Higher and Higher…

Oil prices keep hitting new record highs. Yesterday saw the price of oil hit $57/bbl for the first time, before it fell slightly by the end of the day. Probably of more significance is the fact that market sentiment is apparently solidfying around the idea that such high oil prices are here to stay, and in fact that they will trend still higher if anything:

DALLAS (MarketWatch) — A new forecast for world oil demand, coupled with concerns about U.S. gasoline and distillate supplies, drove gasoline to a record closing Thursday, while crude gave back gains after a 4 percent run-up in the previous three sessions.

What’s more, the forward months for crude and gasoline closed even higher, an ominous sign ahead of the summer driving season. Mike Fitzpatrick, an energy analyst at Fimat, called it a classic case of contango, which is when the front month trades at a discount to the later delivery dates.

Crude for April delivery settled at $56.40, down 6 cents, after trading at a record $57.60 a barrel. May crude closed at $56.91, June crude closed at $57.42, and July crude finished at $57.64.

…”There’s rampant speculation that there’s plenty of supply in the front, but that in the third and fourth quarters, supply won’t be able to meet demand,” Fitzpatrick said, adding that prices at these levels could serve to temper demand.

Prices are these levels certainly will have effects on demand. After all, even in inflation-adjusted terms we are now nearing oil prices that were last seen during the major oil shocks of the 1970s and early 1980s.

The following chart shows the price of oil since 1970 expressed in today’s (Jan. 2005’s) dollars. The chart shows two series: the orange line shows the real price of oil adjusted for consumer price inflation (for all items other than energy), while the blue line shows the real price of oil after adjusting for producer price inflation (also for all items other than energy). The orange line is therefore the relevant line if you want to know how expensive oil is from the consumer’s point of view, relative to all other items that consumers buy; the blue line is the relevant line if you want to know how expensive oil has become from the point of view of firms, relative to their other costs.

From the consumer’s point of view, oil is now more expensive than it was in the wake of the first oil shock. From the point of view of businesses, oil is now more expensive than at any time except for the period immediately after the second oil shock, 1980-82. Another $10 rise in the price of oil and it will be near its all-time highs in real terms.

Given these very high real prices for oil, I think that it is certain that these prices will have noticeable effects on economic activity — and thus the demand for oil — in 2005. It will probably also have noticeable effects on inflation.

Markets have seemed uncertain lately; some analysts have talked of being at or near an economic tipping point, a moment where things will soon appear substantially better or substantially worse. The continued rise in the price of oil would seem to make the latter outcome more likely.