A new oil price shock for 2010? It is already happening

6th April 2010 by Shaun Richards

Welcome back to those who have been on an Easter break. For those of us in the UK then today is also likely to be significant as the Prime Minister Gordon Brown is expected to fire the starting gun on a General Election campaign today. Whilst we have been away there has been some economic news from the United States where an okay employment report (particularly when you allow for revisions) was followed by good housing and service sector statistics yesterday. However something else took place yesterday which was a strong move in the oil price which was up by 2.1% on the day. Also Copper which is used as an industrial benchmark for metals rose by 1.5% to over $8,000 per tonne.

What is happening?

If we look at yesterday we saw an all round increase in oil prices for example on the New York Mercantile Exchange (NYMEX) for delivery in May 2010 rose to $86.62 per barrel the highest closing price since Oct. 8, 2008. If we look at some of the related contracts then Heating oil for May delivery gained 5.08 cents, or 2.3 percent, to $2.2675 a gallon, and gasoline for May delivery increased 2.65 cents, or 1.1 percent, to $2.3502 a gallon. Both contracts are also at the highest since October 2008.

If we put the rise into context this means that over the past year the oil price has risen from approximately $52 to $86 per barrel using WTI crude oil as the measure. This is a rise of 65% and it is the impact of such a rise I wish to discuss today as it has clear implications for world economic output and world inflation.

What impact does a rising oil price have?

There have been several attempts to measure the impact of a rise in oil prices on the world economy and they show broadly similar results. One of course has to be careful with the assumptions used and take them as a general guide rather than taking the numbers as a gospel truth as all types of econometric analysis suffers from the flaw that you cannot stop the world economy and just change one variable and see what happens! But the results are rather revealing I feel.

Anecdotally most readers will be aware that most of the major economic downturns in the United States, Europe, and the Pacific region since the 1970s have been preceded by sudden increases in crude oil prices. Although other factors of course have had an impact the idea that rising oil prices have had quite strong impacts on the world economy is generally accepted.

How is the impact transmitted?

In itself crude oil has few uses but demand for crude oil arises from demand for the products that are made from it—especially petrol, diesel fuel, heating oil, and jet fuel, as well as many materials such as plastics; and changes in crude oil prices are passed on to consumers in the prices of the final petroleum products. If we look at the impact of changes in the oil price on industrial countries we get five main transmission mechanisms where it impacts on the general economy.

1.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. The extra amounts spent on those products go to foreign and domestic oil producers. In effect this is deflationary ( I define this as a fall in aggregate demand/economic output and do not refer to falling prices).

2.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. In effect this is inflationary particularly as it feeds through the economy.

3.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; and if the cost increases cannot be passed on to consumers, economic inputs such as labor and capital stock may be reallocated. Inflationary and possibly deflationary again.

4. Because most industrial countries are is a net importers of oil, higher oil prices affect the purchasing power of their national income through their impact on the international terms of trade. So generally deflationary here.

5.Changes in oil prices can also cause economic losses when macroeconomic frictions prevent rapid changes in nominal prices for final goods (due to the costs of changing “menu” prices for example) or for key inputs, such as wages. Because there is resistance on the part of workers to real declines in wages, oil price increases typically lead to upward pressure on nominal wage levels. Moreover, nominal price “stickiness” is asymmetric, in that firms, unions, and other organizations are much more reluctant to lower nominal prices and the wages they receive than they are to raise them.

So there are five main mechanisms which affect a typical industrial economy from a rise in oil prices. There are variations between the exact effects if for example you compare Japan which has no oil to the UK which became a net oil importer in 2005/06 but still is a producer itself.

Also effects are impacted by how well economic policy in the country or countries concerned responds. The actual state of the economy in the first place also matters as for example one with pre-existing inflation is likely to be disproportionately affected by an oil price rise. Also if an oil price move is sudden and large (often called an oil price shock) it is likely to have a more substantial impact than a move gradual move.

The Numbers: a US $10 rise in the oil price

There have been many analyses of this undertaken and accordingly I owe thanks to the US Federal Reserve, the NIESR,the IMF, the IEA and Global Insight. So I have looked at general analysis and merged the numbers and taken a typical industrial country.

Economic output (GDP): falls by 0.4%  in year one and by 0.4% in year two

Inflation: rises by 0.4% in year one and 0.5% in year two

Unemployment: rises by 0.1% in year one and by 0.1% year two

Another impact of this is that there is a large transfer of wealth/economic income to the oil-producing nations of the order of US $150 billion. Happy days for OPEC, much less happy for most other countries.

Analysis

If we take the statistics above and take a look at the last year we get the following for the move in oil prices over the last year if we round them to $30.

