Nothing
seems to hold back world oil prices. Taking one of
many internationally traded varieties of relevance
to developing Asia, the price per barrel of Dubai
Fateh crude averaged $28 in February 2004, around
$35 between May and December 2004, nearly $40 in February
2005, crossed $45 in March and $50 in June and stood
at $55 in mid-August. Other varieties like American
light crude have crossed the $65-per-barrel mark in
international markets in recent weeks.
Chart
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to Enlarge
The fundamental
reason why prices have risen so dramatically is that
demand-especially driven by growth in the US, China
and India-has outstripped the capacity of the industry
to pump out crude and refine it. Global demand is
estimated to have risen by 2.7 million barrels per
day in 2004, the highest since 1976. Nearly a third
of that growth came from China, where oil consumption
soared by around 16 percent in 2004. On the other
hand capacity has not been expanding to meet this
growing demand. As a result, surplus capacity in the
oil producing system is limited. Spare capacity in
2004 is estimated to have fallen to 1 million barrels
per day (b/d), its lowest level in 20 years. Saudi
Arabia, the country which sits on the largest share
of global reserves and which was responsible for increasing
availability when supplies were tight in the past,
is also nearing its limits. Given the nature of the
industry, supply can adjust only with a considerable
lag, since investment requirements are large and involve
substantial gestation lags. Investment has not kept
pace with demand partly because of the low oil prices
of the 1990s, when the average real price of oil was
half that in the 1980s (Chart 2).
The other reason why supply is inelastic is that much
of the oil that was discovered in non-traditional
locations after the oil shocks, as in the Arctic and
offshore in many countries, has already been exploited.
Thus the world’s dependence on traditional sources
of "easy oil" has increased.
The effects of medium term excess demand on prices
have been aggravated by a number of factors that have
increased uncertainty. The most important is, of course,
the continued occupation of Iraq by the US and its
allies and the strong resistance of the Iraqi people
to that occupation. The inability thus far of the
US army to contain the armed struggle, despite the
use of violence even when it endangers civilians,
has reduced exports and led to expectations of uncertain
future supplies from Iraq. In addition, the war has
precipitated terrorist attacks in the world's largest
oil producer, Saudi Arabia, which have affected oil
supplies, even if temporarily. So long as the threat
of such attacks remains, supplies are uncertain and
prices are buoyant.
The net result has been that any development that
affects or could affect supplies from any other country
triggers a price increase. This could be political
uncertainty in Nigeria, the battle for control of
Yukos in Russia, civil strife and oil industry strikes
in Venezuela or fears of the impact of Hurricane Dennis
on US oil supplies. All of these have in the recent
past substantially affected prices at the margin and
even led to a spike in prices.
The upward pressure on prices that result from these
developments has been further exaggerated by speculative
investments by financial investors in oil markets.
It is known that price trends in energy markets have
substantially increased financial investor interest
during 2004. This has also affected the relative price
of oil. It is widely known that capacity shortfalls
in both extraction and refining are greater in the
case of light sweet crude oil. For example, the little
excess capacity available with Saudi Arabia is in
heavy crude that is harder to refine into the cleaner
fuels demanded by rich countries. This places a premium
on light (low specific gravity) sweet (low sulphur)
grades, whose supplies are relatively inelastic.
Chart
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to Enlarge
With investor interest focused for this reason on
the light sweet grades during 2004 the spread between
light and heavy grades rose during 2004. According
to the Financial Times, in the first 10 months of
2004 West Texas Intermediate (WTI) rose 65 per cent,
but heavier sour oil blends rose by less than half
as much. But as investors have discovered that excess
demand is more generalised this spread has tended
to decline more recently. The discount for Saudi Arabian
oil relative to WTI rose from below $6 a barrel to
almost $20 in October 2004. This year the situation
has reversed. Saudi grades have gained by more than
twice as much as WTI and the spread is back down near
$6.
The base for speculation seems even greater since
the sharp price increases of recent times have not
spurred inflation, curbed growth and forced a cutback
in demand. The dissociation between the level of oil
prices and the rate of global expansion only strengthens
expectations of further price increases.
One explanation advanced for this lack of association
between oil prices and growth is the fact that the
real price of oil, which adjusts the nominal price
increase to take account of changes in the prices
of commodities other than oil, is by no means at a
peak. Thus, in terms of 2005 dollars, the 1980 price
of Arabian Light, which was $35.69 in nominal terms,
amounted to $84.29. That is $25 per barrel or 40 percent
higher than today’s price in real terms.
However, the fact that in absolute terms today’s real
price of oil is far short of its historic peak does
not detract from the fact that recent increases in
that price have been dramatic and that the real price
of oil is at a 15-year high (Chart 3). So the persistence
of growth and demand for oil is indeed puzzling. It
suggests that the expectation that rising nominal
oil prices would trigger contraction in government
spending to smother inflation, as happened at the
time of the second oil shock at the end of the 1970s,
has not been realised. One reason for this could be
that the impact of oil price increases on the balance
of payments is immediately debilitating because of
the greater access to foreign exchange of the big
spenders. Many countries have been able to finance
a rising oil import bill without much difficulty.
For example, China keeps sucking in oil despite higher
prices because of the consistently high increase in
its export earnings; India manages because of large
IT-related revenues and capital inflows; some other
developing countries are able to stay afloat because
of remittances from migrant workers; and the US pulls
through because of capital flows that finance its
burgeoning trade deficit and make it the world’s largest
debtor nation.
