Sunday, September 11, 2005
Why the dog of high oil prices is not barking
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

On October 8, 1973 the Organisation of Petroleum Exporting Countries (Opec) invited the oil giants to Vienna and demanded a doubling of the price of crude oil.

The companies, which had always ruled the roost, dismissed Opec’s demands and the talks broke down. But the mainly Arab oil producers weren’t finished. A few days later they announced a unilateral price increase. Two days before Christmas 1973, they came back for more. By the end of the year oil was $11.65 a barrel, more than four times higher than the price had been in October.

The world was shocked. Politicians, businessmen and economists quickly worked out that the immediate effect of the end of cheap oil would be to plunge the global economy into recession.

America summoned other big oil-consuming nations to an emergency conference in Washington in February 1974, the main outcome of which was the creation of the International Energy Agency (IEA). The main purpose of the IEA, part of the Organisation for Economic Co-operation and Development, was to ensure members carried enough oil stocks to avoid being held to ransom by Opec.

A few days ago we saw the virtue of that decision as the IEA’s members agreed to release some of their stocks to tide America over in the wake of the Hurricane Katrina disruption and calm the markets. It worked, although only to the extent of bringing crude prices down into the mid-$60s. The US Department of Energy still expects prices to top $70 a barrel over the winter and average $63.50 next year.

The 1973-74 episode gave us the term “oil shock”. A few years later the Shah of Iran’s fall and the Iraq-Iran war gave us a second, arguably more serious, shock. Both times prices rose sharply. Both times there was a global recession.

The world recessions of the early 1990s and 2001-2 also came after periods of high oil prices. In the case of the early 1990s the first Gulf war, which began with Saddam Hussein’s invasion of Kuwait in the summer of 1990 and lasted until the allied victory the following year, was plainly a factor. It would be hard to argue in either case, however, that high oil prices were the driving factor, not least because price spikes were much smaller than in the earlier episodes.

During the oil shocks of the 1970s, finance ministers would gather at the OECD in Paris and survey the wreckage. Last week the OECD, the advanced countries’ club, gave us its current view on the impact of high oil prices today. And pretty relaxed it was.

According to Jean-Philippe Cotis, its chief economist, the rise in oil prices since the OECD’s last full forecast in May has not materially affected the world economic outlook. Growth among the leading industrial countries then was expected to be 2.4% this year. Its latest forecast, admittedly not allowing for the full effects of Hurricane Katrina, is 2.5%.

Japan and the eurozone have been doing better than expected, America about the same. Britain stands out as weaker. In May, the OECD expected 2.4% growth, now just 1.9%, which is why it thinks the Bank of England should be thinking about cutting interest rates again.

Cotis admitted that growth could be temporarily weaker in the second half of the year because of the hurricane, suggesting the full year may fall slightly below the OECD’s 3.6%.

Its rule of thumb suggests oil-price rises have little economic impact. Each $15-a-barrel rise in the oil price knocks 0.2% off industrialised countries’ growth in the first year, 0.3% in the second. The inflation effect is slightly greater: 0.7% in the first year and 0.4% in the second, but not huge.

Prices have risen about $25 this year, more in absolute terms than during previous spikes, but in their impact on the world economy this shock looks like a pinprick. The dog of high oil prices isn’t barking.

Why is this? This year’s rise has been dramatic, but oil prices have been in a seven-year climb. From a 1998 price of $11 a barrel — lower in cash terms than at the end of 1973 — prices have been on an upward trend. We have had a chance, in other words, to get used to it.

Policymakers have also got better. Central banks have learnt to be more relaxed — they know there is only a problem if dearer oil feeds into more generalised inflation — for example because of higher pay deals.

In the advanced countries, too, the switch from heavy industry to services, and to more fuel-efficient transport, has reduced the so-called “oil intensity” of economic growth.

Each 1% of growth in Britain requires 0.4% extra oil. In the past, 1% growth required 1% or more oil. Emerging economies such as China and India have much higher oil intensities, but they also have a lot more economic momentum to carry them forward.

So is it all plain sailing? Janet Henry of HSBC, in a report, Oil Spoils, wonders if the latest rise in American petrol prices, which hit more than $3 a gallon in the wake of the hurricane, will be the tipping point for American consumers and mark the end of the “US-consumer-leveraged expansion”.

In Britain the sight of pump prices clicking up to more than £1 a litre in some places could have more of an impact than the economic models suggest. Consumers were already feeling subdued before prices started rising.

Five years ago fuel protesters took to the roads and blockaded refineries in protest at high petrol and diesel prices, which they blamed on big excise-duty increases by the government. I did not agree with their methods but in September 2000 they had a point. This time they don’t. The price rise is a global phenomenon. The protesters, who have been talking about repeating the exercise this Wednesday, should keep their tractors in the farmyard. That way, the oil dog will stay muzzled.

PS: Did Kenneth Clarke bequeath a “golden legacy” to Gordon Brown, who has squandered it? The former chancellor, who had the job from May 1993 to May 1997 has been blowing his own trumpet, as befits a jazz buff. But is he right to do so?

At The Guardian, where they have a soft spot for Brown, they think not. The newspaper claims that Clarke’s tenure at the Treasury, while superficially good, failed to tackle Britain’s underlying weaknesses.

“All Clarke offered was complacency and drift,” wrote Larry Elliott, its economics editor, last week.

That was also the view of many Treasury officials. One reason they cheered Brown to the rafters on his arrival in 1997 was because he offered the prospect of serious policy action.

Sometimes, however, inaction is a good thing. After the Lawson boom and subsequent bust, the ERM (exchange rate mechanism) fiasco and the embarrassment of a Conservative government announcing big tax rises, the last thing the country needed was a flashy chancellor.

Clarke was a safe pair of hands and handed over an economy with low inflation, five years of growth under its belt, falling unemployment and a shrinking budget deficit.

A more relevant question is about Clarke’s judgment. He favours the euro and British membership of it (which is also the government’s position), but concedes that the currency has been a disappointment. He was largely responsible, in the summer of 1993, for keeping the ERM going when fellow EU finance ministers were prepared to abandon it.

Most importantly he was a vigorous opponent of giving the Bank of England independence. To have done it before the 1997 election would have deprived Brown of the act on which most of his reputation rests.

From The Sunday Times, September 11 2005

Comments

Interesting observation and explains nicely the lack of 'panic' about oil prices. While the numbers may look good what about people.

So this is how it will play out. Petrol prices will go up, and for those with means it is only a slight inconvenience, in fact, they will benefit because there will be less cars on the road. Those who will feel the pinch, will abandon their cars for public transport, this will also be seen as a good thing. But, and here's the rub, those at the bottom of the socio-economic ladder will be dealt another blow as the prices of essential good and services goes up.

But this suffering will not be reflected in the figures on economic growth which will still look good, and the politicians will tell everyone who will listen about how well they are managing the economy.

The threat is that most economists seem to miss is that the number of people at the bottom is inreasing.

Posted by: DavidMills at September 14, 2005 02:07 AM