No need to scream

The Business: Wednesday, 31st October 2007

No need to scream

By Philip Thornton

Like a precocious child seeing how long it can hold its breath, the world economy has remained defiantly indifferent to the relentless rise in the price of oil. Hardly a day goes by without West Texas Intermediate, the light crude that is the market benchmark, hitting new records. Oil for December delivery reached a trading peak of $93.20 (£45.46; €65.63) a barrel on the New York Mercantile Exchange earlier this week. It is just a matter of time before it smashes through the symbolic $100 barrier.

The Cassandras who thought sky-high oil prices would derail the world economy and stock markets have been confounded. Share prices are back on a strong rising trend, at least for the time being, while global growth is predicted to be an encouraging 4.8% next year, according to the International Monetary Fund (IMF) – not as high as previously expected but close to a record rate (the IMF’s slight downward revision to its previous forecasts was due to problems in the American housing market and the global credit crunch rather than because of any oil price-driven slowdown).

Inflation remains under control, overall, despite the pressure from higher oil and petrol prices. The IMF cut its outlook for consumer price inflation in the advanced economies by 0.1 percentage points to 2.0%. This would have been unimaginable three decades ago when prices soared in the wake of the Iranian Revolution and Iran-Iraq war, let alone in the early 1970s when the oil-exporting cartel, Opec, imposed an embargo on the West in response to its pro-Israel policy.

A common notion, based on the experience of the early and late 1970s, is that oil price shocks trigger bitter recessions and double-digit inflation. But since 2002 the world has seen a threefold rise in oil prices and average growth in world gross domestic product (GDP) of almost 5% a year. Clearly this “common notion” needs to be revised.

The laws of economics have not changed, but the world economy has – dramatically so. It is now much better able to cope with a gradual, largely demand-driven increase in the price of oil. An IMF simulation of a repeat of a doubling in oil prices shows world GDP slowing at worst by 1.4 percentage points before returning to normal after two years. Inflation rises by 1.5 percentage points at worst, but the spike only lasts a barely noticeable five months.

The shocks of the 1970s were caused by an abrupt and overwhelming reduction in supply; now it is a gradual increase in demand – punctuated by regular hits to supply – that drives prices. Demand-driven shocks are much more gradual and allow the economy to adjust; the supply-side problems have remained manageable; and Opec has played almost no role in the recent spike.

The International Energy Agency (IEA) forecasts global demand will be 85.9m barrels per day (m/bpd) this year; next year, demand will jump to 88m/bpd. But supply is forecast only to rise from 85.2m/bpd to 85.6 m/bpd, leaving a shortfall of 700,000/bpd this year and 2.4m/bpd next year. Oil reserves are also at low levels. Last week America’s Energy Information Agency (EIA) said stocks had shrunk by 5.29m barrels in the week to 19 October to 3.17m, against forecasts of a 963,000 barrel increase.

The growth in demand is being driven by the booming emerging economies and the China effect, in particular, is key to understanding why oil is set to hit $100. The OECD estimates China contributed 24.3% of extra oil demand between 1995 and 2004, more even than America’s 20%. According to the IEA, Chinese demand will reach 7.6m/bpd in 2007 (up 5.7%) and 8m/bpd in 2008 (a further 5.6% rise). India’s oil demand is expected to rise 4.6% in 2007.

The increasing price of oil is a result of economic success, especially in Asia, rather than the cause of economic failure, as it was 30 years ago in the West. For all the credit-crunch and housing-related problems, the world economy is in a robust condition in 2007; by contrast, it was already in such a weak state in the late 1970s that it did not take much to cripple it.

Today’s story is not purely about demand. The tensions between Turkey and Kurdish militia in northern Iraq have contributed to the most recent spike, as traders speculate on America being dragged into the dispute. Fears of an American/Iranian war have in small part been priced into the market; there could be a lot more to come on that particular front.

The collapse in the value of the greenback, which is now trading at around $2.06 against sterling and $1.44 against the euro, is another reason why the price of oil has gone up. Because oil is denominated in dollars, a weaker greenback cuts revenues for oil exporters (apart from those Middle East states whose currency is pegged to the dollar). So producers jack up their prices.

Western economies today are far less dependent on oil, thanks to a relative decline in manufacturing and the expansion of the services sector. This reduces both the direct effects on inflation and the medium and long-term effects on GDP.

Asia is more reliant on manufacturing; but China and India’s underlying robustness is such (and their overall cost base still relatively so low) that they have been able to ride out the storm. The eurozone has partly been cushioned by the slide in the value of the dollar against its currency; a large part of oil’s appreciation has been cancelled out. For Britain, which remains close to self-sufficient in oil, gains and losses broadly cancel out.

