Interesting article:
ft.com
Markets News / Commodities
OIL: A barrel of woes
Could hopes for another strong year of economic growth
be dashed by high energy costs? Ed Crooks reports as
oil prices rise to a nine-year high
One of the greatest worries caused by the millennium
bug last year was that it would disrupt energy supplies.
Survivalists pictured themselves roaming the
post-apocalyptic wilderness in search of fuel; more
rational worriers fretted about empty tanks and queues at
the pumps. That was one of the explanations offered for
why the price of oil trebled last year.
But even though the turn of the millennium has come and
gone with minimal disruption, the oil price has pressed
on relentlessly upwards.
Businesses and policy makers are getting an
uncomfortable reminder of oil's role at the heart of
economic activity. As oil prices reached a nine-year high
last Friday - at $29.66 for Texas crude and $26.35 for
Brent crude - the surge brought fears of a global
economic slowdown.
It is sometimes claimed the modern world runs on
information, not oil. This year may be the year that puts
that claim to the test.
The fundamental force driving the oil price higher is an
intersection of demand and supply that is exceptionally
favourable for producers. A strengthening world economy
has led to growing demand, while the Organisation of
Petroleum Exporting Countries has since last February
been able to hold the line on agreeing to limit production.
The latest surge in prices came after Saudi Arabia
suggested it saw no reason to expand production when
the agreed cuts formally expire at the end of March.
After the announcement, the US government apparently
decided it could no longer afford to stand aside and
watch. Bill Richardson, the US energy secretary, is to
meet officials from Mexico and Venezuela at the end of
this week and visit Saudi Arabia next month.
"The US government is concerned on two levels", says
Heather Rowland, oil strategist at Warburg Dillon Read in
New York. "There is the political reaction of consumers,
especially worrying in an election year, and there is the
potential issue of inflation."
Inflation may be the first to strike. As the north-eastern
US shivered under several inches of snow last night,
Americans were seeing big rises in the price of domestic
heating oil.
The retail price of diesel fuel rose 10 cents a gallon last
week. Many airlines, including American and United,
have imposed fuel surcharges. Federal Express has also
imposed a surcharge, and UPS has raised prices.
For some, these rumblings are echoes of the greatest
cataclysms to hit the economies of the developed world
since the second world war: the oil shocks of 1973 and
1979.
Professor Andrew Oswald of Warwick University has
pointed out that there is a remarkably strong correlation
between the price of oil and US unemployment. The
three world recessions of the past three decades - in the
mid-1970s, the early 1980s and the early 1990s - were
all preceded by a big jump in the oil price.
"Energy and people make everything in the world," he
says. Prof Oswald argues that when oil becomes more
expensive, real wages have to fall so that companies can
restore their profits. To drive real wages down,
unemployment has to rise. So an oil shock leads to both
higher inflation and higher unemployment.
Other economists would argue that the rising price of oil
was far from the only problem the developed world faced
during the 1970s - the structural rigidities of Europe and
the cost of the Vietnam war were others. But nobody
disputes that the oil shocks were greatly disruptive.
It seems less likely that this latest rise in oil will prove
equally significant. The rise has been from a very low
level - a year ago, oil was at its cheapest in real terms
since the second world war.
"If you plot the real oil price, we are still just about inside
the range we have seen during the 1990s," says Andrew
Sentance, chief economist of British Airways. "The worry
would be if prices went further."
Most western oil companies believe prices are unlikely to
climb much higher. The majority are still requiring new oil
field developments to yield an acceptable return at oil
prices of about $15-$20 a barrel.
The oil futures markets is also betting that current levels
will not be sustained: the Texas crude future is down to
$21 a barrel for the end of the year, and $19 for the end
of next year.
In any case, oil is less important to western economies
today than it was in the 1970s. In the US, oil
consumption is expected to be about 2.3 per cent of
gross domestic product this year; in the 1970s, it was 5
per cent of GDP.
"Oil's share of developed countries' energy use was
53-54 per cent at the beginning of the 1980s. Now it is
down to 40 per cent - that's a very substantial decrease,"
says Fatih Birol, head of economics at the Paris-based
International Energy Agency.
British industry, for example, now uses mainly gas and
electricity, itself mainly generated using coal and gas.
Unlike oil, gas and coal prices have been stable or falling
over the past year.
And structural reform in many countries may mean that
adjustment to a higher oil price can be quicker and less
painful. "The whole wage-setting environment is different
now," says John Llewellyn, global chief economist of
Lehman Brothers. "In the 1970s, we had formal wage
indexation in many countries, and de facto indexation in
many more."
The more relaxed view about the effects of the oil price
rise is reflected in the thinking of the European Central
Bank. Although figures out today are expected to show
another jump in euro-area inflation, the ECB argues in its
latest monthly bulletin that a rise in oil prices "should not
give cause for concern regarding higher inflation of a
more permanent nature".
Not everyone is so sanguine. Mr Birol of the IEA warns
that "despite the declining share of oil, it is still
significant. Businesses and consumers are making
decisions based on oil at $20 a barrel; if they start to
think it will be $30, it could change behaviour
significantly".
Furthermore, companies are already beginning to suffer.
Huntsman, the privately-owned US chemical company
which last year bought many of ICI's manufacturing
businesses, says its costs over the past 12 months have
nearly trebled.
If the price of oil fails to fall as analysts expect - which is
quite plausible considering how poor their recent
predictions have been - then the economic effects could
be severe.
"A standard economic model says that if the oil price
stays around $30 rather than falling to $22, it will add 0.4
percentage points to inflation this year, and one
percentage point next year. Oil has the potential to upset
the cosy consensus that say inflation will stay low,"
says Gerard Holtham, global strategist for Norwich Union
Investment Management.
The US and Europe, he says, benefited from low and
falling prices for oil and other commodities triggered by
the 1997 Asia financial crisis, which gave them room to
grow while keeping inflation low. Now a potential oil
shock could hit the industrialised world at a time when
labour markets are tightening. "If producers are
expecting prices to be higher, then they will be less
inclined to resist higher wage claims", says John
Llewellyn of Lehman Brothers. "And that could be the
beginning of a wage and price spiral." That, in turn, would
undoubtedly provoke central banks to raise interest
rates.
"Unfavourable supply shocks are the worst thing to deal
with as a central banker: they make it very hard to get
the right policy," Prof Oswald says.
And though no one is expecting the next decade to be a
reprise of the 1970s, the rising oil price is a warning that
assumptions of a new era for the world economy could
yet be overturned.
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