By Andrew Mckillop

21-05-04 The US economy attained it highest-ever post-war growth of real GDP, achieving what today would be the unthinkable, and certainly impossible all-year rate of 7.5 %, in the Reagan re-election year of 1984. At the time, in dollars of 2004 corrected for inflation and purchasing power parity, the oil price range for daily traded volume crudes was $ 55-68 per-barrel.
Today, with oil prices now breaking out of the so-called “psychological barrier” of $ 40-$ 42 a barrel, US economic growth on an annual base is around 4.75 %, and both US and world oil demand is at historic highs. Despite these simple economic facts, Cheap Oil is still regarded by the uninformed, the ignorant and the biased as a passport to economic growth. Almost any fit-to-print commentator, or fit-to-pay analyst will find the place and the need to claim that “High oil prices hurt growth”.

Attempts at regime change or “democracy” by massive military invasion in the Middle East are likely to start, and also to finish with Iraq, from which no oil bonanza is either probable, or even possible given the huge spending requirement for reconstruction in a country that has been wilfully and thoroughly destroyed. Apart from Saudi Arabia and Russia, who may in fact either not want, or not be able to provide significantly more oil to the world market, there is little avail and remedy on the supply side which could immediately force down oil prices.
Upside potential for oil prices is therefore strong. In this context, real and longer-term energy adjustment strategies must be dusted off from their “antique” status, and brought forward. In other words energy conservation, transition to renewable energy, and restructuring towards a low energy economy, habitat and society. For some 18 years or so, since the oil price collapse of 1986, these real alternatives have been discarded as utopian or unworkable by political decision makers.

Without these strategies there is only one method of economic adjustment to oil prices that can now move fast to “exotic” highs under the force of geopolitical instability in the Middle East, and the “market fundamental” of ever-tightening supply/demand balances. This is by economic crisis and “demand destruction”. Economic “adjustment” through destroying demand is brought on, as a self-inflicted wound, by the so-called interest rate weapon.
The last time this was done, in 1980-83, the impact was surely to reduce oil prices (in 2004 dollars from a peak around $ 110 a barrel in late 1979 and early 1980, to around $ 60 a barrel in 1984), but the collateral economic damage was awesome. In addition, the world economy, and especially the OECD economy started from a position of growth, with balanced budgets in many countries including the USA, in 1979-80. The world economy could and did take the horse medicine of sky-high interest rates without imploding into a sequence like that of 1929-31, after which no way out from endless recession was possible.

The interest rate weapon would blow back, today
Things are very different today. No “soft landing” is currently on offer. The world economy, outside the Eurozone, is driven by intense growth in the emerging industrial superpowers of China and India (and other large population industrializing economies).
While the “Eurozone” wallows in near recession, growth of the US economy is totally dependent on extreme consumer debt, national debt (US federal deficit of around $ 500 bn for 2004-05), and all-time record trade deficits (running, also, at about $ 500 bn per year). Raising interest rates to double-digit highs, today, would likely entrain massive financial and economic crisis for the USA, and then for many other players.

Hysteria concerning oil prices is nothing new, and a return to oil prices of 1984, at about $ 60 a barrel in dollars of 2004 would do little to harm the world economy. They would in fact trigger increased growth at the “composite” world economy level within a few months, through raising world solvent demand, due to higher energy prices “trickling down”, and raising the prices of export commodities (mineral and agricultural) traded by the lowest income countries.
Extreme interest rates, today, would conversely result in near-instant economic crisis. The interest rate weapon, today, would surely entrain complete collapse of world stock markets, severe financing problems for so-called “emerging economies”, runaway domino effect bankruptcy of many major service and finance sector corporations, mass layoffs and unemployment, and grave problems for financing the structural trade deficits of especially the US and UK.

The US would expose itself to perhaps uncontrolled flight from the dollar as the interest rate weapon firstly produced stock market collapse, with inflationary recession as the likely outcome. The currently unstable but likely appreciating US dollar, subjected to “benign neglect” in its unequal struggle with the yen and euro, could in this scenario perhaps suffer uncontrollable flight and fall below EUR 0.75.
The declining petromoney status of the GB pound, as the UK inexorably shifts to again being an oil importer country, would unlikely shield the UK economy from the sequels of the interest rate weapon being used in the OECD group of economies as a blunt tool of energy policy, to force down oil demand.

