Company News » Economics – Oil well that ends well

Although it eased as August gave way to September, the climb in oil prices towards $50 a barrel in the summer revived uncomfortable memories of the 1970s. When oil prices jumped 16-fold between 1973 and 1980, retail price inflation soared into double figures and economic activity slowed. Today, there are again fears that rising oil prices will threaten the stability of the global and UK economies.

Many explanations have been offered for the current price surge – political tension in the Middle East, booming demand from China and India, shortages of refining capacity, supply constraints in Russia and speculation by hedge funds. While it is impossible to disentangle these individual strands, some assessment can be made of how high prices are likely to go and what will be the consequences for the UK economy.

While some analysts still believe a price nearer $30 than $40 a barrel reflects the fundamentals of the market, other pressures point to oil staying at the sort of levels seen this summer. Tension in the Middle East is the most obvious factor. If not Iraq, then Saudi Arabia – producer of 11.5% of the world’s crude – makes markets nervous. The technical difficulties of trying to protect 85 oil fields with more than 1,000 wells and 20,000kms of oil and gas pipelines are obvious, and the political implications of a destabilised House of Saud have been well documented.

Independent estimates suggest that about $10 of the current $40+ a barrel reflects political risk – in Nigeria and Venezuela as well as the Middle East. Only if this risk subsides will the $30 a barrel price look sustainable. On top of this, the US, which accounts for a quarter of global oil consumption, is not the only large economy in which activity has been robust. The unexpectedly strong growth in oil demand from China does not look to be a temporary phenomenon, with a 20% increase in the first half of this year, followed an 11% rise last year. And if current trends continue, by 2030 there will be more cars on the road in China than in the US.

These factors imply that economies should plan on the basis of oil prices staying at current levels rather than falling back. Although few forecasters in the UK have not yet built this into their projections, the consequences are likely to be less dramatic than the price hikes of the 1970s.

In the first place, the current oil price should be kept in context. It certainly reached record levels in the summer, but only in nominal terms. Once allowances were made for inflation, it is clear the economy had to cope with much higher real oil prices in the past. The 1980 price, for example, at today’s price is equivalent to $100 a barrel – more than twice the recent peak.

In addition, all industrialised economies are more energy efficient than they were 30 years ago. In 1981, spending on oil in the UK was about 6% of GDP; now it is less than 2%. Oil’s share of energy consumption, moreover, has fallen from 50% in the 1970s to 35% today. This suggests there is much less scope for oil prices to inflict the sort of damage they did a generation ago.

Given that the OECD area now produces twice as much output per barrel than 30 years ago, the macro economic impact of the recent rise will be less than newspaper headlines imply. The OECD model predicts that a $10 per barrel rise sustained for more than 12 months lowers the level of US GDP by 0.2% and adds 0.4% to inflation. For the eurozone and Japan, the consequences are more marked – 0.4% off GDP and 0.4% on inflation.

In the UK, there are worries about inflation re-igniting the old wage-price spiral. An analysis by HSBC confirms the OECD’s apparently modest consequences. At $40 a barrel, UK GDP would fall by just 0.2% this year and by 0.3% next. Even at $60 a barrel, the drop in GDP in 2004 is only 0.4%, and 0.6% in 2005. The inflationary impact is equally muted, largely because of a more benign industrial relations climate compared with 30 years ago.

On the positive side, every $1 on the price of a barrel of oil generates an extra £225m of tax revenues to the Treasury from oil-related taxes. Given his central assumption of $27 a barrel, the Chancellor will be about £3bn better off if the $40 price is sustained.

For policymakers, the challenge is to frame a response that takes higher oil prices into account and avoids the mistakes of 30 years ago, one of which was to accommodate the resulting inflation by letting wages rise too quickly. It then took the best part of 20 years to get back on track after the policy shambles of the 1970s.