Opinion

Future shocks in store

Adarsh Gopalakrishnan | Updated on March 18, 2011 Published on March 14, 2011

Mr Adarsh Gopalakrishnan   -  Bijoy Ghosh

Rising oil prices and lower supplies can have an exaggerated output impact, as consumer confidence dips. This could lead to falling output and prices.

The ongoing power struggle in Libya is estimated to have reduced crude oil supply from the beleaguered nation to a third of its 1.6 million tonnes capacity. This has sent prices of Brent crude oil up by 15 per cent in the space of three weeks to three-year-high levels.

While Libyan oil may account for only 2 per cent of daily global consumption, a deficit which idle refining capacity in Saudi Arabia can help tide over, the possibility of political unrest spilling over to other regions in the vicinity (including Saudi Arabia) has spooked investors globally.

Higher oil prices have a variety of ramifications ranging from higher inflation in import-dependent India and China to derailing consumer confidence across Europe and the US.

EFFECTS ON BUSINESS

Through his NBER working paper 16790 titled ‘ Historic Oil Shocks' ( http://www.nber.org/papers/w16790.pdf), author Mr James Hamilton has sifted through 150 years of oil supply and price data and how they relate to recessions in the business cycles. The author's basic assertion that oil shocks, or violent spikes in the price of oil, are among the major contributing causes to the slowdown in the business cycle, is backed up by empirical evidence dating back to the 1970s.

The author's major observation is that ‘‘insofar as events such as the Suez Crisis and first Persian Gulf War were not caused by US business cycle dynamics, a correlation between these events and subsequent economic downturns should be viewed as causal''.

In a similar vein, the author points out that all but one of the 11 post-War recessions were associated with an increase in the price of oil, the only exception being the recession of 1960.

The author also observes that while it may be impossible to gauge the exact magnitude of crude oil prices on economic growth,“the indicated conclusion is that oil shocks were a contributing factor in at least some post-War recessions”. The length of the recessions attributed to oil shocks range from a few months to a few years.

The author digs deep into the history of oil-well discoveries starting with the early oil wells in the US state of Pennsylvania which went bust after very short span due to over-exploitation by drillers.

He goes over several regulatory developments such as the emergence of the Texas Railroad Commission as an effective force in regulating oil prices after the Second World War.

The most interesting anecdotes were the oil-embargo imposed for six months by OPEC states in 1973 to protest US support for the Israeli military during the Yom-Kippur war. This, combined with the price control mechanisms in the US, resulted in a huge spike in oil prices.

The 1990 Iraqi occupation of Kuwait led to a similar situation with the loss of 6 per cent of the world's oil production.

However, the difference this time is the nature of uprising led by internal factions of the local populace. The possibility of a long drawn-out civil war in the region, not to mention the possible spill-over effect of civilian movements in a region dominated by monarchs, has led to anxious times globally.

Rising oil prices have an effect akin to the Keynesian multiplier effect on economic output. They amplify the costs and conversely demolish consumer confidence.

As the author notes, the production shortfall from the OPEC oil embargo in 1973-74 may have accounted for only a market value of $5.1 billion spread across the globe, the US' output declined by 2.5 per cent or $38 billion between the first quarters of the period(1974 -75).

AMPLIFIED IMPACT

“The dollar value of output lost in the recession exceeded the dollar value of the lost energy by an order of magnitude.”

One observation is that the price elasticity of oil demand is never very high in the short term. That is, a very large price increase is necessary to contain demand.

Simply put, consumers are going to cut back on a whole lot of daily spending on purchases on a long list of items before they get to oil which is seen as a ‘necessity'.

“In the five quarters following the oil price increases of 1979 and 1990, real GDP would have increased rather than fallen had there been no decline in autos,” the author adds.

Consumer confidence dented badly by higher oil prices results in discretionary spending getting deferred, which leads to curtailed demand, hurting economic growth.

UNCERTAIN FUTURE

The author also alludes to the effect of the ‘peak-oil' theory, which states that crude output from sizeable assets such as the Ghawar fields in Saudi Arabia or the Mexican fields of Cantarell will diminish in the future.

This may result in a ‘scary couple' with production remaining stagnant, few sizeable oil ‘finds' to replenish diminishing reserves and soaring demand from economies such China and India driving up oil prices. Both India and China depend on oil imports to meet 70 and 50 per cent, respectively, of their total demand.

Given the aforementioned tendency for consumers globally to bite the bullet on oil prices, consumers and governments dependent on revenue gained from taxing oil may find themselves waiting for oil producers to blink and crank up output.

In such an inertia-laden environment, history suggests that the pain of higher crude prices may actually set in long before producers choose to blink.

By this point, both oil producers and consumers may find themselves engaged in a vicious spiral of falling output only to be met with falling prices.

This is evidenced by the fall in crude oil realisations by around 40 per cent between 2008 and 2009.

Between the same period, consumption and production slipped by 1.7 and 2.6 per cent, respectively.

The author ends stating,“given the record of geopolitical instability in the Middle East, and the projected phenomenal surge in demand from the newly industrialised countries, it seems quite reasonable to expect that within the next decade we will have an additional row of data… to inform our understanding of the economic consequences of oil shocks”.

Published on March 14, 2011

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