Costly oil, slower growth

Capitalists//The good news is that GDP in the first quarter grew by 7.4 per cent, well above expectations. The bad news is that the price of crude oil has crossed $50 a barrel. Call me a pessimist, but I think the good news is ephemeral while the bad news is here to stay. Oil prices can swing crazily down as well as up. Small changes in supply and demand can mean huge swings in price. As a pessimist, I fear that upward swings are more likely. For the first time in half a century, global production is close to capacity. Saudi Arabia alone has some spare capacity, but only for heavy oil, which is not in great demand. Meanwhile, terrorists have attacked Saudi oil facilities several times. Venezuela, another major producer, suffers from civil strife. And many other oil producers suffer outright civil war (Nigeria, Angola, Sudan, Iraq). A supply shock could come from so many different points that normalcy would be abnormal.

Philip Verleger of the International Institute of Economics, a top Washington think-tank, predicts that any “shortage conditions” could send oil to $60 per barrel by mid-2005, and up to $80 per barrel by mid-2006.

That may be too pessimistic. But I do think it reasonable to expect oil prices to average at least $35 per barrel, and more probably $45 per barrel, over the next few years. That will suffice to slow India’s GDP growth sharply. Indeed, it could create a global recession. Verleger has made projections based on economic simulations published by the International Energy Agency. At an average price of $35 per barrel, GDP growth in India will slow by 1.0 per cent in 2005 and by 0.8 per cent in 2006. At $45 per barrel, India’s growth will slow by 2.2 per cent in 2005 and a huge 3.2 per cent in 2006.

Table:Impact of higher oil price on GDP growth (%)

2005/$35 2005/$45 2006/$35 2006/$45
India -1.0 -2.2 -0.8 -3.2
China -0.8 -1.8 -0.6 -2.6
OECD -0.4 -0.9 -0.3 -1.3
HIPCs -1.6 -3.6 -1.3 -5.1

The rich OECD countries will also slow down. It remains to be seen whether this pushes them into outright recession. The worst hit will be the Heavily Indebted poor Countries (HIPCs), mostly in Africa.

How is the current oil shock different from earlier ones? Mainly because of the prominent role now played by India and China. These countries accounted for a negligible part of global oil consumption in the 1970s. But both economies have grown rapidly since 1980, and both are at a very energy-intensive stage of development. Rural areas are moving from wood and cowdung to liquid fuels, and urban areas are motorising rapidly. In consequence, an increase of 1 per cent in GDP in these countries can lift oil consumption by up to 1 per cent, against just 0.2 per cent for the USA.

Between 1990 and 2003, consumption in India and China grew at an average rate of 7 per cent, against just 0.8 per cent for the rest of the world. In 1990, these two countries consumed 3.6 million barrels per day, less than 5 per cent of global consumption. By 2003, this was up to 8.7 million barrels per day, around 12 per cent of global consumption. Chinese annual consumption is projected to rise by 2.5 million barrels per day.

This is why the outlook is sombre. Demand in buoyant while supply is beset with difficulties. Till recently, global oil companies planned investment on the assumption of oil at $20 per barrel.  Some have raised this to $25 per barrel. This is still overcautious. This means it should take many years for enough new oil to be discovered and produced to bring down prices.

Western markets put pressure on oil multinationals to increase dividends and share price (through buybacks) rather than invest in fresh exploration. Despite huge profits, oil companies are investing relatively little.

This is partly because adventurous managers suffered badly in the 1990s, when oil prices trended downward. They fell to just $10 in 1998. After that, nobody invested for years in oil exploration, refining, pipelines or tankers. Today all are in short supply. So it will take some years to catch up.

Optimists say that oil is now a very small share of household consumption in the rich West. So, they argue, a global recession (caused by falling consumer demand) is unlikely till the price of oil hits $75 per barrel.

I suspect that even $50 per barrel, if sustained, will cause a recession. But if I am wrong, if oil needs to hit $75 per barrel to cause a recession, then I suspect it will indeed hit $75 per barrel. This, because we will almost certainly need a recession in the USA to bring down global consumption. There is no chance of China and India reducing their consumption. They are likely to consume more (though at a slower pace) even in a global recession.

I hope I am wrong. I hope oil suddenly pours out of new finds in Russia, and out of a resurgent Iraq. But I doubt it.

What do you think?