Royal Dutch Shell Group .com

The Guardian (UK): How high can the oil price go? And when will it start to hit us where it hurts?: “Either stock markets are celebrating the fact that the world economy has not been blown off course or they are celebrating record profits at oil companies, which make up 20% of the FTSE 100, or they think oil no longer matters. But the latter is open to question.”: Monday August 15, 2005


Ashley Seager


How high can it go and when will it start to hurt? This may sound like something the actress should ask the bishop but the question is, in fact, about oil. Black gold, as it is also known, smashed through the $66 a barrel level last week, its highest ever, and has risen 10% this month alone.


It is up more than 100% since the spring of last year, when prices were bobbling around the $30 a barrel level until the latest run-up began and carried on, and on, to where we are now.


Bizarrely, though, the world economy appears to have come through relatively unscathed, so far at least. The global downturns that followed the oil shocks of 1974, following the Yom Kippur war in 1973, and the Iranian revolution of 1979, are recorded in all the economic textbooks. One could be forgiven for deducing that global recessions follow oil shocks as night follows day.


The stock market does not read it that way, however. Last week's record highs in crude prices coincided with stock markets highs. The FTSE 100 rose to its best in nearly four years; the FTSE 250 hit an all-time high. Either stock markets are celebrating the fact that the world economy has not been blown off course or they are celebrating record profits at oil companies, which make up 20% of the FTSE 100, or they think oil no longer matters. But the latter is open to question.


What has happened in Britain since oil prices shot up is that growth has slowed sharply, consumer spending has dropped back and inflation has risen, although only to the Bank of England's target of 2%. But it is not clear to what extent this is due to oil, or the Bank's rate rises early last year, or the ending of the house price boom. Disentangling cause and effect in economics is never easy and this is a good example of it. But it would be brave to argue that a sharp increase in energy costs has had nothing to do with it.


Oil impacts on an economy in two ways: on prices and on activity. Inflation can be pushed up easily by oil. The most obvious way is through prices at the pump but the other way is that companies pass on any cost rises they suffer to customers in the form of higher prices.


In Britain little of this has happened, mainly because of the intense price pressure on the high street, which has forced firms to take the higher costs on to their bottom line. This is well illustrated by recent data on producer prices. They showed firms' input costs had jumped 13% over the past year, the highest since records began 20 years ago. Prices that firms were able to charge for their goods were only up 3%. That's a big gap and it must be hurting some companies. This is how the hit comes on activity, through company profits. Facing a big rise in costs, companies may either have to lay off workers or cut investment spending because they have less money, and so on.


So why has the British economy, and indeed others, not succumbed to the power of high oil prices so far?


There are several likely answers. One is that the industrialised economies have become much more efficient in their use of oil in recent decades, so are in theory less vulnerable to a rise in prices. Another is that oil has not, yet, risen as far as it did in 1974 or 1979. In 1974 it quadrupled to nearly $12 a barrel, whereas today it has "only" doubled. After the 1979 shock, it tripled again to over $30 a barrel, equivalent to about $80 today after allowing for inflation. So we are still not back, in real terms, to the prices we had back in 1980.


Furthermore, firms in Britain, and others countries, are enjoying a cyclical high in profits now, so are better placed to absorb higher energy prices - for a while anyway.


Consumers are aided by the fact that tax makes up three-quarters of the price of a litre of fuel, meaning the doubling of oil prices has not seen a doubling of prices at the pump. Although pump prices have set records above 90p a litre, prices are in fact up about 30%, rather than the 115% crude has risen.


In the US, though, tax is far lower, and last week the average pump prices there rose to nearly $2.40 a US gallon, equivalent to 35p a litre here. Although it's tempting to say, "the US motorist does not know he is born", from an economic point of view it matters that prices have doubled in the US because motorists there drive more than we do. So how come American consumers are still spending like mad?


Stuart Thomson of stock broker Charles Stanley reckons Americans have run down their savings to carry on spending in spite of higher petrol prices. They borrowed $55bn against the inflated values of their homes in the second quarter to keep on spending - encouraged, too, by what Thomson calls the "suicidal" recent price cuts by General Motors.


The latest oil price rise represents a tax hike of more than $70bn on the US economy, he says, and at some point that has to have an effect on the US consumer, especially as the Federal Reserve is steadily raising interest rates. "It would be extremely foolish to write off the US consumer. Homo Americanus is the most optimistic of creatures, forever given to chasing rainbows," says Thomson. What has happened in the US, however, is that people have given up buying SUVs. So there is always an upside to a rise in oil prices, namely that people may start using less. But the key reason that rising oil prices have not tipped the world into recession is, as Bank of England governor Mervyn King said last week, that the price has been driven up by soaring demand, not an interruption to supply. "It is simply not a repeat of the 1970s," he said.


World oil demand expanded at its fastest pace in 30 years last year, driven mainly by the US and China. That came at a time when there was little spare capacity in the world, particularly in oil cartel Opec. It was also driven by a lack of new refinery capacity, particularly in the US, and concerns about the stability of many countries in the Middle East. It's a very jittery market in which every piece of bad news pushes oil up and any piece of good news does not push it down.


Where's it heading? Nobody knows, really. Some experts think it's going to $100 a barrel. The oil futures market sees it staying at current levels through the winter. But it thought that last autumn, and then oil dropped rapidly. Others think it could fall fast quite soon as the US driving season ends and if the northern hemisphere winter is not too cold, thereby relieving demand for heating oil.


You only have to look at a graph of oil prices in recent years to see how volatile they can be. Fortunes have been made and lost trying to predict prices.


Vince Cable, the Liberal Democrats' Treasury spokesman and former Shell economist, reminded us on this page last week of the old adage that "high oil prices lead to low oil prices". Every price spike contains the seeds of its own doom. High prices eventually choke off demand, which pushes the price down. We may reach that point quite soon, but nobody knows. Longer term, of course, oil will run out, but we are not nearly there yet.


We had the global equity market bubble of the late 1990s, then the housing bubble of the past few years. Now we may be seeing an oil price bubble that will burst at some point. That would justify stock market optimism. But if oil goes to $80 or more and stays there we could be in real trouble, and the stock market may turn out to have been hopelessly optimistic.,,1549074,00.html


Click here for HOME PAGE

Click here to return to Royal Dutch Shell Group .com