Why the current rise in the price of crude oil could have a more powerful economic effect than expected

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.

Comment

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……

 

 

 

 

 

This entry was posted in Euro zone Crisis, General Economics, Greek Financial Crisis, Inflation, Japan's Economic Situation, Stagflation, The US Economy, UK Inflation Prospects and Issues. Bookmark the permalink.
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  • Andy Zarse

    Shaun, literally half an hour before I read this I just phoned my supplier and ordered central heating oil. They quoted me 79p per litre. I checked and they told me I’d paid 59p per litre in October 2011, just four months ago. So that is a rise of 33% in four months and if the increase is sustained all year (which i doubt, but) it gives an annual inflation rate of near enough 100% on 28 sec burning oil, as used widely by industry…

  • JW

    Hi Shaun,
    As well as Iran, the rises are also due to the CBs QE, as it chases oil and other commodities higher. So the professed strategy of ‘helping the economy grow’ does the exact opposite by taking money away from consumers ( but of course the CBs are really only interested in the inflationary effects on notional GDP)
    I have seen an estimate in the States that every 10c increase in ‘gas’ takes $13bn away from consumer spending.
    You are correct that oil price increases affect electricity prices directly and indirectly. Directly for any oil generation ( not much in UK), indirectly a) because most gas contracts are indexed to oil in one way or the other and b) coal substitution in other parts of the world ( ie more coal used rather than oil products in generation) forces coal prices up sometimes even as they are being shipped to the UK.  If the SoS doesn’t know this she should be sacked!
    Commented previously that the Gallup mid-Feb figures have US unemployed up to 9% from 8.3% mid-Jan, interested to see how this is ‘seasonally adjusted away’ this month.

  • JW

     notional should have read ‘nominal’, sorry, trying to engage brain.

  • Mike

    The price of oil, like other comodities & land, have indeed been driven up by QE and continue to be so.
    This is having a dramatic downward effect on spending on other goods & services, while GDP will not necessarily be affected overall. There is only so much money in the system so oil takes more and other busineses less.
    I note that the price of land has increased by 100% over the last 4 years!! This is also due to QE and high oil prices as speculation builds on biofuels & safe havens. This feeds through to food prices.
    QE is ruination, it is causing prices on lifes basic goods to spike during a resession just when they should be getting cheaper and previous balances have been wiped out. We will not see any recovery while this continues.
    Meanwhile a very few will get very very rich, while the 99.90% will struggle.

  • Aptrayes

    This situation is even more complex than it seems. Worldwide production of “Oil” is 86M BBD currently. Conventional oil stands around 75M, the balance being “Other liquids”. Oil in production is tailing off at 5% or more per annum, $20 to produce has be replaced with $80 to produce oil. Price at at least $100 is required to continue production replacement. Not all oil is equal, “other liquids” are less energy dense for the same volume so there is a trick in play, after all we want “energy” not oil, which is the carrier. (Diesel has 10% more energy than petrol). So the supply side needs an increasingly high price to maintain current levels of production, let alone increase it.

    Now factor in demand destruction in the West due to recession (e.g US gas consumption has collapsed in the last qtr), the “spare capacity” has been picked up by BRICS. The demand/supply balance is precariously maintained but in a way that the headroom for the West to expand energy consumption again has gone…forever. 

    There are many other factors at play, politics and war, amongst many but you get the idea. OIl Price has indeed now become a powerful moderator on economic performance. It will show continued volatility as leads and lags in consequences play out and may well show us $170 as the brakes go on, or $70 as demand collapses again but the effect will be to suppress growth. Unhelpful statements about “100 years of shale gas” creating bubbles only exacerbate the situation (data shows around 24 years of shale gas play only).

    The key message is that modern economics still insists it is the master of nature and that the law of substitution is inviolate. It is not. There is no substitute for energy dense hydrocarbons in sight. We are accelerating the depletion of natural resources, many sources are getting close to the point of uneconomic extraction (Energy.Return.On.Energy.Invested at one or less, eg tar sands). The EROEI is heading off a cliff, we currently use 6M BBD (it used to be 2 a few years ago) to win the 86M we use and that is accelerating and that number is not properly accounted for at present.

