When oil turns pricey

An Iraqi fire-fighter watches a burning oil pipeline after a blast on the outskirts of the country's northern city of Kirkuk. - SALAH AL-DEEN RASHEED/REUTERS

The persistent rise in oil prices has revived the debate on whether the world is near reaching or has reached the point of peak oil.

NOTHING seems to hold back world oil prices. Brent spot prices that averaged $24.9 a barrel in 2002 rose to $28.7 in 2003, $42.7 in 2004 have crossed the $60 mark in recent weeks. This sharp and persistent rise has revived the debate on whether the world is near reaching or has reached the point of peak oil. `Peak oil' is a maximum that the production of the finite resource is expected to reach before it declines on way to the depletion of the resource. The surge in prices is seen by some as indicative of the fact that the world is arriving at that peak.

Like all such discussions in the past, this one too is tinged with an element of alarmism - influenced by the steep rise in prices. But there are encouraging statistics at hand for the optimists. 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 a barrel, or 40 per cent higher than today's price in real terms.

However, the fact that in absolute terms today's real price of oil is short of its previous peak does not detract from the effects that the recent rise and the current high level can have on different segments of the global system. Hence, the question whether these increases are temporary or more enduring in nature is of significance. Clearly, there have been developments that are not long-term in nature that have influenced the price of oil. The most important is, of course, the continued occupation of Iraq by the United States and its allies and the strong resistance of the Iraqi people to that occupation. The inability thus far of the U.S. 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, that have affected oil supplies, even if temporarily. So long as the threat of such attacks remains, supplies are uncertain and prices are sticky downwards.

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 U.S. 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 reason for this is that while demand has been rising rapidly, normal supply has been relatively inelastic. Even a small shortfall in production leads to a significant supply-demand imbalance. Demand increases have been driven by growth, in China, India, the U.S. and elsewhere, which remains high despite rising oil prices. According to The Economist, global oil consumption last year increased by 3.4 per cent instead of the usual 1-2 per cent. Nearly a third of that growth came from China, where oil consumption soared by around 16 per cent.

This 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 the fact that over the long term oil prices have not kept pace with the prices of other commodities, resulting in a fall in the real price of oil. But more important is the fact that 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 Information Technology-related revenues and capital inflows; some other developing countries are able to stay afloat because of remittances from migrant workers; and the U.S. pulls through because of capital flows that finance its burgeoning trade deficit and make it the world's largest debtor nation.

Thus the fact that the world is awash with liquidity that can be accessed in the form of 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 does not occur. The resulting persistence in strong demand for oil has contributed to buoyancy in prices because supply too has not been responsive to price increases. Supply responses have also been slack for two reasons. First, surplus capacity in the oil-producing system is limited. Spare capacity in 2004 is estimated to have fallen to one million barrels a day (b/d), its lowest level in 20 years. This is because 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 reluctant to raise production beyond a point. Currently, Saudi Arabia pumps 9.5 million b/d into the world system and has promised consumer countries that it could raise this to 12.5 million b/d by 2009 and probably 15 million b/d eventually. But that is the maximum level they expect to get to. But if present trends continue, the global demand is expected to rise from around 30 million b/d to 50 million b/dby 2020.

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.

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.

What then are the implications of these tendencies? Clearly, if prices rise further, global growth could indeed stall. Even the otherwise optimistic International Monetary Fund (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 [gross domestic product] 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, such projections usually hinge on the perceived trade-off between growth and inflation, and are 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 will 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 U.S., 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 Organisation for Economic Cooperation and Development (OECD), net oil imports accounted for 2.4 per cent of the GDP in 1978, but have since fallen continuously, to amount to only 1 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. This means that even though energy is a universal intermediate good, its price rise does not cause prices of many other commodities - and especially the money wage - to increase accordingly. 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 one of a substantial decline in the bargaining power of workers vis-a-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 the working class, the peasantry 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 they 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-payment 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.