Early in March, the cost of a barrel of Brent crude hit a post-Gulf War record of over $30-a-barrel. Prices have since fallen back a little, but the bargain basement oil that we saw at the peak of the Asian crisis is now just a distant memory – the oil price has nearly tripled in little over a year.
Prices have been surging because demand is outstripping supply. Partly, sales of oil have picked up as the world economy strengthened, but a much more important factor is the production cut agreed by the Organisation of Petroleum Exporting Countries (OPEC) last year, which is still in force. This brings back bad memories of the OPEC-lead production squeezes and price hikes that created inflation and then global recession in the 1970s and early 1980s.
However, we should not see such severe consequences this time around. For a start, the recent rise appears dramatic only because oil prices started from such a low level. The $10-a-barrel oil in the winter of 1998/99 was the cheapest we had seen for nearly 30 years. The average oil price over the 1990s was closer to $20-a-barrel, and against that benchmark the rise appears less dramatic. In real terms, prices are still a long way from the levels of the early 1980s – which would be equivalent to $80 to $100-a-barrel today.
Secondly, the 1970s price increases took place against a much more inflationary background across the world economy. Surging oil prices were reinforced by rises in commodity prices in general. In the UK, we were struggling to keep down inflation even before the first oil price shock in 1973, with wage increases running at double-digit rates as successive incomes policies failed.
The present situation is very different. Inflation is subdued worldwide, and we have seen deflation in many sectors – including the airline industry. Underlying inflation in the UK is just over 2% – comfortably below the government target – and the prices of a wide variety of goods (for example: food, clothing, footwear and cars) are falling. With tough competition at home and abroad, it is now hard for firms to push rising fuel costs through to customers.
We also now have tough and independent central banks that are prepared to raise interest rates and nip inflation in the bud. This contrasts with initial attempts to stimulate the world’s economies when oil prices were rising in the 1970s.
Another change is that the world economy is now less dependent on oil. The high oil prices of the late 1970s stimulated an energy efficiency drive across industry, which has been reinforced by steps to curb emissions. At the same time, the new economy is much less energy intensive than the traditional manufacturing industries that dominated the industrialised countries 30 years ago.
However, perhaps the most important factor preventing a re-run of the 1970s is the behaviour of oil producers themselves. OPEC countries recognise that pushing prices too high in the 1970s backfired when the economies of their customers were damaged, causing the oil price to collapse. Also, high oil prices stimulate non-OPEC oil production – undermining OPEC’s long-term market position.
This time OPEC is likely to behave responsibly and gradually expand supply to avoid destabilising the market. The cuts of last year were introduced as a temporary measure to stem a dramatic price decline. Over the long-term, oil producers seem to be targeting a price of $20 to $25-a-barrel – not far above the average for the past decade. Already, meetings are taking place between the major producing nations, reviewing the scope for increasing supply and the likely timetable, and there is growing hope of some significant action at a full OPEC meeting later this month.
Overall, we should expect a much milder response from the world economy to higher oil prices than we saw in the 1970s. But there will be some impact. Costly oil is one of the reasons that interest rates are now rising worldwide – and we should expect them to go higher still in the short-term, despite the Bank of England’s recent pause. The high oil price will also dampen growth directly as companies respond to a squeeze on profits and consumer purchasing power is reduced as consumers spend more on petrol.
This latest oil price surge reminds us that the current buoyancy in the world economy is unlikely to proceed unchecked and that we should expect some moderation in growth over the next couple of years. However, oil prices will probably play only a supporting role in bringing this about. The main driver is likely to be the US economy.
Despite the optimism about the new economy, recent strong US growth is unsustainable. With inflationary pressures building, interest rates rising and an increasingly nervous stockmarket, the long US boom looks vulnerable. The only difficult questions are how quickly the boom will be punctured – and whether the landing will be hard or soft.
Dr Andrew Sentance is chief economist at British Airways.
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