Sunday, August 15, 2004
Oil prices soar again but no need to panic yet
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

Every time the oil price looks ready to lie down, up it pops again. A promise last week by Saudi Arabia to increase output provided only a brief respite. High prices, it seems, are here to stay.

Our definition of high prices, meanwhile, is ratcheting higher. The price of West Texas intermediate, the US benchmark, has risen to $46 a barrel (35 gallons), while Brent crude is above $42 a barrel. These are record levels, and represent a 50% rise since March last year, the start of the Iraq war.

Then, many hoped that prices would soon come down to $20 a barrel or below. A pessimistic view was that oil would remain around $30. But $45 has been breached, and there may be more to come. Emergent, a hedge fund manager, has been basing its strategy on $55-60 oil for some time. CSFB, in a new report, warns that prices are likely to trade in the $50-60 range, if only briefly, in the coming months.

The reasons for high prices are well known. Insecurity and insurgence in Iraq, which last week hit oil exports, has produced the opposite post-war effect to the one the optimists were expecting. There are vast unexplored tracts of Iraq, and one day it may have the scope to increase oil output dramatically; but not for a while yet.

Tight supply, in the Organisation of Petroleum Exporting Countries (Opec) and elsewhere, means prices are acutely vulnerable to rising demand from China and elsewhere. The result is that any supply shock - actual or threatened - whether it be Yukosís problems with the Russian authorities, political uncertainty in Venezuela, or the fear of terrorist attacks in Saudi Arabia have a disproportionate effect on prices.

Not only that but the current spike in prices has coincided with more than the usual soul-searching about the future of oil. Speculation about a so-called ďHubbert peakĒ for global production has intensified.

Dr M.King Hubbert was the American geophysicist who predicted in the 1950s that US oil production would peak about 1970, and was right. He also predicted, wrongly, that there would be a peak in global oil production in the mid-1990s. But some of his followers say a global Hubbert peak will be reached before 2010, while many others think it will happen over the next 30-40 years.

In the meantime, high oil prices are a reality. So why isnít there more of a panic? After all, oil has been responsible in the past for 20%-plus inflation and, in consequence, deep recession. The Federal Reserve made mention of energy prices in nudging US interest rates higher last week, but central bankers generally have been relatively sanguine about its effects.

Oil barely featured in last weekís discussion about the Bank of Englandís latest, very dovish, inflation report. If there is an inflation shock out there from higher oil prices the bank has not spotted it, implicitly endoring the marketís view that only one more quarter-point rate hike (taking the base rate to 5%) will be needed.

The inflation report, in fact, gave a pretty good explanation for why the Bank is not that worried about oil. We are used to looking at the dollar price of oil. Converted to sterling, however, the picture is somewhat different. The sterling price of Brent crude, currently just over £23 a barrel, is not yet back to where it was in the mid-1980s. In real terms - adjusted for inflation - oil hit nearly £60 a barrel in 1979-80, and is thus well below previous peaks.

Not only that but, as the Bank also pointed out, all advanced economies have become less sensitive to oil, Britain particularly so. The decline of heavy, energy-intensive manufacturing means that OECD countries use just over half as much oil for a given level of gross domestic product as in 1970. In Britain the decline has been even more pronounced - the oil intensity of GDP is only 40% of what it was just over three decades ago. Just to be clear, this does not mean we use less oil now than we did then; it does mean that oil consumption has risen much more slowly over time than GDP.

Adding these two bits of information together produces an interesting result. For high oil prices to have the same effect on the economy as in the 1970s we need to adjust both for the fact that real oil prices were higher in the past and that economies were more oil-sensitive. I calculate that it would need an oil price of £110 a barrel, or just over $200, to produce the same kind of inflationary and recessionary shocks as in the past. That would be uncharted territory and is not remotely on the agenda. According to CSFB the highest ever oil price, in todayís prices, was $95 a barrel in the late 19th century.

That does not mean the effects of higher oil prices will be negligible. An exercise by Goldman Sachs suggests that $50 a barrel oil prices, if sustained, would add 1.6% to OECD inflation. In Britain the effect is relatively modest, 1%, while in other countries the effect is larger. Developing countries dependent on oil are hit hardest. Alongside higher inflation, the effect of dearer oil will be to reduce global growth, although not catastrophically; probably by 0.7%-0.9%. In the context of a global economy growing at 4% a year this is small beer.

Before we get too relaxed, however, there is another dimension. Last week brought news that Britain had her first monthly deficit on oil for 11 years, and that British Gas has signed a £4 billion deal to buy liquefied gas from Petronas, the Malaysian energy giant, to replace diminishing North Sea gas supplies. The North Sea era is not over, but the end is in sight.

Tie that to official figures showing that Britain had a record trade deficit in goods and services of £10.8 billion in the latest three months and the picture becomes more worrying. Add in the fact that, as the Bank pointed out, Britainís share of world export markets is declining - sharply in some cases - and it becomes more so. Britainís overall world market share has dropped by 30% in the past 15 years. Outside the EU, it has plunged by 45%.

What this means is that we can no longer be as relaxed about the medium-term impact of high oil prices as when Britain was a large net exporter of oil. The more that we import, the more high prices will add to an already substantial trade deficit. The balance of payments has been the dog that hasnít barked in recent years. But it is already starting to growl in the distance. And it may come back to bite us.

PS Is Britainís job market, a source of pride for the government and support for the housing market, taking a turn for the worse? That is the view of some who scrutinise the figures. Unemployment among both men and women turned higher in the April-June quarter according to the latest Labour Force Survey, pushing the jobless total up by 27,000 to 1.44m.

Employment dropped by 53,000 to 28.3m over the same period, with manufacturing jobs down by 102,000 to 3.37m. The number of people of working age who are classified as economically inactive has risen to 7.85m, a record, up 89,000 over the latest three months.

As always in the job market the evidence is mixed. The claimant count - the old measure of unemployment - continues to fall, and dropped by nearly 14,000 to 835,000 last month. Alongside record inactivity the number of people in full-time jobs, almost 21m, is also a record. The big gap in society is between households where everybody works and those in which nobody does.

It may be a little early to call the job market turn. After all, growth is still pretty strong. But the figures raise an interesting question. Now we are moving into a phase of much weaker public sector jobs growth, will the private sector take up the slack? Industry is still shedding jobs while the lionís share of service-sector employment has been generated by the state. Unemployment isnít about to soar but the best of the job market looks to be behind us.

From The Sunday Times, August 15 2004

Comments

"Britain had a record trade deficit in goods and services of £10.8 billion in the latest three months".

But what will this mean for interest rates?

Left unchanged, sterling should fall in response to a worsening trade deficit. Weaker sterling will help exporters and discourage consumption of imports. So the trade decifit should automatically stabilise.

But what if sterling plummets before the trade balance starts to improve? The MPC would have to impose panic rate rises to avoid a jump in inflation.

Why not get a hefty rate rise jab in first to prevent sterling falling? Would the effect on consumers stopping them buying imports be greater than the effect on exporters having to manage with a weaker home market?

And what about the effect on other countries - if we reduce consumption of their goods will they keep buying ours?

Or maybe the MPC should cut interest rates to help exporters and not worry about sterling. After all, the US and Australia have high trade deficits too. How low can sterling go when the US is in a worse situation? Surely the UK inflation effect wouldn't be too bad. Or would it?

Perhaps the MPC should not touch the controls and leave it to the automatic pilot.

Posted by: David Sandiford at August 15, 2004 08:50 AM
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