Download High oil prices

Case I9
High Oil Prices
What is their effect on the world economy?
Oil on the up?
Are oil prices related to the level of economic activity? Does rapid economic growth lead to a
rise in oil prices? Does an independent rise in oil prices lead to a recession? Part of the answer
lies in the proportion of total expenditure accounted for by oil consumption. Part lies in the price
and income elasticities of demand for oil. Part lies in the activites of OPEC to stabilise the price
75
70
65
60
55
$ per barrel
50
45
40
35
30
25
20
15
10
5
0
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Oil Prices: $ per barrel (Brent Crude)
of oil.
As far as oil prices being dependent on world economic activity, there is clearly some effect,
with the rapid economic growth in 1999/2000 being partly responsible for the tripling of oil
prices from late 1998 to late 2000 (see the chart). Partly, however, the rise in prices over this
period was the result of OPEC’s decision in early 1999 to cut oil production by 4.3 million
barrels per day. Similarly, the huge rise in oil prices during 2004 to 2006 (see chart above), was
not so much the result of a booming world economy – although the rapid increase in demand
from China and India was playing a sugnificant part – it was also caused by worries about the
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security of oil supplies, with continuing violence in Iraq and threats to Saudi Arabian and
Nigerian oil installations.
But what about the effect of oil price increases on economic activity? Certainly oil today
accounts for a much smaller proportion of total consumption than in the early 1970s when there
was the first major oil price increase. It is estimated that the oil price rises between 1974 and
1980 transferred the equivalent of 2 per cent of oil importers’ GDP to OPEC economies. The
price increases of 1999/2000, by contrast, resulted in a GDP loss to oil importers of a mere 0.5
per cent of GDP. Only if oil reached $80 a barrel would a crisis as big as that of the 1970s be
repeated.
Take the case of the early months of 2003. A war with Iraq was looming, and worries about
oil shortages drove the price up to $33 per barrel in February. Yet this had very little impact on
the economies of the major oil importing countries.
The reason why higher oil prices are likely to have such a small impact on the world’s
industrial economies is partly to do with the relatively low real price of oil – much the same
today as in the mid-1980s and lower than the early 1980s (see the diagram in Box 4.3 on page
134). More importantly, since the 1970s the western economies have been weaning themselves
off oil. Today, they use 40 per cent less oil per unit of output, and for a given amount of growth
in output, OPEC oil imports are only half as much as in the 1970s.
How do higher oil prices affect the economy’s performance?
There are a number of ways in which higher oil prices might impinge upon economic
performance.
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Price effects. Higher oil prices are passed on in higher energy costs. These higher
costs are then passed on in higher prices. Price rises might, in turn, push up wage
demands, initiating a wage–price spiral. However, even though labour markets in both
Europe and the USA are tight, the enhanced flexibility of labour markets achieved
over the past decade is likely to moderate any such impact. Of more concern might be
the policy of central banks which, in anticipating higher inflation following an oil
price rise, put up interest rates, causing output to fall even further.
Supply-side effects. A rise in oil prices generates a negative supply-side shock. Higher
prices for oil or energy push up costs of production, which result in lower production
at a given price. If demand within the economy remains unchanged, then prices will
rise and output will fall.
Demand-side effects. The spending power of consumers within oil importing countries
will fall as oil prices rise. If the income transferred to the oil exporters does not offset
such a reduction (via increased demand by them for imports from oil importing
countries), then global demand will fall. IMF estimates suggest that upwards of 80 to
90 per cent of the oil exporters’ extra income earned from the 1999/2000 increases
would be spent on foreign imports within 2 years. So, even though the final decline in
global aggregate demand may be small, there is likely to be a bigger initial decline,
given the time lag between income being withdrawn from oil importers and being
spent by oil exporters.
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Is a rise in the price of oil a problem?
For the western economies, which have generally diversified their fuel use and improved energy
efficiency, oil prices will need to rise a lot further than $75 per barrel before they seriously
restrict growth. Where it does appear that higher oil prices are having a noticeable impact is on
the world’s non-oil exporting developing and newly developed economies, such as South Korea
and Thailand. A survey by The Economist found that a $15 rise in the price of oil over a twoyear period would reduce Korea’s GDP by over 2.5 per cent and Thailand’s by almost 3 per
cent.
Question
What would be the benefits and costs to the world economy of a substantial fall in the price
of oil?
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