A fall in economic output of 1.2% for this year which will be repeated next year. Also a rise in inflation of 1.2% this year and a rise of 1.5% for next year. We would also see a rise of 0.3% in unemployment. All other things being equal (ceteris paribus)

Now superimpose this on the world economy where the industrialised nations are recovering from a severe credit crunch. They can ill afford a reduction in growth of this size. If we look at inflation we in the UK already have issues which it is likely to exacerbate although ironically Japan which is mired in disinflation may actually be grateful for it. I cannot think of any country which actually wants a rise in unemployment at this time.

If we look at the way economies this year such as the UK and Europe have grown more slowly in 2010 than has been expected then it is quite possible that it is the rising oil price which is more of a culprit than many have so far considered. Let us hope that it does not rise further.

NB

Looking at my analysis above I have a further thought. In July 2008 oil prices surged to $147 a barrel, how much of the recession we have just been through was caused by this surge?

Going Forwards

Amid yesterdays excitement caused by the oil price rise it is easy to get carried away. Some technical analysts (chartists) feel we could now go to $100 a barrel relatively easily, I counsel taking this with at least a pinch of salt and only report it because of the experience of the summer of 2008.However if we take a step back it is clear that oil has rallied substantially over the past year and there are clear implications from it.

One interesting fact has come from Saudi Arabia which revealed yesterday that exports to India have doubled over the last year and exports to China have increased by 10/15%. So it is not just recovering western economies causing this.

One day we will also run out of oil, I am in the camp that feels that we should be looking to be more frugal with it. Another thing is clear from todays analysis further oil price rises may put the world economic recovery in doubt.

Today

To UK readers as we approach an election I would like to request that everybody who reads this uses their votes as I am a supporter of democracy and believe that you should vote. However I am also disappointed that our ballot papers will not have the option of voting for none of the above…

11 thoughts on “A new oil price shock for 2010? It is already happening”

  1. andy of yarm says:

    You can bet if Oil continues to soar that will be seen as part of some grand Bilderburg led conspiracy!

    Shaun,any suggestions where to put the X would be welcome.

  2. Mac says:

    If I had the time I would stand as a candidate for the ‘None of the Above’ party just to get it on the ballot papers! Trouble is I think I would stand a good chance of winning! I think sitting MPs are about to get smacked!

  3. Drf says:

    I agree entirely with your point about ballot papers, Shaun. The electorate should be given the option “None of the above” on all ballot papers. That is the only way in which we are likely to get any real political change in government, provided that this option also meant that no government could be elected with less than say 50 % of the total votes. All of the three major parties are now clustered so closely together as to be hardly distinguishable in their policies.

    The fact that most of the electorate do not want any of the existing politicians to run their country is demonstrated by the falling percentage of the electorate who voted for the present government in the last two elections. The present government was elected by only around 24% of the electorate. In other words the great majority (around 86 %) did not want the present government, but they had no voice!

    1. Mac says:

      Labour received 35.3% of the popular vote, equating to approximately 22% of the electorate on a 61.3% turnout, up from 59.4% turnout in 2001.
      The total electorate in 2005 was 44,110,782.
      The total number who voted in the 2005 General Election in the whole of the U.K. was 27,123,697 which was 61.3% of the total number of people on UK electoral registry.
      Of these 8,772,599 voted for a Conservative, 9,547,876 for a Labour candidate and 5,982,164 for a Lib-Dem Candidate in their constituency.
      The number voting in 2005 was slightly up on previous election when 26,368,798 voted of whom 8,357,622 voted for a Conservative 10,724,895 for a Labour and 4,812,833 for a Lib-Dem candidate.

      1. Drf says:

        OK Mac: so it was even lower according to you, at only 22 % of the electorate. So, I do not quite understand the point you are trying to make? That is still election by a distinct minority of the electorate, where the rest of the electorate evidently did not want this government?

      2. Mac says:

        I agree Drf, I was only trying to put the best factual figures I could find, which actually lend more weight to your view.
        This stuff only works because we have a democratic system which owes more to the 19th century than the 21st! With the main parties now facsimiles of each other how much longer do we have to put up with the sham?

      3. Drf says:

        OK Mac, we agree then. As you say. how much longer do we have to put up with the sham – which is not real democracy at all.

  4. zak says:

    I agree with the ‘none of the above option’ but have believed for a long time that this measure should be coupled with a compulsory vote. Too many people just ‘cant be bothered’ to turn out and both these measures I feel would add to the democratic process.

    On oil prices.. it was reported in the uk press today that Market speculation is the cause of the rise, just as happened in 2008. If this is the case then in order to protect their long term interests why does OPEC not simply signal higher rates of production and stabilise the price? Or is it just a case of short term greed on their part?

    With diesel and petrol prices at the uk pumps already hitting record prices again, it might not be long before we see more industrial unrest from lorry drivers joining the ever growing list of striking workers across the uk. And this is before the severe cuts in spending and tax hikes to come later this year.

