regardless of where demand levels were. So the gasoline price is now jumping up.

The Houston Chronicle reports that Gas costs expected to follow oil price.

Crude oil’s march to $100 a barrel is about to hit Americans square in their wallets, bringing higher gasoline prices that could set records by year’s end…

This week, average regular gasoline prices topped $3 a gallon nationwide, the highest ever in November, despite a post-summer slowdown in driving that usually helps ease pump prices this time of year. But the full impact of the recent jump in crude prices still hasn’t found its way to the pump, meaning gasoline prices are likely to keep climbing…

“There’s no question there are more increases to come,” said Michael Wittner, senior oil analyst with investment bank Societe Generale in London. The increases come as gasoline refiners are passing through higher crude costs to customers after those costs ate into refinery profits during the third quarter.The price of crude oil, which accounts for about half the cost of a gallon of gasoline, has risen nearly 30 percent since Labor Day…

On Friday, gasoline for December delivery rose 0.7 percent to $2.46 a gallon in New York Mercantile Exchange trading. To estimate what consumers will pay at the pump, a good rule of thumb is to add 75 cents to the wholesale price for retail markup, taxes and other handling charges, Wittner said.

AAA Gasoline Prices 2007 Wittner’s formula predicts that gas prices will rise to an average of $3.21/gallon in coming weeks. On November 13th AAA listed the average regular price as $3.105, up 0.244 from a month ago and 0.778 over last year’s price on the same date (the graph left shows this year’s trend).

As noted in The Perfect Storm (ASPO-USA, October 31, 2007), oil prices (and hence gas prices) are not yet high enough to provoke major changes in American driving behavior. It is not clear at what price this will happen—perhaps $120/barrel and $4.00/gallon will cause significant changes if these are possible. The price elasticity of gasoline demand (UC Davis study) is quite low, suggesting that Americans are “locked in” to their driving habits. If this conjecture is true, consumers have little choice but to absorb the pain until costs become prohibitive. As DeMarcus Sims told the Shreveport Times about buying gasoline, “you ain’t got no choice. And I’m not fixing to walk.”

Energy Expenditures The standard explanation for why increased energy costs, and particularly gasoline costs, have not altered consumer behavior much is that energy spending is still fairly low as a percentage of all household expenditures. This proposition has been true in the past, as the measured by the Chicago Federal Reserve in Household energy expenditures, 1982-2005. The graph (left) shows the overall historical trend. The Chicago Fed found that “energy consumption represented approximately 7% of expenditures between 1990 and 2004, a decrease from 11% in the early years of the 1980s and an average of 9% throughout the 1980s.”

Note the spike in 2001 and the steady rise since 2003. The long data series says that everything is going fine, but as Dorothy told Toto, we’re not in Kansas anymore. The Chicago Fed estimated 2005 expenditures as approximately 8.5% of the household budget, assuming a price elasticity in the low case of –0.23 for gasoline, which is not in accord with the UC Davis study (link op. cit.), which estimated elasticities of 0.034 to -0.077 for the 2001-2006 period, values much lower than that assumed in the Fed’s letter.

Household Energy Expenditures The Consumer Federation of America (CFA) has been keeping a close eye on the emerging energy costs trend, and they are increasingly alarmed about the situation. The graph (left) from their study No Time to Waste (October, 2007) shows rising expenditures for energy since 2002. Household energy costs surpassed those for groceries after 2004.

Turning now to gasoline, the recent trend becomes even more compelling. Mark Cooper1, the Consumer Household Expenditures On Gasoline Federation’s data analyst, was kind enough to give us his most recent data on expenditures (graph left). The numbers given are nominal dollars. Estimates have been made for 2007 and 2008. Cooper’s analysis shows that gas costs leaped 48.8% from 2002 to 2006, an average annual increase of 9.76%. As exponential functions go, that’s a doozy!