    Of Course, People are right, there still are Trillions of barrels of oil in the earth, we aren’t “running out”. But to try getting them barrels out with a positive energy return is increasingly difficult and heading for a cliff, as easy oil goes. So hell yes, the oil situation is drastically affecting the economic dynamic right now and is one hell of an elephant in the corner waiting to dump on everyone. And of course people have spotted this and are gaming the system , as they always do, speculation is inevitable, if unhelpful.

  • Eric Bingham

    Andy, 79p per litre – they are having a laugh at your expense!
    The current UK average price for heating oil is 62p per litre as per the following link:   http://www.boilerjuice.com/heatingOilPrices.php

  • JW

    Hi Shaun
    Off topic, back to Greece.
    They have just changed the acceptance %age required for the PSI to 75% to tie in with the English-law bonds. They will never get this. Germany will walk, its over!

  • Anonymous

    Hi JW
     
    I have been analysing the U-6 unemployment numbers for the US.It is hard to get a clear pattern from the unadjusted numbers but there is a hint of issues over the year end as discussed before. If so then May/June is a significant period as the numbers then tend to jump back up sharply.
     
    If we do get #carboncopy2012 in this repect then we will be overoptimistic in the spring and lose it in early summer….

  • Anonymous

    Hi Alan and welcome back
     
    I think you point is well made (about the increasing marginal cost of oil extraction) and it seems that such pressure is likely to make the oil price itself even more volatile. This of course may well make economic performance more volatile too as we go forwards

  • Anonymous

    I think that holders of the Greek bond which matures on March 20th may look at the timeline and think that “Just say No” might work as a good piece of game theory….

  • Anonymous

    Hi Mike
    I was emphasising the effects on Western nations in this article but the 1%/99% argument does apply on the other side of the game as oil price rises lead to richer oil Sheikhs….
    I did not know about the scale of the rise in the price of land and will take a look….

  • http://www.keeptalkinggreece.com/2012/02/26/guest-post-2nd-greek-bailout-an-exircise-in-compact-stupigidty/ Guest Post: 2nd Greek Bailout – an Exercise in ComPact StuPIGidty | Keep Talking Greece

    [...] it means that during a global downturn (eg a supply-side shock such a rise oil prices e.g Iranian crisis) a governments will face lower tax revenues.  more welfare payments and an increase in its [...]

  • Anonymous

    Hi Shaun,

    On topic of electricity – I read in Spiegel that electricity price rises are starting to cause problems for German industry. this is a direct result of the nuclear shutdown.

    Cameron is saying that he wants nuclear plants substantially engineered and manufactured in the UK. In short he should not trust the French because they always support their national champions and do not allow foreign firms to compete.

    The UK should reject boiling water reactor design which is responsible for 5 meltdowns (Fukushima * 4 and Three Mile Island) of the 6 nuclear power plant meltdowns. Put safety before EDF & Westinghouse lobbying. There are safer designs – British AGR, Candu, Pebblebed and Thorium molten salt reactors.

    With decisive action to ensure a reliable electricity supply for industry, Cameron could help support an industrial renaissance.

  • JW

    Hi Shaun
    Mr Cook is forecasting that Brent will hit $60 in Q2 2012 as Glodman/BP unwind their ‘dark’ positions. Coincides with US election requirements and plunges Iran into crisis.
    For all those ‘peak oil’ people, this is not a lot to do with actual supply/demand of oil, but backwardation deliberately manipulated on futures, ie its financial.

  • JW

     Goldman

  • Anonymous

    Hi Alan

    I have replied again as I read something in the Spectator magazine which I meant to point out before as it travels in the opposite direction to your thoughts. An article written by Matt Ridley I think said that you could get the same amount of energy from US $4 worth of shale oil that you could from US $25 on ordinary oil. He quoted the US EIA as having established this.

    I await your thoughts on this which on the face of it suggests we should switch to shale oil everywhere we can which seems to say the least to be doubtful…