Only last Thursday I discussed the rise in the oil price that has taken place so far in 2012. At that time the price of a barrel of Brent crude oil had touched US $120 and since then we have seen a further increase to US $124. This provokes further thoughts along the line of the twitter #carboncopy2012. Having reminded myself of the numbers it is clear that we are in fact safe from an exact copy as the Brent benchmark was in the mid 90s at the beginning of 2011 rather than the mid-100s of this year. But should we mimic the increase then last years peak of US $126.91 (Financial Times figures) would be replaced by one of more like US $136/7.
Another copy-cat like move is that as the price moves higher then the West Texas Intermediate benchmark seems to catch-up. This happened in 2011 and has been happening over the past few days as it has surged to US $108 per barrel. It has rallied ten US dollars since its recent low on the tenth of February.
The economic effects from this
Last Thursday I discussed the way that an oil price rise has both inflationary and recessionary effects around the world. Having considered the matter in the meantime I wonder how much of the current slowdown being experienced in places like Europe is due to the oil price rise then. We know that there are other factors at play too but in my opinion an oil price rise can be a powerful influence. For example this week I have been reviewing again Greece’s Balance of Payments figures and take a look at this from the Bank of Greece.
The trade deficit grew by €499 million, as a result of a substantial increase by €660 million in the net oil import bill, compared with the exceptionally low level of December 2010
Okay so that is one possibly exceptional month. But later we get the figure for the year as a whole.
By contrast, the net oil import bill rose by €2.5 billion.
This opens up a few issues. Firstly Greece is hit by something outside her control when she is struggling to present improved trade figures. We are back to Shakespeare’s “Sorrows come in battalions” I think. But also we are back to Greece’s statistics as her agency is producing trade figures numbers without oil (and shipping). I think why is now rather clear and we are back to a problem we had hoped had gone away.
The IMF attempts to quantify the effects of an oil price rise
Two IMF economists have tried to calculate the effect of an oil price on oil importing countries and I have taken a look because much of the research I think is out of date as the world economy has changed substantially since it was conducted. So let us take a look.
They seem surprised that there is only a small effect in the first year but to my mind lags were always likely. And looking at any set of data has the problem that in the real world you cannot look at just one factor. As in general the world economy has been expanding they end up with this.
Given that periods of high oil prices have generally coincided with good times for the world economy
This of course was always likely! And illustrates a problem with econometrics and let me offer a long word which bedevils it, multicollinearity, and this applies here where economic booms and oil price rises and highly correlated. This is likely to explain why they find little impact in year one as the boom has momentum which takes time to end.
What is the final impact?
Here is the direct effect
To put these numbers in perspective, it is useful to think of an economy where oil accounts for 4% of total expenditure and where aggregate spending is determined entirely by demand. If the quantity of oil consumption remains unchanged, then a 25% increase in the price of oil will cause spending on other items to decrease and, hence, real GDP to contract by 1% of the total.
But there are also offsetting effects which mean that we end up with this.
The effect is still not particularly large, however, with our estimates suggesting that a 25% increase in oil prices will typically cause a loss of real GDP in oil-importing countries of less than half of 1%, spread over 2 to 3 years.
Why I think that this likely to be an under-estimate of the effect
Many countries are in an anti- boom right now
For countries in weak economic circumstances a high oil price hits them when they have less flexibility to adapt to it. If we look at how the US Energy Information Agency defines this we get the idea.
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.
My point is that we have countries in Europe in particular where “spending on other goods and services” is either flat or declining. For example the UK has just revised her Gross Domestic Product figures this morning and they now show an economy which only grew by 0.7% in the last year and shrank in the last quarter by 0.2%. So there is much less flexibility than one might see in a boom. There must be no flexibility at all in Greece with an economy which shrank by around 7% over the last year or Portugal which shrank at 1.5% and is accelerating downwards. Here higher fuel prices will have to mean less consumption of something else.
The effect of inflation
This seems to be missed by the analysis and let us return to the EIA’s view on this.
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
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.
As an aside it might be helpful if someone would explain the latter effect to UK Secretary of State for Transport Justine Greening who seems to think that electricity prices are unaffected by oil price rises if her recent interview on BBC News is anything to go by. Returning to the theme we will see inflationary pressure from the effects above and coming at a time when quite a few economies are weak it will create problems.
Low wage growth is a factor here
Here is a clear difference with the analysis of the EIA too as we see that it comes from better economic times.
oil price increases typically lead to upward pressure on nominal wage levels
Not right now they do not and the did not in 2011 either! The UK Office for National Statistics publishes figures for average earnings across the economy with a base where 2000= 100 and in December 2010 it was 142.7 and in December 2011 it was 145.7.
If you recall last week I took a look at wage/income increases in Japan
The yearly average of monthly income per household stood at 510,117 yen, down 2.0% in nominal terms and down 1.7% in real terms from the previous year.
According to the US Bureau of Labor statistics the average earnings numbers for the United States over the past year are a rise from US $784.10 to US $803.51. They helpfuly also calculate real wages which have fallen from US $10.34 to US $10.24 per hour.
In Portugal we see that the average labour cost rose by 2% but as hours worked to get that rose by 3.8% we see that nominal wages fell by 1.7%. For a measure of real wages we see that Portugal’s consumer inflation averaged around 3.5% in 2011.
So my contention is that due to the current downturn/recessionary conditions a prolonged period of high oil prices is likely to have stronger effect compared to many past episodes. With the squeeze on both nominal and real wages evident in many places higher oil prices are likely to lead to less consumption of other goods and in some places at virtually a one to one rate. Sadly weak economies seem likely to be affected the most.
Politicians versus the people
As oil products are often heavily taxed we hit on another problem. A rise in the oil price means that petrol and diesel prices in the UK rise by more than that amount because Value Added Tax is added as a percentage. As that percentage has risen to 20% tax revenues will rise more than in the past for a given oil price rise but consumers will be proportionately poorer.
So politicans may be able to claim the credit for higher tax revenues and hence lower fiscal deficits for a while……