    As for where to put the ‘X’? Make ur own mind up! However, my money is firmly on a second election within 12 months following either a minority government collapse or a small majority for the Conservatives proving to be too small to govern effectively when either is faced with massive public disquiet over the forthcoming “austerity package”.

    PS. I see Greek borrowing is STILL getting more and more expensive and so is the UK’s.

  5. andy of yarm says:

    Topic suggestion for you Shaun.

    I note Aus has put rates up again,The fifth raise since since October,

    Plenty of yesmaneconomists are decrying this as a dangerous move.Personally I’m delighted to see at least one nation determined to let the air out of another property bubble forming.

    Care to comment further?

    1. The Reserve Bank of Australia has announced in the past that it considers “normal” interest rates to be in the range of 4.25/4.75%. So it has returned to the bottom of that range. Having read its statement I think the next sentence is the most pertinent.
      “Interest rates to most borrowers nonetheless have been somewhat lower than average. The Board judges that with growth likely to be around trend and inflation close to target over the coming year, it is appropriate for interest rates to be closer to average. Today’s decision is a further step in that process.”
      If you literally believe in the average then Aussie base rates will be 4.5% before too long. As a piece of analysis one has to remember that Australia escaped the credit crunch in the main because of her geographical position and her natural resource based economy. So now with iron ore and coal two main export earners rising in price and unemployment dropping sharply ( nearly 200k since August 2009) a central bankers mind should turn to rate rises, or at least a withdrawal of stimulus programmes. So those who feel this is a bad idea are going to get more opportunities to decry Aussie base rate rises. They could easily be 5% by the end of this year if current trends persist.

      Whilst that may dampen the housing market my understanding is that, whilst it may cool the general economy, it probably is not enough to fully control the Aussie housing market but it is 3/4 months since I looked at it in depth.

      As an aside are those upset by a 0.25% rise in rates those calling for 5% of rate cuts in the UK not so long ago? We are in danger of assymmetry again. If 0.25% is so powerful then 5% should have our economy leaping like a salmon…..

  6. jeannick says:

    .

    An excellent overview , thanks !
    I would have arranged the point by what I believe are the time line of the effects
    short term is within a quarter , medium term is within a year , long term is the five to ten years range
    I’ve put some comments within brackets , the last point is the trickiest to quantifie but maybe I didn’t understand your meaning properly

    1.Because most industrial countries are is a net importers of oil, higher oil prices affect the purchasing power of their national income
    through their impact on the international terms of trade. So generally deflationary her

    [ The financial drain out of the economic recycling machine is severe enough to create a temporary money scarcity until the oil money find its way back into the system ,
    high leveraged operations suddenly found themselves with higger borrowing costs , if the rise is steep and sharp it’s enough to pop a financial bubble ]

    This is a short term effect

    2.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.
    The extra amounts spent on those products go to foreign and domestic oil producers.
    In effect this is deflationary ( I define this as a fall in aggregate demand/economic output and do not refer to falling prices).

    [ There is some decrease in discretionary spending first , but the drop in consumers confidence is the killer ,
    mostly in defered spending at first it slow retail and the service sector ]

    This is a short term effect

    3.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; and if the cost increases cannot be passed on to consumers,
    economic inputs such as labor and capital stock may be reallocated. Inflationary and possibly deflationary again.

    [ the producers must absorb those costs at first but , price rise feed through the whole economy
    It shrink the purchasing power of the consumer for basic spending unless they can obtain some income compensation with wages rises ]

    this is a medium term effect

    4. 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.
    In effect this is inflationary particularly as it feeds through the economy.

    [ oil is a price component of other energy source , the substitution also play a role but infrastructures are difficult and ineficient to switch unless re-engineered or re-build ]

    this is a long term effect

    5.Changes in oil prices can also cause economic losses when macroeconomic frictions prevent rapid changes in nominal prices for final goods
    (due to the costs of changing “menu” prices for example) or for key inputs, such as wages.
    Because there is resistance on the part of workers to real declines in wages, oil price increases typically lead to upward pressure on nominal wage levels.
    Moreover, nominal price “stickiness” is asymmetric, in that firms, unions, and other organizations are much more reluctant to lower nominal prices and the wages
    they receive than they are to raise them.

    [ the term of negotiating power change within the society , leading to social stress ,
    the classic response is the keynesian one , more government deficit to substitute public spending for private one , that has proven useful in the past
    in the best of world , governments would run surpluses in good times unfortunately democracy is not the best of world , the election cycle see parties promissing much
    and have steadily racked up public debts to very high level for peace times ,
    also the case of Japan would indicate that running large deficit as an economic stimulus lose its efficiency if done too often ]

    this is a long term effect

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