6th April 2010 by Shaun Richards
Welcome back to those who have been on an Easter break. For those of us in the UK then today is also likely to be significant as the Prime Minister Gordon Brown is expected to fire the starting gun on a General Election campaign today. Whilst we have been away there has been some economic news from the United States where an okay employment report (particularly when you allow for revisions) was followed by good housing and service sector statistics yesterday. However something else took place yesterday which was a strong move in the oil price which was up by 2.1% on the day. Also Copper which is used as an industrial benchmark for metals rose by 1.5% to over $8,000 per tonne.
What is happening?
If we look at yesterday we saw an all round increase in oil prices for example on the New York Mercantile Exchange (NYMEX) for delivery in May 2010 rose to $86.62 per barrel the highest closing price since Oct. 8, 2008. If we look at some of the related contracts then Heating oil for May delivery gained 5.08 cents, or 2.3 percent, to $2.2675 a gallon, and gasoline for May delivery increased 2.65 cents, or 1.1 percent, to $2.3502 a gallon. Both contracts are also at the highest since October 2008.
If we put the rise into context this means that over the past year the oil price has risen from approximately $52 to $86 per barrel using WTI crude oil as the measure. This is a rise of 65% and it is the impact of such a rise I wish to discuss today as it has clear implications for world economic output and world inflation.
What impact does a rising oil price have?
There have been several attempts to measure the impact of a rise in oil prices on the world economy and they show broadly similar results. One of course has to be careful with the assumptions used and take them as a general guide rather than taking the numbers as a gospel truth as all types of econometric analysis suffers from the flaw that you cannot stop the world economy and just change one variable and see what happens! But the results are rather revealing I feel.
Anecdotally most readers will be aware that most of the major economic downturns in the United States, Europe, and the Pacific region since the 1970s have been preceded by sudden increases in crude oil prices. Although other factors of course have had an impact the idea that rising oil prices have had quite strong impacts on the world economy is generally accepted.
How is the impact transmitted?
In itself crude oil has few uses but demand for crude oil arises from demand for the products that are made from it—especially petrol, diesel fuel, heating oil, and jet fuel, as well as many materials such as plastics; and changes in crude oil prices are passed on to consumers in the prices of the final petroleum products. If we look at the impact of changes in the oil price on industrial countries we get five main transmission mechanisms where it impacts on the general economy.
1.When the prices of petroleum products increase, consumers use more of their income to pay for oil-derived products, and their spending on other goods and services declines. The extra amounts spent on those products go to foreign and domestic oil producers. In effect this is deflationary ( I define this as a fall in aggregate demand/economic output and do not refer to falling prices).
2.Higher oil prices cause, to varying degrees, increases in other energy prices. Depending on the ability to substitute other energy sources for petroleum, the price increases can be large and can cause macroeconomic effects similar to the effects of oil price increases. In effect this is inflationary particularly as it feeds through the economy.
3.Oil is also a vital input for the production of a wide range of goods and services, because it is used for transportation in businesses of all types. Higher oil prices thus increase the cost of inputs; and if the cost increases cannot be passed on to consumers, economic inputs such as labor and capital stock may be reallocated. Inflationary and possibly deflationary again.
4. Because most industrial countries are is a net importers of oil, higher oil prices affect the purchasing power of their national income through their impact on the international terms of trade. So generally deflationary here.
5.Changes in oil prices can also cause economic losses when macroeconomic frictions prevent rapid changes in nominal prices for final goods (due to the costs of changing “menu” prices for example) or for key inputs, such as wages. Because there is resistance on the part of workers to real declines in wages, oil price increases typically lead to upward pressure on nominal wage levels. Moreover, nominal price “stickiness” is asymmetric, in that firms, unions, and other organizations are much more reluctant to lower nominal prices and the wages they receive than they are to raise them.
So there are five main mechanisms which affect a typical industrial economy from a rise in oil prices. There are variations between the exact effects if for example you compare Japan which has no oil to the UK which became a net oil importer in 2005/06 but still is a producer itself.
Also effects are impacted by how well economic policy in the country or countries concerned responds. The actual state of the economy in the first place also matters as for example one with pre-existing inflation is likely to be disproportionately affected by an oil price rise. Also if an oil price move is sudden and large (often called an oil price shock) it is likely to have a more substantial impact than a move gradual move.
The Numbers: a US $10 rise in the oil price
There have been many analyses of this undertaken and accordingly I owe thanks to the US Federal Reserve, the NIESR,the IMF, the IEA and Global Insight. So I have looked at general analysis and merged the numbers and taken a typical industrial country.
Economic output (GDP): falls by 0.4% in year one and by 0.4% in year two
Inflation: rises by 0.4% in year one and 0.5% in year two
Unemployment: rises by 0.1% in year one and by 0.1% year two
Another impact of this is that there is a large transfer of wealth/economic income to the oil-producing nations of the order of US $150 billion. Happy days for OPEC, much less happy for most other countries.
If we take the statistics above and take a look at the last year we get the following for the move in oil prices over the last year if we round them to $30.
A fall in economic output of 1.2% for this year which will be repeated next year. Also a rise in inflation of 1.2% this year and a rise of 1.5% for next year. We would also see a rise of 0.3% in unemployment. All other things being equal (ceteris paribus)
Now superimpose this on the world economy where the industrialised nations are recovering from a severe credit crunch. They can ill afford a reduction in growth of this size. If we look at inflation we in the UK already have issues which it is likely to exacerbate although ironically Japan which is mired in disinflation may actually be grateful for it. I cannot think of any country which actually wants a rise in unemployment at this time.
If we look at the way economies this year such as the UK and Europe have grown more slowly in 2010 than has been expected then it is quite possible that it is the rising oil price which is more of a culprit than many have so far considered. Let us hope that it does not rise further.
Looking at my analysis above I have a further thought. In July 2008 oil prices surged to $147 a barrel, how much of the recession we have just been through was caused by this surge?
Amid yesterdays excitement caused by the oil price rise it is easy to get carried away. Some technical analysts (chartists) feel we could now go to $100 a barrel relatively easily, I counsel taking this with at least a pinch of salt and only report it because of the experience of the summer of 2008.However if we take a step back it is clear that oil has rallied substantially over the past year and there are clear implications from it.
One interesting fact has come from Saudi Arabia which revealed yesterday that exports to India have doubled over the last year and exports to China have increased by 10/15%. So it is not just recovering western economies causing this.
One day we will also run out of oil, I am in the camp that feels that we should be looking to be more frugal with it. Another thing is clear from todays analysis further oil price rises may put the world economic recovery in doubt.
To UK readers as we approach an election I would like to request that everybody who reads this uses their votes as I am a supporter of democracy and believe that you should vote. However I am also disappointed that our ballot papers will not have the option of voting for none of the above…