High oil prices and their impact

Odds are stacked against those who feel oil prices wouldn't do much harm

The recent spike in oil prices has caught almost everyone by surprise. Even structural bulls on oil could not have imagined that oil prices would cross $45 (Brent). Oil prices are now significantly above the previous record of approximately $40 reached in 1982, and are up dramatically even in SDR terms, reflecting the fact that this rise is not linked to any currency moves.

Even in real terms (inflation adjusted), the current price is above the peaks of 1991 (Gulf War I) and the early 1970s (Yom Kippur War), though only about half the level reached in 1979 (Iranian Revolution) of over $80 per barrel (in current dollars).

The current oil price is about 60 per cent above the average level prevailing during 1986"�2000, and also significantly above the average price of $29 per barrel prevailing since the year 2000.

While there is no doubt that we are in the midst of an oil shock, the view on the economic impact of this shock is deeply divided. The global growth optimists remain positive and feel the world economy can withstand this oil drag, while the economic bears remain convinced that this shock will push the global economy into a recession in 2005. It may make sense to examine both sides of this debate.

The economic bulls point to a whole series of arguments which dimension the impact of this oil shock within a historical context.

First of all, they point out that unlike the previous three oil shocks (1973-74, 78-79, 1999-00), when prices increased by more than 210 per cent in each case, currently prices are up about 130 per cent in dollars and only about 50 per cent in euros from the lows of December 2001.

The bulls also point out that the global economy today uses about 40 per cent less oil per dollar of real GDP than before the first oil crisis (source: BCA), making the recent rise in oil prices less significant.

This reduced intensity of oil use partly reflects greater efficiency and conservation and partly the fact that the share of oil in primary energy supply has dropped from 45 per cent to 35 per cent.

The bulls also point out that assuming oil prices stabilise at an average level of $40 for 2004, global spending on oil will rise by about 40 per cent, or $350 billion. Using IMF projections for global GDP, world spending on oil would rise by .7"�3 per cent of global GDP. While seemingly very large, this incremental oil expenditure of .7 per cent of global GDP is actually quite limited when judged by the standards of the oil shocks of the 1970s.

The 1973-74 crisis increased the world's oil bill to 4.2 per cent of global GDP from 1.3 per cent the previous year (source: BCA). The 1979 crisis saw global spending on oil rocket from 3.3 per cent of GDP to 6.9 per cent.

The global oil bill in fact peaked in 1980 at 7.1 per cent of GDP, much higher than today's worst case level of 3 per cent of GDP. Thus, the ability to withstand shocks should be much better this time around.

One key negative of higher oil prices is the impact they have on raising inflation, as experienced during previous shocks. Given the fact that inflation expectations appear to be well anchored and most of the developed economies still have a degree of slack, inflation risks may be more subdued in this episode compared to prior periods.

This distinction is critical because in most of the global econometric models that predict a reduction in global growth of between .5 per cent and 1 per cent over two years (with the oil price at $45), a hike in central bank rates to combat inflation is automatically assumed.

To the extent the presence of independent central banks with market credibility obviates the need for any significant interest rate hikes, the negative impact of higher oil prices will be lower than the models imply.

The bulls also point to the fact that identifying the cause behind the oil spike is key in determining its negative impact. While geo-political fears have clearly driven oil prices recently, a bigger driver seems to be the fact that global demand in 2004 is growing three times faster than the average of 1998"�2002. An oil spike caused by strong demand has far less negative consequences to one caused by a supply shock.

The track record of global oil shocks is perfect, the bears say. On each of the three occasions, at least the US drifted into a recession, and given the importance of the US as the main engine of global growth, this is a poor omen.

These recessions were similar in that in all the three cases, the US economy was already vulnerable and weakening when hit by the oil shock. While it is difficult to characterise the current US economy as very weak, it is clearly slowing and the fact is that this recovery in the US has been one of the weakest on record despite record fiscal and monetary stimulus.

The second quarter of 2004 was a disappointment, with GDP coming in below expectation at only 3 per cent. This figure masked a minuscule gain of only 1 per cent in real personal consumption expenditure. Clearly, given the well-documented imbalances in the US with a record low savings rate, sky-high consumer debt, fading fiscal and monetary stimulus, and the twin deficits, there exists economic vulnerability. Would an oil shock of the current magnitude be enough to tip the economy back into recession mode?

The bears point to the structural weaknesses of the US and global economy, their high dependence on an indebted consumer to sustain growth, and the impact of high oil prices on the disposable income of this consumer.

Every time an oil shock occurs, bears also point out, there is an inclination on the part of economists to dismiss the impact on the basis of a reduced energy intensity of global GDP. Yet each time the oil shock has triggered an economic recession.

One has only to go back to 1999-2000. Though this was not a full-fledged energy shock, the surge in oil prices in this period played an important part in the subsequent economic slowdown in 2000-2001. Even here, if you had read the economic research of the time, most economists had refused to accept that the surge in oil prices could slow down the global economy.

With the oil intensity of China and India at 2.3 and 2.9 times, respectively, the average of the Organisation for Economic Cooperation and Development, a strong case can be make that globalisation is inherently very energy-intensive and thus the case for oil prices remaining at a higher plateau is quite strong.

As the baton of incremental global growth passes on to these countries, the "lower intensity of energy use" argument anyway loses relevance.

The fall in most leading indicators of global economic activity lends further credence to the view that this oil shock is starting to bite. Most indicators have lost momentum and point to a slowdown developing in 2005. A slew of high frequency current economic data also seems to confirm that global growth has peaked.

While the data seem to support the bull case on economic growth, my own sympathies are more with the bear camp. Having been burnt in 1999-2000, I don't want to make the mistake of underestimating oil once again. Even then the logic of oil having a very limited economic impact was intellectually very appealing, but ultimately flawed.

If the bears are right, then expect much less upward pressure on interest rates than is currently discounted in global markets. Is your portfolio positioned accordingly?