Many countries have implemented reforms that have increased flexibility in their labour and product markets, making it easier for relative prices to adjust to oil shocks. Inflation also remains tame because central banks are now expected to raise interest rates promptly to prevent a ratcheting up of inflationary expectations and a spill-over into wages and prices, as happened in the 1970s.

Taxes on petrol are higher than they used to be. That reduces the impact on the consumer of a per-barrel rise in the oil price, even if petrol now retails at around £1-a-litre in Britain. American consumers, who enjoy much cheaper petrol, are more exposed; to them, the surging price of oil acts like a tax on disposable income, which helps to explain why American retailers are suffering more than their British counterparts from the current troubles.

How high would the price of oil have to go to inflict real pain on the world economy? Nobody really knows; but the most likely trigger for another massive surge above the $100 level would be an attack by America or Israel on Iran to prevent it from going nuclear.

Stephen Lewis, chief economist at Insinger de Beaufort bank and one of the few remaining senior figures to have worked in the City since the early 1970s, puts the unbearable pain threshold at around $150. Intriguingly this is the level Jim Rogers, the investor who predicted the start of the commodities rally in 1999, said oil could reach within the next six years back in January.

It is hard to judge how high oil prices are today relative to past levels. They are, of course, at a record in nominal dollar terms; but accounting for inflation and the shifting value of the dollar makes the calculation of the real price harder. Economists now think that the previous peak would be worth between $100 and $110 a barrel in today’s money, suggesting that the world will soon enter virgin territory; but that calculation has been significantly altered by the 40% fall in the dollar so far this century. In 2000 the OECD estimated the record real price at less than $80 a barrel.

The obvious winners from high oil prices are the Middle East and Russia, whose governments have built up large sovereign wealth funds on the back of oil revenues and are now planning to snap up vast amounts of assets around the world. This may be an uncomfortable reassurance for the West, but if there were an economic slowdown these funds, which are estimated to have $3 trillion under management, would act as a powerful counter-cyclical force on the world economy.

Oil consumers and importers should respond to the soaring price of oil in two ways: they must continue exploring for new sources of oil while seeking alternative sources of energy.

Higher oil prices have made it more economic to search for new oil reserves while technological advances have reduced the cost extracting it once it is found. It has become easier, for example, to exploit oil sands in areas such as the Canadian Athabasca tar sands, which is estimated to contain 1.7 trillions in reserves, and the Venezuelan Orinoco oil sands with 1.8 trillion. According to one estimate, demand for oil sands is expected to reach 10.31m barrels next year, up from 8.59m barrels in 2003, equivalent to an average annual growth rate of 3.7%.

The obstacle is the extraction process that requires large quantities of natural gas to steam the oil out of the sands and the vast network of pipes needed to deliver the oil. But in less than 20 years of mining and upgrading, production costs have been cut in half. Oil sands are seen as break-even with oil at $20 a barrel and, since crude prices breached $60, there has been a rush to invest reminiscent of the Klondike gold boom in the late 1800s.

The leading alternative energy sources are biofuels. In recent years some have become increasingly competitive, notably ethanol from sugar cane in Brazil and biodiesel from palm oil in America. A litre of ethanol costs 18 cents to make and biodiesel 40 cents, compared with 50 cents for gasoline. But biofuels have their problems: it would take far too much land and resources to provide enough fuel to replace oil completely.

Far more promising in the long run is a combination of greater use of nuclear power for general energy needs (which the Government should encourage, especially in Britain) and hydrogen fuel cells for cars. Honda, the Japanese car maker, is launching the first mass market hydrogen cars at the Los Angeles motor show later this month. It will cost £50,000, have zero carbon emissions, will reach 100mph and cover 270 miles between refuelling stops.

The trouble, of course, is the complete lack of any hydrogen refueling infrastructure. If governments were really serious about moving away from oil, they would extend ultra-generous tax breaks to the car and oil industries to develop proper hydrogen provision at petrol stations (it could even divert some of its huge petrol tax receipts to that end).

Fans of Edvard Munch, the expressionist painter, should relax: the modern economy has the wherewithal to thrive even at oil at $100; and by providing incentives to generate new sources of energy and economise on oil, such elevated prices could even be a blessing in disguise. There is no need to scream.

http://www.thebusiness.co.uk/the-magazine/cover-story/313281/no-need-to-scream.thtml

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