The Hindu Business Line : Dynamics of an oil shock

Interestingly, the Federal Reserve monetary policy setting body (FOMC) had cited rising energy prices as the important reason for the softness seen in the US economy. In this article, we examine if this is a demand or supply shock and how the oil shock is likely to affect the global economy.

Even though the crude oil prices have pierced the high levels seen during the earlier oil shocks, it may still not be as severe as in the late 1970s. We have witnessed three oil shocks in the past in 1973, 1978/79, 1999/2000.

In percentage terms, the current oil shock is the smallest since 1973. If one works out inflation adjusted oil prices and compare the real oil prices, the current prices are the highest since 1986, but still around half of the real peak in 1980.

The rise in oil prices has been smaller for major industrial countries than for the US, given the general weakening of the dollar over the past couple of years. However, this year, the dollar has been broadly unchanged and the impact of the oil prices has been similar in Europe and Japan.

One reason why this oil shock would not severely slow the global economic engine is that the global dependence of oil has reduced. Efficient energy usage has reducedthe ratio of oil consumption as a percentage of the GDP.

For example, in the US, the oil consumption is now only 1.5 per cent of the GDP compared with almost 7.5 per cent of the GDP in late 1970s. Even the oil consumption as a percentage of the energy consumption has also dropped. However, one must also note that though the US economy is less energy-intensive, it also produces far less oil now and the net oil imports as a percentage of GDP is little higher now than at the time of the first oil shock. The US oil production peaked in 1973 and it has fallen now by almost 58 per cent from that peak.

There is keen interest to know how the oil shock plays itself out. High oil prices result in transfer of income from oil importing countries to oil exporters. However, the propensity to consume out of this extra income is smaller for the oil exporters than oil importers which results in weaker global demand. In OPEC and other oil producing countries, higher oil prices would result in improvement in current account and also cause windfall revenue gain. This would result in this region showing a higher GDP. However in the OECD countries and the rest of the world, higher oil prices would create negative terms of trade, higher input costs and inflation, lower tax revenues, lower real wages and current account deterioration. This results in lower non-oil demand, lower investment, higher unemployment and lower exchange rate. This region would show lower GDP.

Higher oil prices would put pressure on profit margins of companies and if they are unable to pass the higher costs on, this would discourage investment and employment. Higher oil would push up inflation and reduce real household income and affect consumption unless they perceive the high oil prices as temporary and dig into their savings to maintain spending. Wage rise could restore the real household income; however, wage price spiral looks unlikely at the moment.

How central banks respond to rise in wage inflation would also impact inflation. Hike in interest rates would hit consumer spending, but if the Governments cut interest rates or ease fiscal policy the risk of an inflation spiral developing increase. One must remember how inflation went out of hand in 1970s. If one uses statistical regression model on the demand, supply and oil price data, it seems that a one per cent increase in demand leads to 8 per cent increase in oil prices; on the other hand a one per cent increase in supply would decrease oil prices by around 5 per cent. The current increase in oil prices has both the impact of demand and supply shock. Over the last couple years oil prices have moved from $25 to $40 a barrel due to increase in demand. Asian demand has risen by 45 per cent in the past three years. The rise in oil prices from $40 to almost $50 a barrel is due to the fears of a supply shock.

Chinese demand of oil still looks robust and it is now a significant user of oil. China now consumes 8.4 per cent of the global oil production. Chinese demand is 6.9 million barrels a day, out of the 82 million barrels a day of global demand.

There are no signs yet of any wage negotiations and any significant inflation spiral in any region of the world. This would prevent the impact of the shock. One reason for lack of inflationary impact is that the global economy had been on a strong economic background. IMF estimates suggest that a permanent $15 per barrel hike would impact GDP growth rates in industrial countries by 0.6 per cent this year and 0.3 per cent next year.

One factor that can affect the oil market is if US decides to use its strategic oil reserves. The US had used this reserve in 2000. At that time it has released 30 million barrels to the oil companies in an oil swap deal.

The US had strategic reserves of around 575 million barrels at that time. Now these reserves have grown to 665 million barrels. The US oil demand is around 25 million barrels a day and this reserve represents a 26-day oil demand. At the time of the strategic oil reserve release, oil prices have crashed by $7 a barrel. The only difference now is that the US is involved in a battle in Iraq and there might be a cold winter ahead. In such a situation the release may calm the market in the short-term, but may not change the direction.

This oil shock is likely to persist and is coming at a different stage of the economic cycle (when the economic recovery is still immature). A lack of employment growth and a hit of real income growth could affect consumer confidence which can impact the economic upturn.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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