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FT REPORT – WEEKEND MONEY: Oil leaves a bad taste in the mouth

By John Authers, Financial Times
Published: Nov 10, 2007

Oil price spikes can hurt. Ask anyone who can remember the 1970s. Then, two sudden increases in the price of oil, in 1973 and again in 1980, both led to recessions and surges in inflation.

What we are living through now looks an awful lot like an oil price spike. Using West Texas Intermediate (WTI) crude as a yardstick, oil prices have risen more than 90 per cent since January, when unseasonally warm weather in the US pushed prices down.

Longer term, the rise is stunning. Since prices bottomed in 1999, at about $12 per barrel, they have risen sixfold, even after inflation is taken into account. That is much the same as the rise from the low in 1973 to the high in 1980.

And yet the world’s stock markets are up since January (in spite of the returning extreme credit fears of the past few days), and the world’s economy has been in incomparably better health than it was in the 1970s. Why has a rising oil price lost its power to chill the economy?

First, and most obviously, the world has changed. Economies are less reliant on oil than they were 34 years ago. Industry is far less “oil-intensive”. As Peter Hooper and Thomas Mayer of Deutsche Bank point out, companies do not need oil in order to grow, or at least not nearly as much as they did in 1973.

Second, they say, inflation has been tamed since then. Central banks have slain inflation expectations. The contrast with the 1970s is obvious.

Third, the causes of this oil spike look different. A rise in price can be caused either by tighter supply (as very obviously happened in 1973, thanks to the Opec embargo), or rising demand.

Threats to supply, such as hurricanes in the Gulf of Mexico, political unrest in Nigeria or conflagrations in the Middle East, still cause sharp short-term increases in the crude price.

But the long-term rise this decade seems to be about demand. Rob Carnell of ING points out that much of it can be put down to China. By the end of last year, marginal Chinese demand for oil had reached 72 per cent of the total growth in oil consumption. This sounds like such extreme pressure from demand that it really does account for the rise in prices.

Economically, this is more benign than a supply shock. It implies that the oil price is reacting to economic growth, not impeding it.

Veronique Riches-Flores, of Société Générale, suggests an “oil burden index” that tracks global oil consumption, multiplied by the oil price, as a proportion of global gross domestic product.

This measure shows that the oil price imposed an abnormally low burden on the economy in the late 1990s, and that oil prices have risen in line with GDP since then.

Further, the upward gush in crude prices has not been passed on at the forecourt. Crude is up more than 90 per cent since January, but gasoline is only up about 70 per cent. This damps the impact on the consumer.

Add in the fact that this decade’s rise in oil prices has been far more gradual than in the 1970s, when the world suffered two sudden shocks, and it becomes clear that, to date, high oil prices have been much less of a problem.

In the UK, we can also take some comfort from the fact that problems caused by expensive oil are concentrated on the other side of the Atlantic.

The continuing extraordinary weakness of the dollar is linked to the rising oil price: oil exporters tend to be paid in dollars and then immediately diversify into other currencies.

In dollars, WTI is up more than 260 per cent since the invasion of Iraq in March 2003. In euros, it is up about 180 per cent.`

In addition, American consumers’ far greater propensity for guzzling gasoline, combined with lower US taxes on fuel, mean that rising oil prices have a much greater impact on consumer spending and inflation. In the US, “headline” inflation – incorporating fuel and food – fluctuates wildly compared with “core” inflation, which excludes them. The measures differ in the UK, too, but they are much more closely in alignment.

So if the high oil price is an economic problem, it is a much bigger problem for the US than for everyone else.

However, even with the rest of the world possibly “decoupling” from the US economy, bad news for the US is still bad news for the rest of us.

There is also disquieting evidence that, even with all the modern mitigating factors, the oil price may now have reached a level that is more than the world can bear.

The latest spurt in oil prices has happened against a backdrop of signs that economic growth is slowing. That is concerning. It seems to have been carried to its current level by continuing huge speculative demand from investors.

According to Riches-Flores, if crude averages $85 per barrel for a year (which will require it to stay at the current levels for several more months), then the oil burden index will get back to its level of the late 1970s – and hence we can expect it to start having a negative effect. “Stagflation”, the union of inflation and stagnation, becomes conceivable.

Even with improved efficiency in refineries, US motorists now have to pay more than $3 per gallon for petrol – a level that could be psychologically important.

And the upward pressure that puts on US inflation deters the Federal Reserve from cutting interest rates. That is potentially extremely bad news for everyone, because the crisis of confidence in the US financial system, provoked by the credit squeeze, is back – as can be seen from the sharp sell-off of bank stocks this week. But the oil price limits the Fed’s ability to respond to the problem.

This is not a repeat of the 1970s, but if oil prices stay this high they will contribute to a new kind of crisis for a new decade.

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