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Will the soaring price of oil drown the UK economy?

20.08.2004

by James Ferguson

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The oil price has been rising steadily for the past three years, so why the upset now? The reason is that oil has just breached a new record high price in nominal US dollar terms. This is frightening stuff, given how oil-dependent our global economy is. According to Larry Goldstein, president of the Petroleum Industry Research Foundation (PIRF) and a 40-year veteran of the oil market, quoted in The Sunday Times, this “price spike amounts to a fourth oil shock”. And it may really be that bad. Some industries, the airlines for example, are already suffering. The FT quotes Giovanni Bisignani, director-general of IATA, the International Air Transport Association, calling the rampant oil price “the fifth horseman of the apocalypse”. But most UK manufacturers are still waiting for the pain, which they expect in October, the month an estimated 60% of firms buy their forward contracts for energy. The signs aren’t good. The managing director of one glass-making firm told The Sunday Times that “the best quotes we have show a 51% increase in electricity and 34% on gas”.

Oil has less impact now

But does this really count as another oil shock? Today’s price is still half the level it was back at the time of the first two oil shocks, once we adjust for inflation. And the de-industrialisation of the UK economy means we are less than half as dependent on oil as we were back then. The Bank of England estimates that the oil intensity of GDP (the quantity of oil used to generate a given level of Gross Domestic Product) is just 40% of what it was in 1972. This implies that to wreak the same amount of havoc on our economy as the first oil shock, the sterling price of oil would have to rise from about £23 a barrel today (a barrel is 35 gallons) to £115. That’s more than $200 a barrel at today’s exchange rate. This seems unlikely. The investment bank Credit Suisse First Boston reports that the highest ever oil price was $95 in today’s money and that was way back in the late 19th century. Besides, in the UK we are further insulated from oil-price rises by, rather ironically, the fact that taxes on petrol are so high. The Americans are not so “lucky”, and so although they have much cheaper gasoline than us, increases in crude prices have a more dramatic inflationary effect on their pump prices, and hence on consumption. Analysts at JP Morgan note that “over the first six months of 2004, energy prices at the consumer level in the US rose more than 35% at an annualised pace”. Wholesale gasoline prices in the US have already more than doubled, to $1.40/gallon, since early 2002. That’s not the case here.

How high will oil prices go?

Most analysts expect the oil price to return to the $35 range before Christmas, but who can trust them? They all thought it would fall to $25 this year, so they haven’t much of a record for forecasting. Technical analyst Paul Nesbitt at Dryden Wealth Management, on the other hand, argues the price has enough momentum to reach a high of nearly $60 before it runs out of steam, and that’s entirely possible – the oil price generally rises into October as the Americans and Japanese turn their central heating on. While 12-month futures are still trading below $40, the price has been on the rise there too, suggesting the market might be gradually coming around to the idea that there is more to the oil price than just a summer squeeze.

It’s mostly about demand

Today’s situation is very different to that of the first two shocks. Those were essentially supply shocks, but this one has been demand driven. With interest rates at 50-year lows, the global economy firing on all cylinders and China growing faster than anyone thought possible, demand growth is at its strongest for 28 years. China’s demand for oil is growing by 20% a year and the country is guzzling “830,000 barrels a day more than last year, accounting for a third of world demand growth”, reports BusinessWeek. At the same time, an extra kicker has come from the fact that geopolitical risks have led many countries, including America, to add to their strategic oil reserves too. And while demand may fluctuate in the short to medium term – if a high oil price slows the global economy, for example – long term the price can only rise as the residents of the large emerging economies adjust their lifestyles to take account of their rising prosperity (imagine if the same percentage of Chinese as Americans drove an SUV…)

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But there are supply worries too

Meanwhile, there are a number of short-term supply concerns, which, with such a small cushion of productive capacity, are exacerbating the situation. There are export-supply disruptions in effect, or feared, from Iraq, Saudi Arabia, Nigeria, Russia and Venezuela. The world’s spare capacity is estimated to be just 500,000 barrels a day. That’s just a tenth of the five-year average spare-capacity cushion of five million barrels, and less than half of one per cent of total daily consumption. The Sunday Times notes that spare capacity is at “the lowest level since the 1970s”. Of more concern longer-term, perhaps, are Indonesia and the UK. In the last two months, both having changed from being net exporters to net importers of oil. Indonesia is the first Opec member country to become a net oil importer. More troubling, however – largely because it is an unknown – is that we have no idea how much oil the world has left. There are suspicions that reserves are routinely overstated at both the corporate and country level and there are many who believe that the world will reach ‘peak oil’ in the next five to ten years. After that, the amount of oil we can produce every year will steadily decline.

What does this mean for the UK?

Ignoring the unknowables, in the medium term it is enough to ask what impact $45 oil is likely to have on our economy. Does it mean, for example, a return to inflation? The answer is both yes and no. Binit Patel, an economist at Goldman Sachs, estimates that $50 oil would only add 1% to the UK’s consumer price index . However, it would have a bigger effect in the US, where he reckons CPI will rise 1.7%. This will undoubtedly mean the world will become a higher interest-rate place than it is today. “The reaction of monetary authorities to oil-price rises in the 1970s was too loose,” writes Scherazade Daneshkhu in the FT, a mistake Ray Barrel of the National Institute of Economic and Social Research believes they are unlikely to make again.

But what high oil prices really hit is growth. Binit Patel estimates that, after one year of oil prices at $50, G7 GDP would be 3% weaker than it otherwise might have been. Equity markets will reflect this. Goldman Sachs equity strategists believe that each sustained 10% rise in oil prices knocks 8% off the value of European equities. US equities, meanwhile, are already falling in response to rising oil.

An uncomfortable future

While we’re still a long way from the horrors of the first two oil shocks, there can be little doubt that high oil prices aren’t good for the nation’s financial health. Rather bizarrely, although the initial effect of higher oil prices is inflationary, which is bad news for interest rates, ultimately the result is deflation. Deflation in growth forecasts, deflation in stock prices and deflation in jobs. That means Gordon Brown’s overall tax-take will be lower than he expected, which in turn means his budget deficit will remain high. One thing we can be sure of is that life with high oil prices isn’t going to be as comfortable as life with cheap oil has been.