Chart
3 >> Click
to Enlarge
Thus the fact that the world is awash with liquidity
that can be accessed in the form of foreign revenues,
debt, portfolio investments or foreign direct investment
by countries that are better off has helped ensure
that a sharp contraction of the kind triggered by
the second oil shock has not occurred. The resulting
persistence in strong demand for oil has contributed
to buoyancy in prices because supply too has not been
responsive to price increases.
These features of the global oil scenario have two
implications. First, it is likely that prices are
likely to remain high for some time to come even if
the era of cheap oil is not altogether over. Second,
as and when specific developments threaten to affect
or actually do affect oil supplies from any existing
location, a further spike in oil prices is a real
possibility.
But already there are signs that things may change.
To start with, not all countries are in a position
to cope with the current price of oil. Many poor countries
cannot access foreign credits with the ease that characterizes
the more developed even among the developing. But
that is not all. Even some of the more developed countries
in developing Asia have been badly affected in 2005,
when prices have continued to rise and the discount
on the West Asian varieties they import has fallen
sharply. Asia, which imports 70 per cent of its oil
from the Middle East, has received a larger oil shock
this year than last. Countries are finding it increasingly
difficult to maintain retail fuel subsidies. Thailand
abandoned subsidies in August, while other governments,
such as India’s, have raised prices despite opposition.
In the event growth and oil demand are likely to fall.
Thus the hike in oil prices is bound to have an adverse
effect on the global system soon. What is not certain
is the nature and location of that adverse effect.
Fears of a global recession arise because the already
high US trade deficit is widening sharply. Clearly,
if prices rise further, global growth could indeed
stall. Even the otherwise optimistic IMF believes
it would. To quote the World Economic Outlook
released in April: ''In the past, a permanent $5 a
barrel increase in oil prices has been expected to
lower global GDP growth by up to 0.3 percentage point;
in practice, the impact over the last year has been
less than feared, partly because higher prices have
in part been a consequence of strong global growth,
and partly reflecting the greater credibility of monetary
policies (so that interest rates have not had to be
raised to ward off second-round inflationary effects).
The impact of further sharp increases, however, could
be more marked, especially if they were to adversely
affect confidence or inflationary expectations; there
would also be a greater danger of negative supply-side
effects over the longer run.''
However, that projection hinges on the perceived trade-off
between growth and inflation, and is predicated on
the assumption that oil price increases will lead
to more general inflation. Governments attempting
to combat inflation will then embark upon contractionary
fiscal and monetary policies, which will bring down
inflation but also imply lower rates of aggregate
economic growth.
It is correct to assume that governments across the
world remain obsessed with inflation control, because
the political economy configurations that have led
to the domination of finance still persist. However,
the prior assumption, that oil price hikes necessarily
lead to higher inflation, may not be so valid any
more.
Certainly it is true that for a very long period-in
fact almost the whole of the second half of the 20th
century- oil prices showed a strong relationship to
aggregate inflation rates in the world economy. Between
1970 and 2000, for example, world trade prices and
oil prices were strongly positively correlated and
in the largest economy, the US, the Consumer Price
Index inflation tracked movements in world oil prices.
But, there is evidence that this relationship may
have changed. Though oil prices have been exceptionally
volatile recently, such fluctuations appear to have
had little impact on aggregate inflation rates in
either developed or developing countries. Rather,
such inflation rates have been relatively stable and
even fallen slightly compared to the earlier decade.
So what has changed in the world economy to cause
such an apparently established relationship to break
down? The first important factor is the reduced dependence
of the industrial economies upon oil imports, at least
in quantitative terms. For the group of industrial
countries in the OECD, net oil imports accounted for
2.4 per cent of GDP in 1978, but have since fallen
continuously, to amount to only one per cent of GDP.
But the second factor may be even more significant.
This is a distributional shift, whereby the burden
of adjustment to higher oil prices is essentially
borne by workers across the world and non-oil primary
commodity producers in the developing countries. These
prices do not rise in tandem with oil prices and in
some cases have declined. This means that even though
energy is a universal intermediate good, its price
rise does not cause prices of many other commodities
to increase anywhere near proportionately. This in
turn enables aggregate inflation levels to remain
low even though oil prices may be increasing.
It is well-known that the period since the early 1990s
has been once of a substantial decline in the bargaining
power of workers vis-à-vis capital in most
of the world, and this has been reflected in declining
wage shares of national income and real wages that
are either stagnant or growing well below productivity
increases. This provides a significant amount of slack
in terms of the ability of employers to bear other
input cost increases. In addition, this disempowerment
of workers also means that such input cost increases
can be passed on without attracting demands for commensurate
increases in money wages in the current period.
Along with workers, agriculturalists and other non-oil
primary commodity producers have also been adversely
affected and been forced to take on some of the burden
of adjustment. Indeed, even manufacturing producers
from developing countries have been adversely affected
in a situation where intense competitive pressure
has ensured that they cannot pass on all their input
cost increases.
Thus, even if growth persists despite rising oil prices,
the distribution of the benefits of that growth is
likely to be extremely unequal. But even growth is
likely to be unequally distributed. In the case of
the poorer, oil importing developing countries, the
effects of higher oil prices are already adverse and
can get worse. These countries have much smaller volumes
of remittance incomes from abroad and cannot access
large capital inflows. Thus the have to adjust to
rising oil prices by squeezing demand through contractionary
policies that reduce domestic incomes and increase
unemployment. This is the only way they can deal with
their balance of payments difficulties.
So long as these sections are forced to bear a disproportionate
share of the burden, the current oil shock may not
seem a big problem. But if for some reason they cannot
be called upon to do so, a global recession may be
inevitable.
