The Hindu Business Line : `Adjusted for inflation, oil not at all-time high'

The reality
In the current context, crude will have to average $97.50 for a month to hit Dec 1979 high.

Inflation adjusted price of oil actually declined slightly between 1946 and 1970s.
Market currently caught between inadequate transportation, maxed out production and rise in demand for oil.

Chennai , May 14

Oil prices seem headed towards $100 a barrel, which when suggested by Goldman Sachs was pooh-poohed away as a Cassandra.

Now, a barrel of crude oil is ruling above $72 and there are no indications of its receding what with the usual reasons of high global demand, especially from China and India (some projections suggest that over the next quarter of a century, world demand could soar from the current 90 million barrels a day to as much as 140 million), the low head room for raising production, or the unsustainability of new fields. And, now, the Iraq and Iran factors.

Fuel costs

The most obvious impact of oil prices on the economy is through the costs of fuel for transport, including the distribution of goods, for travel, and for heating.

With higher crude oil prices translating into costlier petrol, diesel and aviation fuel, these items can quickly push inflation upwards. Also, as crude oil is a key raw material for all sorts of products, the latter's prices will also be impacted by a costlier oil.

A rise in the price of any raw material will affect the cost structure of producers, who will tend to pass on the higher charge onto customers. Of course, they will sometimes, driven by competition, absorb the higher costs, so as not to raise prices and lose customers. But the extent to which they do this will influence the inflationary effect.

Not a very optimistic picture, yet, intriguingly, the inflation rate has largely remained stable through the economically civilised world. In a word relation game, `oil price rise' would perhaps immediately get the response, `inflation' or words to that effect. There would be a harking back to the oil shocks of the 1970s. But neither has happened.

Mr Tim McMahon, editor of Financial Trend Forecaster and InflationData.com, may have at least part of the answer.

With a chart that shows oil prices adjusted for inflation, he writes that current prices are not at their all time highs when adjusted for inflation. The real peak occurred back in 1980. Back then the monthly average price peaked at $38 a barrel (although the intra-day prices spiked much higher).

"The common price quoted is for the all-time high of oil prices is the price that the highest barrel ever sold for. That price does not really have any effect on the price consumers paid. What really matters is the average price the refineries had to pay for the whole month.

Paying less?

"Adjusted for inflation in December 2005 dollars this $38 peak (of 1980) is the equivalent of paying $97.50 today. (This number is constantly changing as we adjust for inflation at the current moment.) In other words, oil would have to average $97.50 for the entire month to be as high as the price we saw in December of 1979. But we are `only' paying about 2/3rds of that amount (at $70)."

But how did we get here? According to Mr McMahon, from 1946 until the early 1970s the nominal price of oil remained basically flat but the inflation adjusted price of oil actually declined slightly. The tremendous spike in the 1970s resulted from the Arab oil embargo and OPEC taking control of oil prices... This is what eventually resulted in OPEC gaining enough power over supplies to give the embargo teeth.

"Whenever prices are artificially held back it works like a stretched slingshot, eventually when it is released it will explode in an effort to return to the free market price causing major disruptions in the process. As the oil price adjusted to true market pricing it spiked up and has been floating freely ever since."

Similar situation

Recently, he says, forces have converged to create a similar situation. But this time it is a transportation/refinery shortage problem. "Remember the Exxon Valdez (the ship that crashed off the coast of Alaska) which spilled millions of barrels of oil all over the coast? Well believe it or not, that was the beginning of our current problem. Because of that accident and a couple of others like it, governments around the world began outlawing single hulled tankers. This created a shortage of double hulled tankers. And double hulled tankers are very expensive to build and weren't very profitable with oil at $20/barrel. So there was no rush to build them (plus they aren't built in a day even if there was a rush).

"In addition to not enough tankers, there aren't enough pipelines or refineries either. So we are caught in a crunch between inadequate transportation, maxed out production and an increase in demand for oil. Because the US and China are both coming out of a recession both countries are also demanding vast increases in oil."

Other reasons

Mr McMahon also offers other reasons for oil still being under-priced compared to the 1980s: One, interest rates are a third to half they were in the 1980s, which leaves more disposable income in the hands of people. Two, the low unemployment rates combined with high wage rates, which, he says, is pumping cash into economies. "Overall, with these other mitigating factors even if we had $100 a barrel oil today the shock would not be as severe to our economy as $38 oil was in 1979.''

Further, in the case of economies like India, the energy intensity of production has gone down dramatically, by up to 60 per cent, according to some estimates. That is, if, a decade back it took one barrel of oil equivalent to bring one tonne of tomato to the market, now it takes less than half a barrel. Also, though wages have gone up, they have not by much in real terms. This forces people to work more to earn more, setting off a virtuous cycle that helps keep inflation reined-in.

Indeed, according to a December 2005 Crisil study, the energy intensity of the manufacturing sector has declined steadily since FY-91, especially from 1998 on.

High energy intensive sectors have successfully reduced their intensity. Thus, the limited impact of rising energy prices on the production cost and profitability of the manufacturing sector.

Compiled by J. Srinivasan