Living in a world of $200 oil

05/09/2008

Financial Times
Published: May 9 2008 19:50 | Last updated: May 9 2008 19:50
(Ed Note: Oil is now $220 a barrel)


It is about 125 years since shipping oil in wooden barrels became obsolete. An oil price above $125 a barrel, however, and speculation that the price could hit $200 are reminders that we have become ever more dependent on the black stuff. Oil is unlikely to hit $200 and remain above it any time soon – but economies would suffer if it did.

The underlying reason for oil’s tenfold price rise in less than 10 years is that demand, not least from China and India, has risen rapidly while supply has not kept pace. That dynamic is different to the supply shocks of the 1970s, but because truck drivers and commuters cannot easily stop travelling, even a small deficit in supply can cause large moves in the oil price.

Tight supply and demand have made markets volatile. The spot price of oil for immediate delivery remains above the price for delivery in future months. This suggests particular fear about short-term supplies, while there is some evidence that speculation and worried buyers laying in stocks have pushed up prices. Spot prices could surge or plunge in the short-term, but seem unlikely to return to levels that are low and stable for some time.

Expensive oil has economic effects. Net oil exporters become richer at the expense of net oil importers: Middle Eastern producers can buy more German cars, French clothes and US Treasury bonds in exchange for each barrel. Importers must buy less of everything else in order to keep up their consumption of oil.

Higher oil prices can, but need not necessarily, cause sustained inflation. A rise in the price of oil should be offset by falls in the prices of other goods for which there is now less demand. But if prices do not adjust smoothly, or if workers try to compensate for the cost of oil by demanding higher wages, it can ignite inflation.

Oil-intensive capital equipment may have to be scrapped: the useful life of all of sports utility vehicles, farm equipment and gas-fired power stations, for example, may be shortened. Such shifts cause real economic losses.

So far the world economy has shrugged off higher oil prices. So far the argument has been that, because rich countries now produce far more goods per barrel of oil than they did in the 1970s, a rise in the price does less economic damage. That is correct, but the further the price rises, the less true it becomes. The share of economic output that importing countries must spend on oil has risen dramatically.

For rich countries, the $125 oil price will be a noticeable drag on economic growth; for poor countries, when combined with higher food prices, it will mean more poverty. Oil supply should grow in response but if it does not, $200 oil is just about conceivable. It would cause serious economic disruption, international tensions and currency crises for some poor nations.