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Finance - Is this another oil shock? |
If oil prices continue to hover around $US40 a barrel it is fair to ask what sort of economic consequences are likely to follow.
Will we be able to shrug it off by accepting a slightly lower standard of living or will there be more serious consequences, particularly if prices go even higher?
There is some cause for concern. Since the end of the Second World War nine out of the ten major recessions were preceded by a sharp rise in oil prices. So there does appear to be a strong correlation. On the other hand there were several sharp rises in oil prices in that period where a recession did not follow.
Of course the size of the rise in oil prices, and the duration of the rise and the state of the world economy at the time the rise occurs are important factors. The big recession of the early 1970s was triggered by a sharp jump in oil prices at a time when OPEC was just beginning to flex its muscles. Before this oil had been incredibly cheap – in current dollar terms (ie. after adjusting for inflation) at around $US10 a barrel. This acted as a sort of wake-up call to world energy users.
In the early 1980s we had the second oil shock where prices went even higher and another recession was triggered. When this happens of course the demand and the price of oil falls – which hurts oil producers. OPEC knows this and over the past few years it has had a policy of keeping oil prices to a band between $US22 and $US26 a barrel although prices have jumped recently due to a combination of factors.
Demand has increased sharply due to the economic recovery in the United States and Japan and sharply higher usage in China. Something like 80 per cent of the increased demand for oil over the past four years has come from China alone.
Supply factors have also changed. OPEC up until the latest production increases had been winding back the supply.
Perhaps more importantly, the fear of oil supply disruptions has pushed up the price on world markets. That is, world markets are anticipating a supply shortage.
Saudi Arabia, the world’s biggest exporter has become a target for terrorists attempting to reduce the flow of oil and to put economic pressure on the US and other western nations. The Saudi supplies are vulnerable and a successful attack on its facilities could result in a sharp reduction in supplies, at least in the short term.
But excluding that possibility, what will be the effects if prices stabilise at around $US40 over the remainder of this year? The first thing to point out is that current prices are not that high – once you adjust for inflation. Back in the 1980s oil prices rose, in today’s dollars, to $US80 a barrel – double their current price. So we still have a fair way to go before we get back to that level.
In addition we are not as vulnerable to oil price shocks as we once were. The world economy has changed since the 1970s and 1980s. About 25 years ago, spending by the US on oil was equivalent to 5 per cent of its gross domestic product. Today the amount is equal to about 2.5 per cent, or half as much.
According to US Federal Reserve Chairman Alan Greenspan, the US economy has become a “conceptual economy” with a resultant smaller reliance on energy. In other words the US, like Australia and other western nations, is now more heavily centred on service industries. Consequently a recession is not likely in the current situation where the world economy is now growing strongly. It will cut the growth rate a bit, but not by much.
So if the latest jump does not presage a recession, what will the economic effects be? At the consumer level, higher petrol and energy prices will mean that consumers have a choice to make. They could simply take the view that the spike in prices is a short term phenomenon and decide to consume just as much as before but finance this consumption by borrowing more or saving less. If this were the case there would be an upward pressure on interest rates as the demand for borrowed funds increased and the supply decreased.
Alternatively they may decide that the price hike is here to stay. They decide to cut back consumption reflecting the fact that their standard of living has fallen. This will affect all sectors of the economy – but perhaps not by much. In the medium term we may see the demand for more fuel-efficient vehicles increase. In addition, alternative energy supples will become more price competitive.
At the industry level the results will be mixed. Energy producers will benefit but the airline, farming and transport sectors will face higher costs. These effects will probably be manageable. If however the oil price soars to $US50 a barrel or more for a sustained period expect more serious consequences.
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