The upward trend
For a number of reasons, underpinned in final analysis by the approach of the ultimate peak in world oil production capacity and output, oil prices are on an erratic, and now strongly upward trend, since their end-1998 most recent low (around $ 10 a barrel). As noted above, the interest rate weapon for reducing oil prices through entraining a so-called “soft landing” should be out of the question at this time.
Thus the “very high price of oil” that has held, off and on since 1999, with a price level that is now well above $ 35 a barrel (that is about one-half the real oil price in 1984), will likely be tolerated and accepted by economic and monetary deciders for the simple reason they have no other choice.

In addition, the supposed “inevitable recessionary impact” of high oil prices is nowhere to be seen -- what is seen and noted, every day, is the fact of record economic growth in East and South Asia, and high if unstable economic growth in the USA, increasing growth in East Europe, and rapid recovery to growth of the Russian economy.
The foolish, unjust and likely illegal military “adventure” decided by G.W. Bush in Iraq will almost certainly guarantee higher oil prices through its complete failure to bring civil peace and order, and its success in bringing further damage to Iraq’s oil producing infrastructure.

Totally unlike the world oil demand/supply context at the time of “Gulf War-1” (1991), spare production capacity is now wafer thin, and “Gulf War-2” will not spin off any Cheap Oil benefits. More likely, the “military adventure” decided by the Bush-Blair duo, will reinforce the trend to regional instability, conflict and emerging civil war throughout the Middle East region.
Finance and business commentators in 2003, in the euphoria of the “Liberation of Baghdad”, when US invading forces, with no UN mandate stormed into Iraq’s capital city, were more than rash in their oil production forecasts for “Liberated Iraq”. Some so-called “respected and informed observers”, such as D. Yergin of Cambridge Energy, went so far as to claim that Iraq could and would produce more than 10 mm bpd by 2010.

Similar and wanton exaggeration was used on Iraq’s oil reserve base, which likely does not exceed 100 bn barrels, but in the “flush of victory” was inflated to 200 bn barrels or more. Today these cheerleaders are somewhat absent from the scene. Oil production and exports from Iraq are unlikely even to recover their immediate pre-war levels, and very few are those who continue reciting the myth of Cheap Oil at perhaps $ 15 or $ 18-per-barrel as being “just around the corner”, thanks to “liberation” of Iraq.
Upward potential for oil prices is in final analysis driven by surging world oil demand. This has attained well above 80 mm bpd and the underlying rate of growth is likely close to, or above 2.25 % annual. This is far above the “long-term trend rate” of 1.3 % annual that held through about 1989-95, but which the IEA and BP Amoco, among others, have erroneously claimed as the "10-year underlying growth rate trend" for 1990-2000.
In fact, and by 1996 at latest, world oil demand growth broke out of its slow growth trend, and dramatically increased. This trend was not at all slowed or reversed by the 230 % price rise of 1998-99, and the growth rate of world oil demand has continued to amplify.

Only since late 2003 have energy and oil-watching entities and organizations begun to publish the real figures for oil demand growth in different world regions, which are well over 5 %/year for all of East and South Asia, above 4 %/year in East Europe, and probably close to 3 %/year for the USA. The net result of this is world oil demand growing at 2 mm bpd each year, close to double the rate of the early 1990s. Until December 2003, the IEA, for example, continued to claim that world oil demand growth in 2003-2004 would be “no more than 1 mm bpd”.
The special case of the US natural gas market, and US gas prices, has been remarked on several occasions by Federal Reserve chairman Greenspan, but the essential and underlying fact is: depletion. The simple fact that the US is “drilled out”, and is experiencing long-term decline in gas production (at perhaps 2 %/year) is mirrored by the emerging gas supply prospect for the European Union, but with a far higher depletion rate cutting EU-produced or “internal market” gas.

