The Economist: The oiloholics: “Oil prices could yet go higher - unless the world's biggest gas guzzlers curb their thirst”: Saturday 27 August 2005
Oil prices could yet go higher - unless the world's biggest gas guzzlers curb their thirst
THE price of oil affects the cost of almost everything. It helps determine not just the cost of driving to work or flying off on holiday, but also the cost of furniture, food and anything else which has to be transported from factory to shop floor. The past three global recessions were all triggered by a jump in oil prices. Thus, it should be alarming that oil prices have more than tripled since late 2001. So far, though, the world economy has held up remarkably well: global GDP growth is strong and inflation remains modest. How long can this continue?
The optimists point to a host of reasons for why "this time is different" and why high oil prices will not trigger a global downturn. For example, it is claimed that in real terms, adjusted by consumer prices, oil is still cheap. Most businessmen reckon that is tosh: relative to producer-output prices, real crude oil prices are now close to a record high (see page 65). In any case, the notion that rising oil prices have no economic impact until they hit the previous peak in real terms is ridiculous.
Roll out the barrel
The main reason why high oil prices have so far not kiboshed the world economy is that cheap money has supported spending sprees and housing bubbles in many countries, notably America, which have offset the impact of dearer oil. The two main engines for the world, the United States and China (also the two biggest oil consumers), have both had their growth boosted by lax monetary conditions in the past couple of years. Indeed high oil prices can partly be seen as a consequence of low interest rates. The two most important prices in the world economy are the price of oil and the price of money, and they are linked. If interest rates are abnormally low (in bond yields as well as short-term rates), then as global demand increases in response, oil prices should rise—especially if production capacity is tight, as it is today.
So referring to the recent climb in oil prices as a "shock" is misleading. The market is simply responding to stronger oil demand on the back of a strong world economy. The increases in both global GDP and global oil consumption last year were the biggest for almost 30 years. Rising oil prices may even be read as a signal that global economic growth has been more rapid than existing output capacity can sustain. Normally, bond yields would perform that role. But the bond market has been behaving mighty oddly, with yields falling over the past year. The rising oil price is thus taking some of the job of constraining the world economy away from higher interest rates. From this point of view, a high oil price is quite healthy, a way of helping to prevent the global economy from overheating. A much more efficient solution would be tighter global monetary conditions. But tighter money now risks pushing the housing and borrowing booms into reverse, tipping economies into recession.
Moreover, even if rising oil prices are a natural market response to rising demand, they can still have nasty consequences for slower-growing economies, such as Europe's. Excessive growth in demand in America and China is, in effect, imposing a tax on others by pushing world prices higher than they would otherwise be. Even more serious, with little spare capacity in the oil industry, such rapid growth in consumption leaves the market vulnerable to any supply disruption, like those that initiated previous oil shocks.
This effect is exacerbated by the fact that the economies that are currently growing the fastest tend also to be the least efficient users of oil. To produce one dollar of GDP, emerging economies use more than twice as much oil as developed economies. Many emerging economies, including China and India, subsidise oil. Insulated from the reality of rising world prices, consumers guzzle more oil than if they had to pay full market prices. This, in turn, pushes global oil prices higher.
Such pressures are likely to grow. The IMF forecasts that over the next five years emerging economies could account for almost three-quarters of the increase in world oil demand. China has single-handedly accounted for one-third of the growth in global oil demand since 2000. With China's oil consumption per person still only one-fifteenth of that in America, it is inevitable that its energy demands will increase over the coming years if its income does too. But China's consumption is also being inflated because domestic petrol prices have not been allowed to rise as fast as crude prices. It is time for governments to scrap price controls and subsidies to allow the market's price signals to get through to consumers.
It is easy to point a finger at China's growing oil demand (which has in fact cooled off this year), but America remains the biggest consumer, using one-quarter of the world's output of the black stuff. America uses 50% more oil per dollar of GDP than the European Union, largely because consumers pay less. As petrol prices have hit $3 a gallon in some cities, there has been an outcry from motorists. Even so, petrol remains dirt cheap in America, compared with Britain or Germany where prices are above $6 a gallon. America's heavy dependence on oil not only leaves the economy more vulnerable to a supply shock, it also pushes prices higher for the rest of the world.
Time for a cure
The best long-term solution—for America as well as the world economy-would be higher petrol taxes in the United States. Alas, there is little prospect of that happening. America, unlike Europe, has preferred fuel-economy regulations to petrol taxes. But even with those it has failed abysmally. These regulations have been so abused that the oil efficiency of its vehicles has fallen to a 20-year low. This week, the Bush administration announced proposals for changing the fuel-economy rules governing trucks and sport-utility vehicles, but failed to close loopholes that allow these gas guzzlers to use more petrol than normal cars, a shameful concession to carmakers.
America and China, in their different ways, are drunk on oil consumption. The longer they put off taking the steps needed to curb their habit, the worse the headache will be. George Bush once learned that lesson about alcohol. It is time for him to wean America off oiloholism too.
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