The CFA data is based on the Bureau of Labor Statistics’ Consumer Expenditure Surveys and average yearly gasoline prices as compiled by the EIA. The 2006 average price was $261.8/gallon and has risen 52.5% since 1997. The labor statistics 2006 data indicates that transportation is the 2nd largest household expenditure after housing.

Annual Expenditures Share Effects on consumers of higher energy prices fall disproportionately on the working poor and other lower income wage-earners who are not “officially” below the poverty threshold. Who are these people? Besides the author, they are the ones cleaning up the building after hours, those who check you out of the grocery store or stock the shelves, the person who gave you that Supercut, the people who served up the large fries with that Big Mac, the people who ate the fries and Big Mac, the ones who sold you that shirt at the Gap, they are Wal-Mart’s “associates”, etc. Many of these people drive to and from work because public transport is unavailable and they can not afford to live close to their jobs. In America’s “service” economy, everyone has the right to a lousy low-paying job. 

The Chicago Fed laid out the less-than-pretty picture (graph above left). While the 1990-2004 average energy expenditure was set at 7%, the number for the entire period was 9.6% for the working poor. It is not surprising that this group led all other categories in the amount budgeted for both gasoline and electricity. It is not hard to imagine the injurious effects of gasoline price increases since 2004 on this beleaguered class of Americans. In a “service” economy, these are the people who provide the most basic services. When Forbes tells you that it’s easy Living with $3-A-Gallon gas, it’s a sure bet they aren’t thinking about the poor. At what point do the lives of lower-income people become nonviable? At the inevitable $4.00 per gallon?

Talk of a recession clouds the issues presented by steadily rising household energy costs. A recession, especially if it is severe, would temporarily interrupt the upward trend. (Driving tends to go down if you don’t have a job to go to.) The horns of the current dilemma (Boston Herold, November 12, 2007) are higher oil prices combined with lower house values now that the housing bubble has officially burst.

The economy – already reeling from a major housing slowdown and a massive financial-sector credit crunch caused by the subprime-mortgage meltdown – is in a “very fragile” state that’s now facing yet another large blow in the form of skyhigh oil prices, said Mark Zandi, chief economist at Moody’s Economy.com.

It is a continuing mystery as to why sharply rising oil prices since 2003 have not resulted in an economic downturn. No one seems to know the answer. Back in 2005, the Federal Reserve Bank of San Francisco asked Why Hasn’t the Jump in Oil Prices Led to a Recession?  Noting that prices are riding the rising tide of Asian demand, the San Francisco Fed, in agreement with the IEA’s 2007 World Energy Outlook about the causes, had this to say—

Our discussion suggests that the answer to the question posed in the title has two parts. First, looking only at the correlation between some measure of the price of oil and output tends to exaggerate the role that oil price shocks played in the recessions of the 1970s, at least partly because one ends up ignoring the other things that were going on at that time. Second, an increase in the price of oil that reflects higher demand will not have the same effect as a decrease in supply. Here, though, it is useful to keep in mind that price increases that reflect higher growth in other countries will have the same effect on the U.S. as price increases that reflect a reduction in the worldwide supply of oil—unless  U.S. exports to these fast growing countries account for a significant share of U.S. output. [emphasis added]

So the Fed’s 2005 study concluded that if it walks like a duck and quacks like a duck, it must in fact be a duck—which leaves us where we started. What the Fed did not know in 2005 was that oil supply levels have been a bumpy plateau since they did their analysis. In any case, it appears that household energy expenditures are now rapidly playing catch-up with levels last seen in the 1970’s and early 1980’s. When those levels are eventually reached, a recession driven by energy-related inflationary pressures and lower overall demand by exhausted consumers seems inevitable. Welcome to the future.

Contact the author [via the original article].

1. I’d like to thank Mark for giving me the new unreleased data set. The new analysis is an update to his The Impact of Rising Prices on Household Gasoline Expenditures published in 2005. The older document shows a very strong correlation between gasoline prices and household expenditures in the 1998-2003 period, which is hardly surprising. Thus projections can be made based on the expectation that this correlation remains strong in future years.