Depletion of gas production in Europe is likely running at 6 %/year. This will certainly raise gas prices and set a floor price to the price of traded oil in European markets, and erode the differential between Brent-grade, and US lighter crudes on world markets.
Through cost, geopolitical or time constraints the coming dependence on “lifeline supply” of LNG, and distant pipeline gas (for Europe), will most certainly be at “exotic” prices relative to the price levels of $ 2/mm Btu for gas and $ 18-per-barrel oil that underpinned or enabled the now long dead Clinton Boom on equity markets through 1992-2000. Inside national energy markets, led by the USA, fuel switching away from expensive gas to cheaper oil will, by “contagion effect” itself ratchet up the oil price.

During the Cheap Oil 1990s much was made of OPEC continually losing market share. With depletion particularly affecting non-OPEC producers (notably the OECD producers USA, Norway and UK) the bottom line of who holds the majority of remaining oil resources becomes the price setting factor. Close to 60 % of the world’s remaining oil is held by the Middle East “core” nations of OPEC, that is including Iraq, whose potential for production increase has effectively been sabotaged or heavily delayed by the military “adventure” of the Bush-Blair duo.
The war of communiqués between OPEC (understating both production and demand), and the big consumer nation economic and energy agencies like IEA and EIA (overstating inventories while overstating production, especially outside OPEC) can surely go on, but the degree of unreality in this now ritual game can only increase. An open shift to the Euro by more members of the cartel would by the magical irony of the oil market itself further lock-in higher oil prices.

At present the only bottom line of which we can be sure is that almost no credible scenario re-enables oil prices at the 1990s “target price” of $ 18 a barrel, or the most recent “preferred price” of $ 22-$ 28 a barrel. A new “effective price range” of about $ 45-$ 60 a barrel, that is about EUR 36-50/barrel may well arise from the current and chaotic Iraq situation as of May 2004.
In the case of generalized Middle East war, itself due to the US-UK military “adventure” in Iraq, prices well above $ 60-per-barrel will be possible. Any prolonged and further destabilization of Saudi Arabia, with an impact on its oil production and export capacities, would necessarily lead to physical rationing and abandonment of the price system as we know it.

No easy alternatives
Some analysts argue the highest-ever one-year growth of the US economy in 1984 was due to equally extreme budget deficits operated by the Reagan administration with the aim of securing Reagan’s re-election. The current Bush administration now seeks re-election of its leader, and is pouring on deficit financed spending like any good Keynesian demand-sider, but with a base of record federal and trade deficits, and hyper-debt of average households and citizens.
One major difference with 19 years ago that very few “experts” will mention is oil and other real resource prices. Only since late 2003 have non-oil real resource prices begun to move strongly upward from their 1990s lows, providing a context for reinforced economic growth at the world levels.
Oil prices at levels close to those of 1984 are probable inthe current and near-term, and in the absence of the “interest rate weapon” will almost certainly lever up world or “composite” economic growth. Whether this comes too late to save the Bush administration, through triggering a major stock exchange crisis in the run-up to the US presidential election in November 2004, is of little importance in final analysis.

In real terms oil prices are still comfortably 40 % below their levels of 1984. Real limiting factors on faster economic growth in most OECD countries include personal debt, fears of job losses, terrorism, climate change and other worries in what are essentially consumption saturated economies. There are ever fewer possible strategies for restoring conventional economic growth in the aging democracies of the OECD group.
Lower interest rates at this time, and apart from symbolic playacting with quarter-point cuts, can be discarded as any kind of rational, or even possible strategy for the simple reason that US, European and Japanese base rates are at historic lows. Most OECD countries, in 2003, have their lowest, or close to their lowest nominal (but not real) interest rates for 50 years! No further cuts in US or any other OECD country’s interest rates is now in prospect - only the level of increased world demand can play locomotive to the OECD group

Higher oil prices restore world economic growth
Higher oil prices operate to stimulate first the world economy, outside the OECD countries, and then lead to increased growth inside the OECD. This is through the income or revenue effect on oil exporter countries, and then on energy-intensive metals, minerals and agro commodity exporter countries, most of them Low Income (GNP per capita below $ 400/year).
Almost all such countries have very high marginal propensity to consume. That is any increase in revenues, due to prices of their export products increasing in line with the oil price, is very rapidly spent on purchasing manufactured goods and services of all kinds.

