Why oil prices will spike again soon

How long till the next oil shock?

Energy prices have been coming down this spring as fears of a Middle East blowup fade. But persistent global demand, tepid supply growth and easy money mean it may not be long till the next damaging spike, Goldman Sachs economists say.

Higher and higher

Oil prices could surge again by the end of 2012, economists Jan Hatzius and Andrew Tilton wrote in a note to clients this past weekend. They say the snail-like pace of global oil supply expansion – which Goldman projects at 1% or so annually – can’t keep a petroleum-addicted world economy rolling without prices rising, perhaps sharply.

So don’t get too used to paying a mere $3 and change for gasoline. Higher prices are on the way soon enough, thanks to stretched supplies and a Federal Reserve spigot that is likely to remain wide open for years to come.

“The fundamental story of increased oil scarcity is unchanged, and our commodity strategists now see distinct upside risks to their current forecast of $120/barrel for Brent crude by late 2012,” Hatzius and Tilton write. “So the impact of scarcer oil and higher oil prices on economic activity remains at the top of our list of worries.”

What makes higher oil prices almost inevitable is the depth of the jobs deficit in the United States. Unemployment is officially 9% but is more like 13% if you consider the low rate of labor force participation, says Bernstein Research strategist Vadim Zlotnikov. That number has fallen this year to levels not seen since 1985.

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High joblessness and weak inflation will keep the fed funds rate near zero at least through next year and perhaps longer, Hatzius and Tilton write. That should help keep pushing unemployment slowly toward its long-run average of around 6% — but at the expense of further dollar depreciation, stronger global demand and, ultimately, higher oil prices.

So the selloff that has taken the crude price down to $100 or so in New York and $112 in Europe, where Brent is traded, may persist through much of 2011. But it won’t last forever, Goldman warns.

“The only way to bring both the labor market and the oil market into equilibrium is likely to be through a further increase in the real oil price,” the Goldman economists write. “This would presumably increase oil supply by making exploration and production more attractive, and reduce oil demand by increasing energy efficiency.”

They add that this policy trade-off is often unfairly portrayed as transferring income from the poor to the rich. The Goldman economists concede that those in the bottom fifth of the U.S. income distribution spend more of their funds on gas than do those in the top fifth, by 4.6% to 3.5%.

But they note that those losses by the poorest consumers are offset by the job creation enabled by the loose Fed policy, which “will lead to significant gains in real income for a subset of households drawn disproportionately from the lower end of the income distribution.”

And while no one is likely to turn cartwheels about higher oil prices, Hatzius and Tilton point out that there’s an obvious way for the United States to turn that trend in its favor: By imposing higher taxes on energy use.

In doing so the government could both hold down consumption (through higher prices) and boost federal revenues (which could use some boosting nowadays, you may have noticed), mostly at the expense of foreign governments that are at best our frenemies. But needless to say, something that makes that much sense has about as much chance of seeing daylight in the current Congress as the return of dollar-a-gallon gas.

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