Oil - $100/bbl

Mr Morse · April 11, 2005

Folks,

An interesting and informative editorial by David Smith of the Sunday Times about the recent hike in the oil price. I have worked in the upstream oil industry for almost 20 years now and have seen nothing like this. It is reality and is going to happen.

Economic Outlook: David Smith: Why we aren’t skidding on sky-high oil prices

"AT FIRST it was a curiosity. When oil prices rose above $30 a barrel before the invasion of Iraq two years ago, we knew they were following a familiar pattern. Sure enough, once the statues of Saddam Hussein began tumbling, so did the oil price, dropping below $25 a barrel.

But that did not last either. Rather than settling at a non-crisis level, and indeed within the Organisation of Petroleum Exporting Countries’ target range of $22 to $28, the oil price began a fresh climb and hit $40 a barrel a year ago.

That, you might have thought, was that. But it wasn’t. North Sea Brent hit the giddy heights of $50 a barrel last autumn, subsided a bit over the winter, but has been above $55, before dipping late last week. But prices could rise again.

In an eye-catching report, Goldman Sachs suggests that oil prices could “super-spike” to more than $100 a barrel, with US crudes reaching $105 or more. This, it should be said, contains many ifs and buts, and is not intended to be the firm’s main forecast. But even its base case has Brent crude averaging $50-$55 a barrel this year and next, before coming down in 2007.

These are big numbers and raise key questions. Why haven’t prices at this level caused more obvious economic distress? Oil has been associated with some of the great economic disasters of the past, so why not now? Will there be a big impact on growth, or inflation, or both? Oil plays a central role in the economy: petrol is perhaps the most visible price. People who could not tell you the cost of a loaf of bread would have a fair stab at the price per litre of unleaded. Unless you drive with your eyes closed, never sensible, petrol prices are hard to avoid.

The same is true in America. Petrol is already above $3 a gallon.The threatened rise to $4 is a “nightmare scenario” the White House has been studying, not least because it looks as though it might come true.

Alan Greenspan joined the fray a few days ago, referring to the lack of global refining capacity as “worrisome” but predicting that the “price frenzy” would subside. The Federal Reserve Board chairman also offered the fascinating statistic that 11% of the world’s energy consumption was by vehicles on US roads.

Although Britain is also more car- dependent than ever, and the government admits it will miss its target for cutting carbon-dioxide emissions to 20% below 1990 levels by 2010, oil has less of an economic impact here than it had in the past.

The “oil intensity” of gross domestic product in Britain has declined by more than 60% since 1970. This does not mean that oil demand has dropped by that much. The economy is much bigger, and so is our demand for oil.

It does mean that the ratio of oil consumption to GDP has dropped. So, whereas in the past a 1% rise in GDP was associated with roughly a 1% rise in oil demand, now it means a 0.4% rise. Oil intensity has also dropped, though by slightly less, in other industrial countries.

The reasons are familiar. Industry in general, and heavy industry in particular, has been in retreat, replaced by a less energy-intensive service sector. Energy efficiency has improved; in the past quarter of a century average new-car fuel consumption has fallen by 25%.

It does not mean, emphatically, that high oil prices are an economic non-event. But it does mean we should think about them differently. Higher oil prices push up inflation, and the extent to which this becomes a problem depends on so-called second-round effects; the extent to which they are reflected in higher wages, for example.

Rises in oil prices also reduce growth, particularly in a world where most firms (except the oil companies) find it hard to pass on cost increases. This reduces profits, investment and employment.

Last year the International Energy Agency, together with economists from the Organisation for Economic Co-operation and Development and the International Monetary Fund, carried out simulations on the effect of a sustained $10 rise in the price of oil, from $25 to $35 a barrel.

It suggested that industrial countries’ GDP would be reduced by 0.4% in the first year and by a further 0.4% in the second. Consumer prices would be 0.5% higher in the first year and 0.6% in the second.

Applying this to the $30-a-barrel rise we have seen, assuming that it sticks, would hit economic growth by 1.2% a year for two years, and push prices up by 1.5% to 2%. In a low-inflation world that would be a big hit.

If oil rose to $100 a barrel and stayed there for any length of time, a global recession and much higher inflation — stagflation — would be what the models predict.

Why, with oil well established in the $50-plus range, are we not seeing many of these effects so far? The models could be wrong, although the IEA stressed that its approach was conservative. It may be too soon. We do not yet know whether $50 will stick, let alone that the super-spike to $100 feared by Goldman Sachs will come to pass.

Perhaps, too, policymakers have become more sensible. In the past, higher oil prices would have had central bankers quickly responding with interest-rate rises, thereby exacerbating the impact on growth.

Both the Bank of England and European Central Bank left interest rates unchanged last week. They recognise that dearer oil is a brake on growth. The last thing the economy needs is a heavy foot on that brake."