Sunday, May 11, 2008
Why high oil prices aren't squeezing us more
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


It is hard to keep up with the price of oil. No sooner have we got used to $100 a barrel than it is in the $120s. Will the price rise to $150, $200 or even $300 a barrel? How far can it rise without doing severe damage to the world economy?

A few days ago Arjun Murti, the analyst at Goldman Sachs who predicted three years ago the price could top $100 a barrel, said the "superspike" could take it to $150 or $200. His prediction had more impact than a similar forecast days earlier from the president of Opec (the Organisation of Petroleum Exporting Countries).

Neither Murti nor Chakib Khelil, Opec president, are disinterested observers. Goldman is one of the world's biggest traders in energy derivatives and Opec has a vested interest in a high oil price. But Daniel Yergin, president of Cambridge Energy Research Associates, has previously predicted a fall in prices and also thinks $150 is likely.

That would be enough to push petrol up to about 1.25 a litre and diesel to 1.40, well over 6 a gallon. It would also, one would have thought, be enough to tip some economies over the edge.

Indeed, why isn't the rise in prices we have seen already having more of an effect? For those who were brought up on the rule of thumb that every 10% rise in oil prices led to a 1% drop in global growth, the resilience of economic activity in response to sky-high oil is surprising.

Those rules of thumb are, however, no longer relevant, according to the National Institute of Economic and Social Research. In January 2007, oil dipped briefly below $50, and futures markets pointed to a price over the next six to seven years in the $50s and low-$60s. When the institute did its latest assessment, oil was above $100 and the curve suggested it would stay around that level.

Had it not been for that rise, America might have grown 2% this year rather than the 1.3% the institute expects. Growth in Europe and Japan would have been half a point higher. But in Britain, however painful the energy squeeze, the effect is calculated to be small, a mere quarter of a percentage point off growth (the smaller effect is because North Sea oil and gas production, while in decline, is still significant). The inflation effect is bigger, roughly a percentage point across all the advanced economies, but a far cry from the old days.

Ray Barrell, an economist with the institute, said the big change is that economies are less directly sensitive to oil prices than they used to be. The "energy intensity" of growth the amount of oil, coal and gas needed to produce an increase in gross domestic product has halved since the 1970s, reflecting greater energy efficiency and the shift away from heavy manufacturing.

Labour markets have also become more flexible, said Barrell, so workers accept temporary reductions in real wages when energy prices rise, while in the past they would have demanded compensation. The wage-price spiral used to mean expensive oil led to inflation, unemployment or both. Central banks now are under less pressure to act to head off the "second round" inflationary effects of dearer oil.

Life would be a lot easier if oil prices fell. So what will happen?

Fans of mine are fond of reminding me I once wrote that the sustainable price of oil was $40 a barrel. I fear some of them did not understand the subtlety of the point so let me try again. It was based on BP's statistical review of world energy, which shows the real (inflation-adjusted) price of oil right back to the Pennsylvania oil boom of the 1860s.

Real oil prices were very high at the start of the period, above $100, but came down by the 1880s and stayed roughly within a $10-$20 range, with occasional jumps, for the next 90 years.

From 1973 to 1985 there was a spike, initially to the equivalent of the mid-$40s, then a peak of over $100, on Opec's flexing of its muscles and the Iranian revolution. Prices then dropped, averaging $20-$30 in real terms from the mid-1980s until 2003. In cash terms, the recent rise above $40 happened only in 2004.

The question was how much prices needed to rise to allow for tighter supplies, rising demand from China and India as set out in a new paperback of my book The Dragon and the Elephant and rising costs. Nobody denied this meant a permanently higher level of prices.

Goldman Sachs suggested a five-year average of $60 a barrel, which was at the high end of predictions. Most other forecasters expected a rather smaller adjustment. Everybody, including me, expected prices to be higher than in the past, but not this high.

So today's prices are unusual. Inflation and the dollar's weakness mean the $40 I wrote about three years ago should be adjusted to between $50 and $60. But that is a long way from $125, which is what the market says oil is worth.

Anybody who doubts something odd is going on should look at the reaction to last Wednesday's announcement of a large rise in crude stocks by the US Department of Energy. Instead of falling, prices hit a new record. "It's going higher because it's going higher," said one trader. Did somebody once write of the wisdom of crowds?

In the four years since oil prices broke above $40, global demand has risen from 82.5m barrels per day (bpd) in 2004 to an estimated 87.2m this year. Supply has just kept pace, rising from 83.4m to 87.3m in the first quarter.

Interestingly, demand in the advanced economies is predicted by the International Energy Agency to be 48.9m*bpd this year, 0.5m lower than four years ago, with even North America's oil use down. So it seems that many countries are responding to higher prices in the normal way.

But demand in emerging economies is up 5.2m bpd, driven by China, up 1.5m bpd; the Middle East, up 1.3m; other Asia, up 0.8m; Latin America, up 0.8m, and Africa, up 0.4m.

So when will the oil bubble burst? Probably not until there is more solid evidence that both supply and demand are responding to higher prices. The higher the price, the more likely such a response. But it takes time. In some economies, like China, prices are controlled. Much oil is bought on long-term contracts, not reflecting current market prices.

As I have said before, oil spikes eventually end. But they do not always end quickly.

PS: David Cameron is not the first Tory leader to launch a plan to revive manufacturing. John Major did so after succeeding Margaret Thatcher. Even so, this government launched what it described as Britain's first ever manufacturing strategy in 2002.

The Tory initiative is welcome, coming when much is expected from manufacturing. Strong growth should be part of the rebalancing of the economy away from consumers. But industry is in danger of falling at the first hurdle, output having dropped in March. Still, a future Tory government that is serious about manufacturing would be good.

Cameron announced the party would link up with Rolls-Royce, "embedding" officials in the firm. All well and good, but we are entitled to be a little sceptical. The announcement came as the Tory leader was about to head north to campaign in the Crewe & Nantwich by-election. Did somebody think of Crewe (where the car company used to be) and Rolls-Royce, put two and two together and make five?

From The Sunday Times, May 11 2008