In the 1973-81 period, in which oil price rises before inflation were of 405 %, the New Industrial Countries of that period -- notably Taiwan, South Korea and Singapore - experienced very large and rapid increases in demand for their exports. These three countries increased their oil imports, in response to this new demand by 60 % to 80 % in volume terms through 8 years, in the 1973-81 period, and despite the 405 % price rise.
This macroeconomic mechanism of higher revenues for fast spending poorer countries quickly levering up world economic growth (the very simplest type of Keynesianism, but at the global level) is easily triggered by rising oil and real resource prices, and flatly contradicts the arguments by authorized “experts” who opine that higher oil prices “hurt poorer countries the most”.

Higher revenue earnings for many low income oil exporter countries, and also for the special case of Saudi Arabia may be the only short-term way to stop these countries falling into civil strife, insurrection or ethnic war. The period of so-called “structural adjustment”, that is enforced impoverishment applied to already poor countries through the later 1980s and the 1990s, by the IMF and World Bank, provides clear proof of how imposed austerity and deprivation leads to civil war, rather than delivering a “squeaky-clean economy”.
No immediate and instant recession can occur with oil at $ 50 or $ 60 per barrel. Vastly higher oil prices than that would be needed to abort the worldwide mechanism of higher oil, energy and real resource prices driving faster economic growth. Conversely, low oil and energy prices entraining low real resources prices, combined with rising population numbers surely aggravate the “cycle of poverty” in low income commodity exporter countries.

Deprived of sufficient revenues in the long period of cheap oil and cheap resources through the 1980s and 1990s, such countries become “basket case” indebted countries, subjected to draconian conditions by the Club of Paris, World Bank and IMF for debt refinancing and restructuring. Constant ethnic and civil war in Africa provides the best and most real example of what so-called “structural adjustment” has done to very poor countries.
Today’s New Industrial countries (NICs) include China, India, Pakistan and Brazil. All have either big or immense internal or domestic markets, and large potentials for military keynesian spending, that is safeguarding national economic growth through deficit financed and labour intensive modernization and expansion of their military systems.

The relative lack of integration of these behemoth economies in the world system, particularly India and Pakistan, also provides them with some cover or shelter from the effects of world recession, when or if the OECD countries tilt to all-out recession. Conversely, whenever an increase in world solvent demand for manufactured goods occurs, these countries will rapidly increase output.
China is now and without question the world’s leading industrial power for medium- and low-value consumer manufactured goods and will soon become the world’s single biggest industrial economy. Under almost any hypothesis, therefore, fossil energy demand -- particularly oil -- will increase in China and India, and in the other large population NICs. Demand growth can only run at rates close to, or above their rate of economic growth.

Conclusions
For various economic doctrinal and economic mythical “reasons” Cheap Oil is seen by the decision making elite in the richer nations as the “passport to economic growth”. This is a pure fantasy.
Cheap oil and energy underpin the service oriented “globalised” economy which drives the urban-industrial reference format, model and framework for economic development and social progress anyplace in the world. This in turn is a powerful motor for continued and strong demand growth for fossil energy, worldwide. Upward potential for personal consumption of fossil fuels is essentially unlimited in this context.
Physical depletion is either rejected or ignored as a price setting factor for oil and gas. Concerning oil there is mounting evidence that net additional production capacity is decreasing every year and may soon fall below the product of new capacity demand + annual lost capacity.

By 2008, and perhaps before, structural supply deficit will be a reality on world oil markets. Before that, loss of export capacity through accidents, stoppages, sabotage or war will produce recurring price “spikes”.
Conventional or classic economic growth will be enabled and facilitated at the world or “composite” level by rising oil prices, even to $ 60 a barrel and beyond. Also because of depletion, but in addition because of environment and climate limits, energy transition away from fossil fuels must and will happen. Price signals, in the existing economic system and framework, are needed if this is to start, and to build from the immediate near term. Existing and developing frameworks provide by the Kyoto Treaty offer some potential for adaptation and direction to the task and goals of energy transition.

Andrew Mckillop is Founder Member, Asian Chapter, International Association Of Energy Economists, Former Expert-Policy And Programming, Division A-Policy, Dgxvii-Energy, European Commission.