The world economy sinks or swims in the black stuff

by Larry Elliott

August is a strange month. Supposedly, the financial markets are in a state of inactivity, but in recent years that has not always been the case. Weird stuff happens, be it Saddam's invasion of Kuwait, the attempted coup against Gorbachev or the Russian debt default. This year the story is oil.
Over the past few weeks, the price of oil on the futures exchanges has crept up and up and it was nudging $ 45 a barrel. The expectation is that it may go higher.
"Fifty to $ 60 a barrel is thinkable for the first time since 1979... But so much has changed between then and now that prices might have to go even higher before demand growth slows down," said Deborah White, senior economist at SG Commodities in Paris.

There is no single explanation for why oil is currently so expensive. Strong global demand is certainly an important factor, with China's explosive growth rates putting pressure on the capacity of oil producers. There is enough crude to go round, but only just. The lack of wriggle room means any threatened disruption to the flow of oil has a rapid impact on prices, so it's not difficult to see why the shenanigans at Yukos have made oil dealers jittery. The Russian company accounts for around 1.6 mm bpd -- 2 % of global daily output -- which is similar to the increase in production that OPEC promised at the start of June.
These are the circumstances in which speculators flourish. Hedge funds attract high-rolling investors by promising to make them hefty returns on their funds, but that requires volatility. In recent months, little has been happening to stocks, bonds or currencies, so the hedge funds have been piling into the one market that has seen some action -- oil.

But speculation cannot explain everything. Some oil analysts believe that this upward move is different from those in the past. Then, the price tended to spike as a result of a shock; this time the rise has been steadier, suggesting that the rise is based more on market fundamentals rather than on war, an embargo or any other form of supply disruption. On the gloomiest scenario, we are getting an early taste of life as the oil wells run dry, which means that while the price may jag around, the long-term trend will be up.
Stephen Lewis, one of the City's most thoughtful analysts, puts it this way: "The kind of economic growth rates to which policymakers in the oil consuming countries are committed appear to be generating growth in the demand for oil well above the underlying rate of growth of supply. Higher prices should certainly act as a spur to the development of exploitable oil resources but it is not at all evident where the large oil fields will be found to replace supplies from the US, the Middle East and the North Sea, which all appear to be past their production peaks."

Lewis draws the obvious conclusions from this analysis: firstly, the west should be embarking on a serious rather than cosmetic attempt at energy conservation; secondly, those who hold out the prospect of a glittering medium-term future for the global economy are perhaps not in full possession of the facts.
Actually, the short-term prospects don't look too clever either. In the UK, this could be as good at it gets for growth, with the likelihood that a combination of dearer money and dearer energy eats into household incomes and corporate profitability over the coming months. In the US, the squeeze on real incomes caused by higher gas prices is already starting to have an impact on consumer spending.

As Andrew Oswald, economics professor at Warwick, has pointed out, each of the peaks in oil prices since the early 70s has been associated with recession in the west. There is, as Oswald has shown, a strong link between oil prices and US unemployment, and despite what some optimists say the world is still heavily dependent on the black stuff.
"People say oil is no longer important but we are now using over 80 mm bpd of the stuff for the first time. The world economy still turns on oil," Oswald says.

Consumers arethe first to feel the deflationary effects of rising crude prices at the petrol pumps, with the impact only gradually being felt on the bottom line of companies. Unemployment goes up, but only after a lag.
There are three possible scenarios for prices over the next year.
Scenario one, that they stay at around today's level of $ 45 a barrel, looks the least likely, both because the oil price is so volatile and because the high oil price affects global output and hence oil prices themselves through a feedback mechanism. If $ 50 crude prices kill off the global recovery, that will affect demand for fuel and hence its price.

Scenario two is that prices go a lot higher and stay there. This could be the result of one big shock, a terrorist attack that took out Saudi production for a prolonged period, for instance, or a series of little shocks -- a strike in Venezuela, a stand-off between President Putin and Yukos, a number of terrorist strikes on softer, residential oil compounds in the Middle East, a couple of tankers running aground -- that together are enough to push the price well over $ 50 a barrel.
While that would be a lot lower in real inflation-adjusted terms than the record levels seen at the start of the 80s ($ 80 a barrel in today's money) it would still be enough to cause severe disruption to the west, and perhaps even push some economies into full-scale recession.

Finally, scenario three is where everything works out fine. There are no more attacks in the Middle East, Yukos and Putin kiss and make up, signs of an easing in growth blow the speculative froth off the market just as the incentive of higher prices encourages supply to increase. Then, it's not impossible to envisage prices at $ 25 a barrel by this time next year.
Without question, rising oil prices add to the problems facing policymakers. The difficulty they have is that the initial impact is inflationary -- pushing up prices and costs -- while the second-round effects are deflationary -- affecting consumer incomes and corporate cash flow. What policymakers would like is for wage bargainers to take the hit from dearer oil rather than seek compensatory pay increases, and for companies to refrain from passing on their higher costs to their consumers. If they don't, the response will be higher interest rates, which will add to the deflationary impact of the oil shock and thereby increase the risk of a hard landing.

In the UK, where the labour market is relatively tight, this autumn will be crucial, because individuals are getting a double whammy from higher oil prices and higher interest rates. Little wonder, then, that some analysts think base rates could go a lot higher, to 6 % or more. That's a possibility but by no means a certainty.
The last couple of months have seen straws in the wind which suggest that consumer behaviour may be on the turn. Looking through the blizzard of wildly differing reports of the housing market, there is at least a hint that activity is slowing and that prices have -- not before time -- topped out. New car registrations have fallen in the past three months, another indication that higher interest rates are making people think twice when it comes to big ticket items.

August is a funny month. The world often looks a completely different place on a crisp September morning than it did in the heat of late July.
The assumption is that the Bank of England is intent on tightening policy over the coming months, but its decisions will depend on the data. If the data is weak, as it may be, interest rates may be close to their peak.